Tech Sector Pushes for Fewer Crowdfunding Restrictions

Aug. 4, 2016, 8:48 PM

By Michaela Ross, Bloomberg BNA

Tech companies are pressuring Congress to ease crowdfunding restrictions in a four-year-old law aimed at reviving U.S. entrepreneurship.

The sector was among the biggest champions of 2012’s Jumpstart Our Business Startups (JOBS) Act, a broad bill designed to meet startups’ increased need for capital. Among its provisions was a crowdfunding initiative, rolled out in May 2016, that cleared the way for the launching of online crowdfunding portals such as Wefunder Portal LLC, SI Portal LLC operating as SeedInvest and Republic, where small investors can browse curated listings of startups and invest to become shareholders in those companies.

But while many in the tech community saw equity crowdfunding as a solution to declining instances of seed funding from angel investors and venture capitalists, the law — under which the U.S.

Securities and Exchange Commission took four years to write rules — has not kept pace with fast-growing startups that demand big cash infusions in early stages.

New legislation, the “Fix Crowdfunding Act” (H.R. 4855), which the House passed last month, aims to ease restrictions on the funding vehicle to allow tech companies to bring in more money from small investors.

“This bill addresses some complaints from before the JOBS Act and tailors the processes that exist now that crowdfunding has started,” said Megan Muir, venture capital and technology company lawyer at the multinational law firm DLA Piper.

But some in the tech community are asking the Senate for higher funding limits and fewer compliance obstacles to make crowdfunding a more viable option. Tech advocacy groups such as Engine and TechNet, and trade organizations such the National Venture Capital Association, pushed for House action on the bill with letters and testimony. Those groups kept supporting the bill as it moved to the Senate as a step in the right direction for expanded access to capital for startups, but said there is more to be done to improve funding availability.

The model for crowdfunding under current law is similar to a Kickstarter campaign, although Kickstarter donors typically get sample merchandise or services — not equity in a company — in exchange for donating if fundraising targets are met. With equity crowdfunding, anyone earning less than $100,000 a year can invest up to $2,000, or 5 percent of their income, to become a private shareholder.

To be sure, tech startups, industry lawyers and advocacy groups are still uncertain that crowdfunding can ever be tailored to meet the tech industry’s needs.

Tech’s Wishlist

Since the JOBS Act passed in 2012, the average amount a tech company aims to raise in its initial seed funding round has only gone up, Minal Hasan, founder of the tech-focused venture capital firm K2 Global and a former corporate lawyer for the industry, said.

Startups now require an estimated average seed investment of $750,000 to $2 million, according to Kevin Laws, chief operating officer of AngelList, an online portal for angel investors in the tech sector. Seed funding round amounts have nearly tripled in size since 2012, with median amounts growing from $375,000 to $1 million in the first quarter of 2016, according to Tomasz Tunguz, partner at venture capital firm Redpoint Ventures, who based his calculations on data from CrunchBase Inc., a startup funding database. The increase is likely due to several factors, including the high cost of real estate in U.S. tech capitals, such as New York and Silicon Valley, and of recruiting top talent in a highly competitive industry.

Some startups, crowdfunding portals and trade groups don’t think the changes under the House bill, by Rep. Patrick McHenry (R-N.C.), go far enough. They are pushing the Senate to include higher funding limits and fewer compliance obstacles to make crowdfunding a more viable option for tech startups. It’s unclear whether the Senate will take up the measure, but supporters say it has broad, bipartisan support there.

“Now you can only raise up to $1 million, which for many companies is not enough for them to get very far,” said Muir, adding that companies producing hardware or internet-of-things technology, or who spend years in costly product research and development, would especially benefit from being able to raise more than $1 million over 12 months from crowdfunding, as current law specifies.

A provision to bring the limit up to $5 million was cut from the House bill before passage after consumer protection groups expressed concerns about investor scams.

Budding high-tech companies also want to be able to raise more money from more people before they must register as public companies with the SEC — and disclose information that could put valuable trade secrets at risk. Under current law, companies must file with the SEC once they hit 500 unaccredited investors and $25 million in asset value.

“At some point, a fast-growing company is going to hit that, and as soon as you cross that number, you’re in trouble,” said Laws, who testified in April before the House Financial Services Committee in favor of McHenry’s bill.

The measure would increase the asset limit to $75 million.

Some tech companies also want the cap on the number of investors eliminated.

“A lot of tech companies are saying, ‘We’re going to reach that limit within a short period of time’,” said Evan Engstrom, executive director at Engine, a research and advocacy foundation for tech entrepreneurs that backs McHenry’s bill but would like to see the language of the original bill restored in the Senate.

For example, a software gaming company could conceivably draw many small contributions quickly from computer gaming enthusiasts.

There are other drawbacks to crowdfunding for tech startups as well. Even if a campaign fails, for example, the cost of complying with regulations is high. Although a crowdfunding campaign can cost $50,000 to $75,000 in legal and accounting fees, a company only gets its pledged donations if it hits its targeted fundraising goal, Muir said.

Some startups, crowdfunding portals and trade groups in the tech community would like to see a test-the-waters provision added to the current bill, under which a startup could gauge interest in a crowdfunding campaign before committing to funding it.

“It’s incredibly costly for a startup to use crowdfunding,” Engstrom said. “This unduly increases the risk for companies that sort of need to role the dice on that chance of making money.”

The House bill also would require a registered investment adviser to lead a crowdfunding campaign, which is another impractical burden for the high-tech world, said Ken Nguyen, co-founder and CEO of Republic. Innovation investors who are respected and qualified to be advisers in the sector aren’t typically interested in tying themselves up with added restrictions, Muir said.

“They don’t want to be subject to regulations, they want to stay out of that world,” Muir said.

Ongoing Obstacles

It’s not clear—even if Congress passes new legislation — whether crowdfunding as a model can fully adapt to some of the tech industry’s unique challenges.

The SEC regulates disclosure and imposes funding caps in order to safeguard less sophisticated investors from a business scams. But the inherent complexity of understanding new technology may also make the high-tech sector more vulnerable to litigation, Hasan said. Investors, for example, may be tempted to sue if they think a startup misrepresented a new technology’s promise when, in reality, investors simply didn’t fully grasp its design or potential.

“Even if these bills pass, tech startups may want to exercise caution in taking advantage of equity crowdfunding,” she said.

Then there is the downside of replacing savvy angel investors or venture capitalists with everyday investors.

Professional investors can advise fledgling companies and lend the kind of legitimacy and culture capital that helps them gain respect in the high-tech world.

Still, crowdfunding represents an opportunity to democratize startup funding for tech companies founded in areas far from Silicon Valley or Boston’s concentration of angel and institutional investors, McHenry said in a House floor statement July 5.

“We have capital deserts in America,” McHenry said. “These days small businesses are struggling to find the financing and investment they need to startup, to grow, that affects jobs.”

That’s valuable because even startups closer to the nation’s high-tech and financial centers have found investors harder to come by. Angel and venture capital investors have decreased the percentage of funding deals made in early stage startups by about half in the last decade, according to the University of New Hampshire’s Center for Venture Research.

As for drawing capital from crowdfunding, companies in 2014 raised $788 million using crowdfunding in North America, and the average size of a successful campaign was $175,000, according to the SEC’s March 2015 final crowdfunding rules citing data from Massolution, a digital data company. The data includes only U.S. equity crowdfunding for accredited investors — those with an annual income of at least $200,000 or a net worth of at least $1 million — who were allowed to invest under the JOBS Act beginning in 2013. Equity crowdfunding for everyday investors was allowed once the SEC finalized its rules in May 2016.

Meanwhile, Engstrom and others plan to push for the tech community’s desired changes to the bill in the Senate.

Some bill supporters, including U.S. Rep. Kyrsten Sinema (D-Ariz.), co-founder of the Congressional Payments Technology Caucus, have cautioned that it may be difficult to pass any new legislation during the remainder of the turbulent 2016 election season.

To contact the reporter on this story: Michaela Ross in Washington atmross@bna.com

To contact the editor responsible for this story: Keith Perine atkperine@bna.com

Full text of H.R. 4855 available at:http://src.bna.com/hnC.

[Image “BLB Newsletter image (LARGE)” (src=https://bol.bna.com/wp-content/uploads/2016/06/BLB-Newsletter-image.png)]

To read more articles log in.

Learn more about a Bloomberg Law subscription.