Two years, one month, and three days have passed since President Obama signed the Jumpstart Our Business Startups (JOBS) Act into law. A product of rare bipartisanship, the JOBS Act was praised on both sides of the aisle as improving access to capital for US small business, which would in turn drive economic growth. ((See House Passes Bipartisan Jobs Bill to Help Startups, Fox News (Mar. 8, 2012) http://www.foxnews.com/politics/2012/03/08/house-passes-bipartisan-jobs-bill-to-help-startups.)) While the JOBS Act has produced a steady wave of discourse regarding its potential effects, Securities and Exchange Commission (SEC) rulemaking, administrative implementation, and participation by Emerging Growth Companies (EGCs) has proved more protracted. ((See Sarah N. Lynch, Republicans Accuse SEC of Dragging Its Feet on JOBS Act, Reuters (April 11, 2013) http://www.reuters.com/article/2013/04/11/us-sec-jobsact-idUSBRE93A0JB20130411.)) As a result, questions remain regarding the extent to which companies will take advantage of the new flexibility of these provisions and the effect that the JOBS Act will have on venture capital and private equity fund activity.
This two-part blog series will assess the JOBS Act 500+ days later within the lens of venture capital and private equity. Part 1 explores three provisions of the JOBS Act with significant potential to impact venture capital and private equity activity. Part 2 presents different opinions about the potential downstream effects of these provisions and analyzes existing data to gauge the current levels of activity.
The JOBS Act remains a work in progress, subject to further rulemaking, implementation, and adoption by industry. As a result, any analysis is necessarily incomplete and any prediction will necessarily involve a set of assumptions, but recent activity provides a basis from which to draw preliminary conclusions.
As media coverage of the SEC’s proposed crowdfunding rules ((See, e.g., Andrew Ackerman, SEC Urged to Scale Back ‘Crowdfunding’ Rules, Wall St. J. (Feb. 27, 2014 3:14 PM), http://online.wsj.com/news/articles/SB10001424052702304071004579409323759964120.)) and platforms like CircleUp increase ((See, e.g., Ari Levy, Crowdfunding Sites Are Letting You Get Something New: Slice of Profits, Boston Globe (Apr. 10, 2014), http://www.bostonglobe.com/business/2014/04/09/crowdfunding-lures-investors-seeking-stock-over-freebies/Gd8kcslisrEtl7z3t7LLJN/story.html.)), the excitement of entrepreneurs and individual investors about crowdfunding is well covered. But the downstream impact of JOBS Act provisions on venture capital activity remains unclear. This blog post, which is Part 2 of 2 in a blog series that revisits the JOBS Act, presents the different potential downstream effects of these provisions on venture capital activity.
A review of the statements made by venture capitalists, platform creators, and lawyers, expressed through the media or to the author, makes clear that opinions differ significantly about how crowdfunding and venture capital will coexist. These opinions roughly fall into two categories, as described in detail below.
Venture Capital and Crowdfunding as Substitutes
One prominent opinion treats financing through crowdfunding and venture capital financing as substitutes in the market for capital. In this view, crowdfunding will act as a disruptive force in the venture capital industry, as young companies seek capital with less strings attached in the form of less concentrated ownership. ((Marielle Segarra, How Venture Capital and Crowdfunding Can Coexist, CFO.com (Apr. 24, 2013), http://ww2.cfo.com/credit-capital/2013/04/how-venture-capital-and-crowdfunding-can-coexist/))
At a macro-level, the JOBS Act provisions add to the increasing flow of money available to businesses. For example, Fred Wilson, a partner at Union Square Ventures, recently highlighted market trends that threaten the traditional venture capital model, specifically focusing on the increasing flow of money available to businesses. ((J.J. Colao, Fred Wilson and the Death of Venture Capital, Forbes (May 8, 2012 12:47 PM), http://www.forbes.com/sites/jjcolao/2012/05/08/fred-wilson-and-the-death-of-venture-capital/.)) JOBS Act provisions like crowdfunding only add to this flow of funds to companies seeking funding.
These alternative sources of fundraising also complicate the fundamental structure of venture capital funding: exits. David Lynn, a partner at Morrison & Foerster, cites the concerns of unnamed venture capital funds with securing priority position amidst complicated capital structures that can result from raising money from thousands of shareholders. ((Segarra, supra note 5.)) Crowdfunding and general solicitation also threaten venture capital exits in a potentially litigious way due to difficulty validating contributing investors. A partner at Honigman Miller recently cited the view of unnamed venture capital firms that fundraising through general solicitation and crowdfunding increases the risk of securities laws violations, which presents a grave threat to a potential share or public offering. ((Interview with David Parsigian, Partner, Honigman Miller (Nov. 23, 2013.) ))
This pessimistic view of the ability of crowdfunding and venture capital to coexist places young companies in an early dilemma. While crowdfunding can provide the capital a company needs to attract the interest of venture capital firms, that same source of funding may disqualify the company from venture capital attention because of the risks that accompany investing in a crowdfunded company.
Venture Capital and Crowdfunding as Complements
Yet, many remain hopeful that crowdfunding and traditional venture capital financing can peacefully coexist. For one, Steve Case, the AOL cofounder and chairman of Startup America, views the JOBS Act provisions as allowing companies to raise small amounts of capital through crowdsourcing without foreclosing the opportunity to raise millions through venture capital. ((Colao, supra note 6.)) For example, companies can access crowdfunding and venture financing simultaneously, with crowdfunding playing a complementary role that allows companies to raise small amounts of capital quickly. ((Segarra supra note 5.)) David Loucks, CEO of boutique investment bank Healthios, envisions a complementary relationship in which these sources of funding are used in sequence. ((Id.)) “Let’s say you have a venture capitalist who is considering an investment in a mid-stage biotechnology company. Fifteeen million is already being invested, but there’s another $5 million of capital needed,” Loucks says. ((Id.)) “Crowdfunding could be a very effective way of attracting the extra funding that enables that transaction to [close]. The company achieves its financing and the investors capitalize on the opportunity.” ((Id.)) In this view, relative investment sizes serve to mitigate capital structure concerns. Similar logic applies in the view that companies can successfully harness the power of crowdfunding to support specific late-stage initiatives. ((Id.))
With SEC final crowdfunding rules expected in October ((Ackerman, supra note 3)), early data trends about crowdfunding and venture capital activity can inform preliminary conclusions about the co-existence of crowdfunding and traditional venture capital.
By any account, crowdfunding is growing quickly. Massolution estimates a 2013 jump in online crowdfunding by 89% to $5.1 billion. ((Levy, supra note 4.)) More specifically, the Registry of Accredited Investors reports 700 companies filing under SEC Rule 506 (c), which allows regulated internet-based fundraising from accredited and non-accredited investors through approved portals. ((Registry of Accredited Investors, Registry Of Accredited Investors Announces Research Findings On Crowdfunding 506 (c) SEC Filings, Pr Newswire (Apr. 9, 2013 7:18 AM) http://www.prnewswire.com/news-releases/registry-of-accredited-investors-announces-research-findings-on-crowdfunding-506-c-sec-filings-254512521.html.)) These companies, predominantly registering in California and 80% of which had less than $1 million in annual revenue, reportedly raised $575 million in under 6 months. ((Id.))
On the venture capital side, Ernst & Young’s 2013 report on global venture capital insights and trends highlights a reduction in early stage investment and a continuing “tough exit environment.” ((Turning the Corner: Global Venture Capital Insights and Trends 2013 Ernst & Young 3 (2013), http://www.ey.com/Publication/vwLUAssets/Global_VC_insights_and_trends_report_2012/$FILE/Turning_the_corner_VC_insights_2013_LoRes.pdf.)) The report also highlights a trend in venture capital activity towards late-stage ventures, which it partly attributes to a substitution for venture capital investment in early stage companies. ((Id. at 12.))
While it is too early to draw conclusions from such a small data set, peaceful co-existence at least seems possible. As mass-based funding sources focus on early round investments and venture capital seeks late-stage investment, one can envision a rapid and orderly path to growth for early stage companies combining these sources of funding. With such a combination, early stage companies (and their legal advisers) will likely face a new iteration of old legal issues related to attracting investment, managing capital structures, and complying with securities laws.
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