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July 23, 2013 9:38 AM Whatever happened to the “crowd” in crowdfunding?

By Daniel Gorfine

The Securities and Exchange Commission recently generated a buzz in the investment world when it voted to lift a nearly 80 year-old ban on advertising private debt and equity offerings to the general public. The SEC voted to allow “general solicitation” so long as the ultimate buyers are “accredited investors” wealthy enough in the SEC’s eyes to be presumed sophisticated and capable of withstanding investment losses.

Starting this September, start-up companies, small businesses, and even hedge funds or private equity firms will be able to advertise investment opportunities publicly, including through internet ads, Facebook, and Twitter. Many companies will also likely rely on web-based investment platforms that will help to advertise offerings, verify the “accredited status” of investors, and facilitate standardized stock and bond sales. In theory, the result should be greater and more efficient access to capital for cash-starved start-ups and new investment opportunities for investors.

If this sounds like what “crowdfunding” was meant to do for the general public, you’re right—except the missing ingredient is the “crowd.”

When Congress passed the JOBS Act in 2012, its aim was in part to increase access to capital for start-ups and small businesses. The idea was to expand both the avenues companies could use to find new investors and the pools of investors allowed to invest in a company without it bearing the cost of “going public.” This was considered all the more necessary given sharp reductions in small company IPOs. SEC research notes that the number of IPOs dropped from an average of 165 per year from 1980-2000 to 30 IPOs per year from 2001-2009.

The law tackled this problem from several directions, including by ending the ban on public solicitation to wealthy investors (which is what the SEC acted on in early July) and by including provisions to legalize public securities crowdfunding or “crowd investing.” The crowd investing provisions, which received the most public attention, would allow companies to sell small debt or equity offerings to the general public, so long as they met the law’s requirements for what to tell investors, abided by caps on how much one person could invest, and used either a broker-dealer investment platform or a newly created non-broker-dealer “funding portal” similar to Kickstarter or Indiegogo.

It’s important to note that the SEC’s recent action only addressed the sections of the law dealing with wealthy investors, not crowd investing. In fact, more than six months past its Congressional deadline to act, the SEC has still failed to even propose the regulations necessary to implement the crowd investing portions of the law. Some of this delay admittedly is due to the difficulties inherent in trying to introduce proper investor protections and education for less experienced crowd investors. But where does this leave crowdfunding now that accredited investors are getting the first shot at utilizing 21st century technologies to connect with and invest in companies, and with far fewer regulatory restrictions than those required for the crowd?

First, the accredited investor model and the investment platforms developing in this space will get a “first mover” advantage over the crowd investing model. Many of the entrepreneurs who began developing online investment platforms had already started to target accredited investors instead of the crowd once it became clear that the SEC was more likely to implement that portion of the JOBS Act first. Engaging with these investors was already permitted, so long as investment opportunities were not mass marketed. These platforms have accordingly been developing an established base of wealthy investors who were already able to review private offerings behind an internet firewall - a wall that is now removed by the lifting of the general solicitation ban.

Second, in lifting the ban on general solicitation, the SEC also confirmed that companies offering investment opportunities to accredited investors will have much greater marketing flexibility than those engaging the crowd. The SEC chose not to limit or direct the way companies will be allowed to mass market private offerings to wealthy investors, whether through the internet or social media. In contrast, Congress mandated that companies looking to raise money through public crowdfunding will only be allowed to post public notices that direct potential investors to funding platforms. They are not permitted to mass market directly or advertise details about a specific investment opportunity.

Finally, it is uncertain whether the crowd will benefit from crowdfunding investment platforms in the same way that wealthy investors do. As we have already seen in the marketplace, many accredited investor platforms have or will register as a “broker-dealer,” or partner with one. Broker-dealers are attracted to the accredited investor space because investment offering sizes are not capped and large generated fees can cover ongoing regulatory compliance costs. A broker-dealer has the freedom to screen potential company offerings and present key information to investors, such as a credit score or rating on a debt offering.

Platforms focused on the crowd, however, may not find it economical to register as broker-dealers due to the small-size of the transactions and small generated fees. If that proves to be the case, then the crowd could be left with non-broker-dealer funding portals to serve as intermediaries - not necessarily a bad outcome though heavily contingent on what the SEC permits these portals to do. Depending on SEC rules, funding portals could be limited in their ability to screen company offerings or offer helpful investment information to investors due to a congressional prohibition on providing “investment advice or recommendations.” Ironically, the crowd could be left with fewer tools to make sound investment decisions than accredited investors.

Given these considerations, many startups and small businesses may opt to seek capital from accredited investors rather than the crowd. The ability to raise significant funds from fewer investors, through less restrictive general solicitation, and on more robust broker-dealer platforms will prove compelling for many. This is not to say that crowd investing is not the better option for many ventures, especially those looking to develop broad and local public support, but the first mover and potential regulatory advantages of accredited investor platforms cannot be overlooked.

Ultimately, the SEC’s delay in allowing crowd investing to go live and the potential for it to restrict the permitted activities of issuers and funding portals could put crowd investors at a disadvantage to accredited investors. That said, the final rules on funding portals will likely be driven at least in part by the near-term outcomes of what happens with accredited investors and their investment platforms. Perhaps this was the SEC’s plan all along - experiment with accredited investors before opening the market to less-experienced crowd investors, notwithstanding such a strategy’s effect on marketplace development and democratization.

In any event, the crowd will have to wait.

Daniel Gorfine is the Washington-based Director of Financial Markets Policy & Legal Counsel for the Milken Institute.