By Daniel Gorfine and Ben Miller
The Jumpstart Our Business Startups (JOBS) Act, passed into law in April of this year, has the potential to help startups and small businesses raise capital through numerous, small investments from "the crowd." This widely discussed crowdfunding exemption is found in Title III of the Act. But the Act also created the possibility that the biggest benefit from the legislation will go not to the crowd, but rather to traditional investors that have long had access to the best startup and small business investment opportunities. Here's how.
Once new SEC rules are finalized, Title II of the JOBS Act allows startups and small businesses for the first time to advertise their investment offerings as long as only "accredited investors" are permitted to invest. Accredited investors are mainly corporate entities and individuals with liquid net worth of more than $1 million or an annual income greater than $200,000; the same exclusive group that the SEC allows to invest in hedge funds. By opening this pipeline, Title II may end up diverting significant crowdfunding opportunities away from the Title III "crowd," and thus create a two-tiered, less democratic investment system.
The Rule 506 Effect
To get a sense of how big a pipeline that may be, let's look at the significant capital-raising impact of Rule 506, the SEC accredited investor exemption that has proven superior to other securities registration exemptions. Even without the ability to solicit investments generally, approximately $895 billion was raised in 2011 under Rule 506, more than five times the $169.9 billion raised in global IPOs in the same year. And the estimated $2.8 billion that will be raised worldwide via crowdfunding this year is a comparative trickle.
Why is Rule 506 so popular? Because the SEC presumes that accredited investors can protect themselves and adequately detect fraud, there are far fewer disclosure and investor protection requirements as compared to the crowdfunding exemption or IPO registration. This, in turn, reduces transaction costs and limits issuer liability. Moreover, unlike with crowdfunding, there is neither a statutory cap on the amount of money a startup or small business can raise with Rule 506, nor a cap on the amount of money an accredited investor can invest.
What Does Title II Mean For the Crowd?
Once implemented, Title II will likely further increase the attractiveness of Rule 506 to startups by increasing the pool of capital available from accredited investors since companies will be able to market their investment opportunities directly to investors, and in some instances make investors aware that they qualify for accredited status. Our hunch is that many professionals and retirees are not even aware that they would be deemed "accredited" by the SEC and thus able to take advantage of the Rule 506 investment mechanism.