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You Will Become a Venture Capitalist, Too

Written By Briton Ryle

Posted February 20, 2014

Seedling venture funding support growth

One of the most cherished American dreams is that any individual – regardless of creed, color, wealth or social background – can unleash their entrepreneurial spirit and build their very own business from the ground up. How far your enterprise grows is limited only by your hard work, ingenuity, creativity and perseverance. Right?

Sometimes. Depending on the complexity of your idea, there will likely exist one more limitation… money. Sure, if you have a lot of wealthy friends and family, you could pretty easily raise the money needed to get your new enterprise started. But strokes of genius don’t check people’s account balances before zapping into their brains. Poor people get brilliant ideas too, you know.

If you are a budding entrepreneur or creative artist who doesn’t have enough money to open all those doors in front of you, don’t despair. Two new laws known as JOBS Act Titles 2 and 3 are about to turn your dreams and ideas into reality by removing barriers that previously barred you from raising investment capital.

With the removal of these restrictions, there is no question that the JOBS Act will allow businesspeople and artists access to sorely needed investment capital. The question is… will it also facilitate the very fraud these restrictions were put in place to deter so many years ago?

Opening Closed Doors

The new JOBS Act is intended to loosen restrictions on soliciting funds from the public that date back to the middle of the Great Depression. With unemployment well over 25 percent, homes and farms being foreclosed upon, and businesses and banks failing across the nation, a lot of desperate people were doing everything they could to make money – including inventing false companies and selling fake shares to the general public.

In an effort to weed out the scams and better regulate the sale of legitimate company stock, the Securities Act of 1933 introduced laws prohibiting the solicitation of investment capital from the general public unless you already were a company fully registered with the Securities and Exchange Commission.

Yet the Securities Act does include a Regulation D section which grants companies an exemption from having to register with the SEC if certain requirements are met, such as when issuing less than $5 million of stock, among others. But Reg. D still prohibits “general solicitation”, barring the advertising and selling of shares to the general public.

As such, the Securities Act is one of the largest obstacles standing between cash-strapped entrepreneurs and artists and the funds to finance their business ideas or creative projects.

Fast forward to the end of the “Second Great Depression” a few years ago. In an effort to stimulate job creation and new business start-ups, President Obama and other lawmakers introduced the “Jumpstart Our Business Startups Act” (aka the “JOBS Act”), which was signed into law in April of 2012.

With that signature, a whole slew of fundraising barriers was lifted. Sine then, websites have been popping up all across cyberspace to facilitate the meeting of small businesses in need of investment capital and investors looking to get in on the ground floor of the next great startup.

One Down, One To Go

Of particular interest to entrepreneurs and artists seeking capital are JOBS Act Titles 2 and 3.

In brief, Title 2 – enacted in September of 2013 – allows private companies to sell shares of their businesses to the general public, and they can advertise or announce these sales in public media, including the web.

Yet there are some restrictions. Only “accredited” investors can invest (persons having $1 million in net worth, or earning over $200,000 a year for the past 3 years), providing written confirmation via a CPA, attorney, investment advisor, Broker-Dealer, or income-related IRS forms.

So while Title 2 opens the door to the public, it is not really general admittance. Fundraisers still need to be selective and observe strict rules governing who they are allowed to receive investments from.

Title 3, however, will tear down even that barrier, allowing private companies and start-ups to solicit everyone – accredited or not. Yet here too there are some restrictions, including investment limits where an investor of less than $100,000 net worth cannot invest more than $2,000 or 5 percent of their annual income in the same company during a 12-month period.

Due to be enacted later in 2014, possibly September, Title 3 will do more than finally bring capital funding into the 21st century. It will take a large chunk of the capital investment market out of investment banks and put it directly into the hands of ordinary people with business ideas and creative talent.

As Forbes assessed it, “Title III will begin to disrupt the entrepreneurial capital market in a more fundamental way, bringing change to the previously elite world of investment fundraising and investing in early stage businesses, which used to be the exclusive domain of the wealthy. As the market matures, we’ll see a more level playing field for everyday citizens to fundraise or invest, regardless of their personal wealth or their immediate personal connections to wealthy individuals.”

Title 3 has the potential to drastically increase the venture capital pool available to new companies – ballooning the $30 billion accredited venture capital market to as much as $300 billion simply by opening the VC market to non-accredited investors.

There’s just one little problem with Title 3 – experts are already predicting it won’t work.

Title 3 – The Door No One Will Use?

MarketWatch last month listed listed three reasons it believes Title 3 will fail:

• “Heightened control over sensitive information: Companies have to essentially report their performance to the public (via the SEC), which may be intimidating for many small companies.”

• “Higher compliance and reporting costs that in many instances require an audit.”

• “Restrictions on fundraising: Companies are restricted to raising $1 million in a 12-month period. For quality small businesses needing capital to fuel growth, this restriction is meaningful.”

The problem with Title 3 isn’t that non-accredited investors won’t invest. It’s more that companies won’t want to deal with its extra costs, disclosures and funding limitations.

Remember that Title 3 opens the door to non-accredited average investors. Companies will be required to disclose everything to these supposedly “less-sophisticated” investors, even divulging sensitive marketing strategies or trade secrets that might eliminate the company’s competitive edge while it’s still in its infancy. Companies don’t want to let too many cats out of their bags. And many won’t want to open their books to public scrutiny for the entire web community to see.

It is likely, therefore, that most young companies will continue to pursue accredited wealthy investors under Title 2, and simply give non-accredited investors under Title 3 a pass.

…Or so some experts believe. Personally, I don’t think so. Not all startups have trade secrets or other sensitive information that they’d rather not divulge.

Take chefs who want to open their own restaurants, or a group of mechanics who want to open their own co-operative shop. No secrets there they’d be unwilling to divulge. Or musicians looking to put together a new album, or production company wanting to film a new movie. Any samplings divulged are copyright protected. This list is endless of artists and entrepreneurs who are eager to tap the venture capital market, and Title 3 will be their key in opening that previously shut door.

Yet there is one other thing Title 3 might open which can become a real concern… it just might open an old can of worms we once sealed.

Reopening the Can of Worms?

The whole purpose behind all those laws and regulations prohibiting the sale of stocks and shares to the general public going as far back as 1933 was to protect inexperienced and less-wealthy investors from charlatans and fraudsters peddling worthless shares of non-existent companies.

By removing all the barriers that once protected unsophisticated investors we run the risk of coming full circle to the trickery and deception we thought had been eradicated.

Yet, here too, the concern by experts is unfounded. The truth is that even with all those protective barriers in place, the capital markets have been fraught with fraud – Enron, Tyco, Bernie Madoff and countless other businesses and businesspeople. The presence of criminal activity within the legitimate capital market did not make that market any less purposeful.

So too it will be with opening the venture capital market to unaccredited ordinary folk. Indeed, there will be cases of fraud, and many of them. But you can bet that lawmakers will be right there with one amendment after another, especially in the early years of this new marketplace for capital investment.

Indeed, the potential benefits will drastically outweigh the risks. Companies will form, business ideas will receive funding, jobs will be created, and investors will be rewarded for having stepped in while the elevator was still on the ground floor.

Joseph Cafariello