What the JOBS Act Means for Startup Capital
If you're not certain what the JOBS Act means to entrepreneurial companies and their ability to raise capital, read Jonathan Ortmans' most recent post on the Policy Forum Blog below. It includes a great distillation of the Act’s three-pronged approach to increasing capital for startups.
The JOBS (Jumpstart Our Business Startups) Act is one small step away from becoming law after its fast passage in Congress and President Obama has given reassurance that he will sign the bill when it gets to his desk this week (probably Thursday). The passage of the JOBS Act last Tuesday during a politically charged time is proof that entrepreneurship promotion is a bipartisan issue. As the clock moves relentlessly toward November, both sides of the aisle found common focus and set out to solve the entrepreneurial access to capital problem. The American public should be proud of how functional Washington was these past few weeks.
Last Wednesday, I had the pleasure of hosting UK Minister Mark Prisk in Washington, DC, for discussions with Hill staff and others around smart approaches to unleashing the startup potential of our nations. I recall my first meetings with Prisk, days after the UK elections when he set out to tackle everything from removing regulatory barriers to young firms to encouraging new firm hiring through a payroll tax holiday. As readers of this column know, I have credited his government with making great headway while often lamenting our own slow progress in Washington. It turns out that Prisk might have been justified in being skeptical of my pessimism. Prior to his visit, the House passed a bill helping startups and the Senate amended it. It went back to the House, passed, and is now on its way to the President.
In less than a month during an election year, the House and Senate came out with a legislative package that combines measures in six different bills to make it easier for young companies to raise money. Its key provisions create a three-pronged approach to increase capital for startups:
Enable a new form of financing by allowing startups to advertise for investment and accept capital from small investors.
By far, the biggest breakthrough of this legislation is the unleashing of crowdfunding. The JOBS Act removes a SEC regulatory ban preventing small businesses that are offering securities under Regulation D from using advertisements or solicitation to reach investors and obtain capital. Currently only "accredited investors”—limited high-net-worth individuals—can legally be exposed to such solicitation and then make investments. This bill is intended to increase the pool of potential investors for companies whose revenue does not yet make them candidates for angel or VC investment, and to reduce the amount each investor will need to contribute in order to participate. While restrictions will still exists (e.g., people with less than $100,000 in annual income cannot invests more than 5% of their income into a crowdfunded offering), the institutionalization of the crowdfunding form of startup financing is for many, including its supporter Steve Case, the former America Online executive, a step towards the “democratization of access to investment.”
Through crowdfunding, or the offering of small amounts of stock to many individuals, startups will now be able to solicit equity investments through the Internet, social media or elsewhere, and accept up to $1 million annually without being required to register the shares for public trading with the Securities and Exchange Commission (SEC). The fewer rigorous compliance requirements for startups, compared to those required by companies seeking to become publicly traded, means fewer onerous costs.
To lessen the risk of fraud, any company using crowdfunding must still file some basic information with the S.E.C., including the names of directors, officers and holders of more than 20% of the company’s shares, and a description of the business and its financial condition. Those companies seeking to raise up to $100,000 must also provide tax returns and a financial statement certified by a company principal, while those raising up to $500,000 must provide financial statements reviewed by an independent public accountant. Companies raising more than $500,000 must provide audited financial statements.
Many of the opponents of the JOBS Act fear those measures will not be enough to prevent fraud. However, the intermediaries seeking to help companies raise money through crowd-funding that will spring up and have already started to spring up, will have a strong incentive to avoid it, or else, fraud will reduce their “crowd” of investors, perhaps to inexistence. In fact, the law will require that these intermediaries register with the SEC, make sure investors are advised of the risks they are taking, and take measures to prevent fraud. Not surprisingly, the crowdfunding industry has already begun to unite behind a self-regulating organization, the so-called Crowdfund Intermediary Regulatory Association. I also remember similar fears when eBay first started and somehow technology managed to find protocols and formulas to help us protect ourselves from those set to exploit others.
Increasing the number of private shareholders young companies can have.
The JOBS Act expands the threshold of shareholders for private firms from a maximum of 500 to 2,000, before they are required to file with the SEC. This means that companies that wish to avoid registering with the SEC will be able to do so for longer, which means they will be able to grow with greater flexibility before choosing to go public or sell out to larger companies, which in turn translates into more and better innovations. This provision also means that now with several markets for the trading of shares of privately held companies we can have greater prospects for growth.
Make it easier for companies to go public.
We have long known that the compliance costs associated with SOX—particularly section 404—have been discouraging many companies from going public, thereby blocking their access to capital and growth. Substantial man-hours and other resources have since been devoted to SOX compliance (over $1 million annually in some cases). Since capital markets are out of reach for startups, entrepreneurial firms have looked elsewhere when trying to “exit,” such as selling to larger companies. And we know that this option risks killing the entrepreneurial energy that was fueling the startup’s success. Research has suggested that Congress address this issue in some way, and a measure to allow shareholders of companies with market cap below $1 billion to opt-in under SOX was one of the ideas floated in the Kauffman Foundation's Startup Act released mid-July.
The JOBS Act will finally do that. It will designate a new category of “emerging growth” companies that file for initial public offerings of stock. This new category will encompass companies with up to $1 billion in annual revenue. These companies will be exempt from certain Sarbanes-Oxley regulations governing financial disclosure and governance requirements for up to five years. Among them are requirements to hire an independent outside auditor to attest to a company’s internal financial controls, restrictions on how financial analysts can communicate with investment bankers in promoting a company’s stock, and governance requirements.
While I understand the risks of opening up these opportunities for young companies, I think that they will likely pay off in terms of innovations, jobs and increased competitiveness. Think of the many companies, and not just tech startups (which are the minority of new businesses and already enjoy the attention of VCs), that are not in the IT sector but are trying to offer cost-cutting or productivity increasing innovations in products or services, or those that are geographically at a disadvantage or not in proximity to angels and VCs. Those are some of the young companies that will likely now have more chances to grow through the new funding mechanisms, opened up through the JOBS Act.
I expect to attend a ceremony this coming Thursday where the President will sign the bill into law, but it won't take full effect until new investment rules are written by the Securities and Exchange Commission, which could extend into next year. In the meantime, our policymakers should not rest on the laurels of this unprecedented legislative victory, but rather continue to look for ways to remove other hurdles. I previously worked on Capitol Hill and this legislation should make any citizen proud of their government. A bill developed from robust research from credible sources like the Kauffman Foundation can be passed—even in an election year. This was the way our founding fathers hoped Washington would work.
After all, startups need not only money, but also networks and an enabling regulatory environment.