William Carleton, Counselor @ Law

Crowdfunding and Local Investing

For those, like me, who approach the crowdfunding exemption under the JOBS Act from the background where startup investing is the exclusive province of angels and venture capitalists, it can be difficult to sort out, not only the prospective utility of equity crowdfunding, but the audience for it.

Seeking correctives, I borrowed two books I have learned about during the course of following the original McHenry crowdfunding bill, through its successive iterations, winding up with the cynical bait and switch of the Merkley/Brown bill. These books are: Amy Cortese's "Locavesting: The Revolution in Local Investing, and How to Profit From It," and Michael Shuman's, "Local Dollars, Local Sense: How to Shift Your Money from Wall Street to Main Street and Achieve Real Prosperity."

(Fun aside: I got to meet Amy and Michael in person at a celebratory gathering of crowdfunding advocates after President Obama signed the JOBS Act in early April. Here is a picture from that event, of Amy Cortese, Jenny Kassen and Kevin Lawton acknowledging Michael Schuman (behind the camera).)

Amy and Michael are both thought leaders for the cause of democratizing investing. That is to say, although they were not (to my knowledge) among the forefront of the activists parsing legislative language with the staffs of Rep. McHenry, Sens. Brown and Merkley, and the White House; and although they are not (to my knowledge) among the nascent crowdfunding industry organizers setting up an SRO and meeting with SEC staff about rulemaking to implement the JOBS Act equity crowdfunding exemption; both have written, spoken and organized on the topic of how the securities laws end up serving the interests of the 1% and large, corporate issuers, at the expense of entrepreurs and the health and vitality of local economies.

I would surmise that Amy and Michael each maintain a keen interest in the current legislation and the upcoming rulemaking, although they also retain a perspective that won't assume the cause will stop with this initial federal experiment.

Because the cause is more broadly concerned with how money cycles through local economies - and about measuring the value of goods and services that re-capture or account for some of the externalities that don't get measured when economic activity is looked at from the perspective of global trade - the federal equity crowdfunding exemption now in the works can't be the only policy redress for how local entrepreneurs access local capital. (The answer will require reform at state levels, too?)

Here's an excerpt from Shuman's book, in a chapter that suggests that securities laws and regulators might do more to truly protect investors, and less to serve the interests larger issuers have in keeping upstarts out of the game, were investor protection modeled after consumer protection, rather than a licensing paradigm:

"Down the rabbit hole of securities law is a jabberwocky of regulations that allows the rich to get richer, while the Red Queen screams 'off with their heads' to any unaccredited investors who dared to have tea with small businesses. Only a Mad Hatter could insist that the least powerful businesses in society dole out a small fortune to attorneys before they even can knock at the doors of potential investors, including accredited investors. . . .

"If we applied the logic of securities law to consumer goods, commerce as we know it would come to a grinding halt. . . ."

" . . . [F]ederal and state laws do impose lots of requirements on the producers, distributors, and sellers of goods in the United States, and much of our political wrangling is over what's a sensible level of regulation. . . . But notice the main difference from securities law. In the consumer context, freedom to engage in commerce is presumed. Small companies have permission to get started, to sell products and services to anyone, and to advertise anywhere. In securities law, the presumption is against selling shares to investors until permission is granted."

The equity crowdfunding exemption under the JOBS Act may be a first step, but it does not shift securities law to a consumer protection paradigm.

Seattle's "First Hill" Neighborhood

My fiance and I took a walking tour Thursday of the First Hill neighborhood in Seattle. The tour was led by Larry Kreisman of Historic Seattle.

First Hill is now known for its huge complex of hospitals, including Swedish and Virginia Mason. But the point of the tour was to call up the residential character of the neighborhood from the early part of the 20th century.

"Residential" at that time meant mansions and grand, single family dwellings, for sure. But "residential" also meant substantial, multi-story, brick apartment houses that gave certain busy thoroughfares, such as Boren Avenue, aesthetic cohesion. (Here we're talking Boren Ave. after it bends and climbs Capitol Hill, not the flatter Boren that helps define the currently booming South Lake Union area.)

The ugly, oversized, anonymous hospital buildings that have gone up, such as this one blocking Terry Avenue, really belong on some eastside campus.

I know the hospitals do great work and contribute significantly to the quality of life in Seattle. If they have to be so big and ugly, however, and so cheaply built, it's a shame they can't be buried underground. Remove the hospitals, and First Hill is an attractive neighborhood. Just a 10 minute walk up the hill from downtown.

Facebook's Pricing

Facebook's S-1 has gone effective and its shares have started trading today.

The latest draft of its IPO prospectus has the following new verbiage, appropos to how the initial public offering price was determined.

Not all that insightful, though it is interesting to see the company grappling with the reality of the private secondary trading in Facebook stock that has occured well into this year.

News item: "Crowd funding warning from Washington and the SEC"

Here's an audio file of a three minute news story from 97.3 KIRO FM Anchor Kim Shepard that ran yesterday in Seattle. (Written version here.) The hook is: regulators warn it is too early to start equity crowdfunding.

Http-__icestream.bonnint.net_seattle_kiro_2012_05_c_kironews051512_9941700

As part of the story, I had a chance to explain what equity crowdfunding is supposed to be, how angel investors feel about it, and some new things I am learning about what motivates many equity crowdfunding proponents.

I didn't realize it at the time of the interview, but the story also features Bill Beatty, the Securities Administrator for Washington State.

If you build a funding portal, will they come?

The crowdfunding exemption of the JOBS Act contemplates three moving parts: companies raising up to $1 million a year; individuals investing from a limited annual budget; and brokers or funding portals, deputized to police the activity.

A lot of smart, ambitious and idealistic people are working on the funding portal leg of the stool. In fact, many are deeply engaged in building organizations for the nascent industry.

But if you build it, if you write the code to run a funding portal, anticipating you will register and be ready when the exemption becomes effective: what kind of companies and investors will show up?

On Asher Bearman's and Trent Dyke's DLA Piper blog, Andrew Ledbetter has an audaciously unsentimental assessment of why a tech startup with high growth ambition won't want to use the equity crowdfunding exemption. Here are excerpts of just three from among ten compelling reasons Andrew lists:

• "An acquirer will be unable to buy the company using acquirer securities as consideration, since the acquirer would likely not have a viable exemption for issuing those securities to the target’s crowdfunded investors."
• "The JOBS Act exemption provides that investors can sue to get their money back (with statutory interest) if the company’s disclosure to investors is inadequate. Giving adequate securities law disclosure is complicated, and the types of companies using crowdfunding may not be in a position to spend money on securities lawyers."
• "The diligence issues associated with confirming securities law compliance in prior crowdfunding deals could be extensive. VC funds or other institutional investors may not be willing to incur those costs, or to risk bankrolling suits by crowdfunded investors."

Taking a view from the investor-protection side, the North American Securities Administrators Association (NASAA) has published a warning to the general public (thanks @JoeWallin for tweeting this). Among the reasons in NASAA's case that equity crowdfunding should be unattractive to investors:

• "The information about the investment is limited to what is provided through the funding portal. Investors may need to rely on their own research to determine the issuer’s track record."
• "Due to limited regulatory oversight over these offerings, investors may be left on their own to pursue costly private lawsuits when things go wrong."
• "Crowdfunding investments are mostly illiquid and investors must be prepared to hold their investments indefinitely.  It also may be difficult or impossible to resell these securities due to the lack of a secondary market."

Neither Andrew nor the NASAA warning are assessing equity crowdfunding from the perspective of the funding portal, of course. Those with ambitions to run equity crowdfunding portals include activists who want to liberate entreprenuers from the frustrations of how access to capital is "gated." Others are motivated by longstanding desires to build local community exchanges and advance the "local" movement (eat food grown locally; patronize local businesses that aren't chains; reallocate some of your 401(k) money into local businesses you can see, touch and patronize.)

Andrew and NASAA also do not raise the provocative possibility that crowdfunding dollars may go where banks, private equity funds, venture capitalists and angel investors fear to tread: big, bold, long term projects of fundamenal societal import that simply won't be attractive if ROI in the near term runs the agenda. Credit Fred Wilson for calling out this vision. We know non-equity crowdfunding works; it could be that adding an equity spoke to the crowdfunding wheel will help make that proven concept effective at big projects as well as small ones.

It's all in motion.

Photo by manyhighways / Flickr.

Signed Laws & Rules Around the Corner

One way to remind ourselves how much is at stake in JOBS Act rulemaking - even though the JOBS Act itself has already passed - is to remember what happened to the net worth standard under the accredited investor definition of Regulation D, following the passage of Dodd-Frank.

Two years ago, Section 413 of Dodd-Frank changed the accredited investor net worth standard, mandating that "during the 4-year period that begins on the date of enactment of this Act, any net worth standard shall be $1,000,000, excluding the value of the primary residence of [a] natural person."

This is how "excluding the value of the primary residence" was expressed in a subsequent SEC rule:

" . . .for purposes of calculating net worth . . . :

"(A) The person's primary residence shall not be included as an asset;

"(B) Indebtedness that is secured by the person's primary residence, up to the estimated fair market value of the primary residence at the time of the sale of securities, shall not be included as a liability (except that if the amount of such indebtedness outstanding at the time of sale of securities exceeds the amount outstanding 60 days before such time, other than as a result of the acquisition of the primary residence, the amount of such excess shall be included as a liability); and

"(C) Indebtedness that is secured by the person's primary residence in excess of the estimated fair market value of the primary residence at the time of the sale of securities shall be included as a liability;"

It took me several days to come to terms with the reality that the rule was not going to let you simply take the principal residence out of the equation. No, the rule says something quite different: ding yourself for an underwater mortgage (even if you live in a state that says you can't be liable for the deficiency), and also ding yourself for any home equity line of credit you draw upon within 60 days of investing in a startup, regardless of how much equity you might have in the property.

Where again was that last bit in Dodd-Frank? That's right, it wasn't there.

All levity aside, entrepreneurs and the angel community should keep a close eye on upcoming rulemaking to implement Article II of the JOBS Act. Article II, a/k/a Section 201, is the provision that (a) lifts the prohibition on general solicitation and general advertising for a Rule 506 offering, as long as all of the purchasers in the offering end up being accredited, and (b) provides a safe harbor for online platforms and incubators that facilitate angel investment. Unlike Section 413 of Dodd-Frank, Article II of the JOBS Act affirmatively asks the SEC to fill in a number of blanks, so expect the proposed rules to be longer and more complicated.

Photo: Just around the corner, by Mathias Heinel / Flickr.

Ads by default

Commenting on Saturday's post on GeekWire, Jake Ludington asked, "I'm curious what you would propose as an alternative to advertising for Facebook's mobile revenue strategy?"

I couldn't really answer the question because I don't know.

Intuitively, I feel that monteziation might well involve the social recommendation aspect that Facebook COO Sheryl Sandberg talked about in the Facebook IPO roadshow video, excerpts of which I transcribed and quoted in yesterday's post.

But the "recommendations" could be negative as well as positive. Negative reviews of the sort that advertisers would just as soon suppress.

There would still be a corporate market interested in paying for this activity. More precisely, for the data. Brand managers would still want to know what people were saying, even if they couldn't game the dissemination of truly authentic reaction. I think it would be fine if "brands" interacted, but the rule should be the same: a brand manager must use his real name; he must earn post ranking the way everyone else does.

A quote from the video I pulled for my response to Jake on the GeekWire post, but didn't include in yesterday's post along with the Sandberg quotes, is from Mark Zuckerberg himself.

"When I was in college, I wasn't actually starting Facebook to be a business, back then. I rented servers for about $80 a month and, I didn't have that much money - I was just a college student - so I put up ads, and when I had enough money to get another server, I would do that. So, ads, you know, have always been this really important part of what we do because we want to keep Facebook free for everyone."

It's a great quote, because he candidly allows that Facebook backed into serving advertising by default. It was an early way to cover server costs. It was not part of a long-term business vision.