The Wisdom of the Crowd: Social Networking Meets Capital Formation
Last year I had a chance to visit Washington D.C. and tour the Washington Monument. I later learned that this magnificent national icon was, in fact, an early example of crowd funding. Crowd funding is the process of aggregating small amounts of money from a large number of people in order to accomplish great things.
It turns out that the construction of Washington Monument was crowd funded by small contributions from individuals across the country. Fund-raisers even placed donation boxes (like the one in the photo) next to ballot boxes on election day in 1860, when voters chose Illinois congressman Abraham Lincoln as president.
Leveraging the power of crowds is not a new concept. The quest to find a vaccine for polio was a “march of dimes,” and we’re all familiar with the fundraising “thermometer” technique used by many nonprofits to raise money for a particular cause or goal.
However, the Securities Act of 1933 and the Exchange Act of 1934 introduced significant regulation to large scale collective fundraising activities. While donations were excluded from regulation, investments in debt and equity securities became subject to the purview of the Securities and Exchange Commission (SEC).
I have worked on numerous public company audits and can attest to the extensive SEC compliance requirements. While these regulations provide significant safeguards to prevent fraud and increase marketplace integrity, they also have the unintended consequence of limiting capital formation options for smaller companies, including startups developing innovative technologies. In other words, you’re not going to spend $2 million dollars on legal and accounting fees if your startup is trying to raise $1 million for an equity offering.
The SEC does have several safe harbors that provide exemptions from securities registration. However, most of these exemptions become invalid once “general solicitation” (i.e. public advertising) occurs. Of course, the dawn of social media and massive connectivity tools was never anticipated in the early 1930’s when the SEC rules were established.
On November 3rd, the House of Representatives passed the “Entrepreneur Access to Capital Act” (HR 2930). The bill, authored by Representative Patrick McHenry (R-N.C.), enjoyed widespread bipartisan support, along with backing from the White House (a .pdf file declaring the President’s support is here.) It passed easily by a vote of 407 – 17. HR 2930 provides a crowd funding exemption from SEC registration with a few caveats:
—A $10,000 limit per investor (or 10 percent of annual income, whichever is less).
—A cap on the amount a company can raise of $1 million per offering (and up to $2 million if audited financial statements are provided).
—No limit on the number of accredited or unaccredited investors.
With startup companies struggling to raise funds and the capital markets still reeling from the banking crisis of 2008, the advent of crowd funding may well find a welcome home in business plans throughout the U.S. This new capital formation pathway needs to be balanced with safeguards to prevent fraud and protect the investing public. Thankfully, newer (and crowd-based) tools to monitor online reputations are emerging. Either way, the potential to unleash untold numbers of new ventures is certainly exciting for would-be entrepreneurs. Up next for crowd funding—the U.S. Senate.