On March 27, 2012, Congress passed the final version of the Jumpstart Our Business Startups Act (‘JOBS Act’), aimed at increasing American job creation and economic growth by making it easier for startup companies to raise funds. As a Kauffman Foundation report posits, “Startups aren’t everything when it comes to job growth. They’re the only thing.”
The package of measures in the JOBS Act are intended to promote more initial public offerings (‘IPOs’) through provisions permitting crowdfunding, redefining the divide between “public” and “private” firms, creating a special IPO “on-ramp” for ‘emerging growth companies’, reducing restrictions on advertising of new securities offerings and permitting more analyst reports of companies undergoing an IPO. However, how much of a help are these measures to the tech entreprenuers of Silicon Valley?
One component of the JOBS Act is “crowdfunding”, which allows startups to raise funds from small investors. Under current law, only “accredited investors”, i.e. investors with a net worth of at least $1 million (exclusive of their primary residence), may generally invest in private offerings.
However, under the crowdfunding provisions of the JOBS Act, anyone may invest up to $10,000 per year, or a maximum of 10% of their net income if they earn less than $100,000 per year, in private companies. The startup may seek up to $1 million per year through crowdfunding without providing the standard public-company disclosures to the SEC or to investors. To counter concerns about possible fraud, basic personnel and financial disclosures are required, as well as an audited financial statement for firms raising more than $500,000.
While such democratization of the fundraising process is pertinent to the growth of small businesses across the US, it is unclear exactly how much it will contribute to the financing of venture-backed technology firms commonly associated with the Silicon Valley. The professional venture capital funders preferred by tech startups not only provide significant amounts of investment but are also able to contribute other tangible benefits such as connections, business advice, and partnerships with other startups in their portfolios.
Professor Bartlett, Assistant Professor of Law at UC Berkeley School, states that, “There is a practical limit on crowdfunding as tech startups often want shareholders who they know and who are not inclined to reveal proprietary information. The level of trust between the company and its shareholders may be compromised if the shareholder base is too diffuse. Many tech startups also want the ability to return to existing investors to fill their financing needs from time to time and so may prefer to continue the traditional venture capital route to do so.”
Nevertheless, he adds that, “Crowdfunding is still an attractive option for companies which are not capital-intensive, such as certain software companies, as opposed to pharmaceutical companies which would need significant investments over a long period of time.”
Some lawyers also warn that there are certain risks involved in crowdfunding, including a possible flood of securities litigation. As Antone Johnson, founder of Bottom Line Law Group, which works with early stage web and mobile startups in Silicon Valley, cautions, “If you have a system set up to sell securities to unaccredited investors, in relatively small amounts, to fund risky new ventures, that’s a gigantic flashing sign to attract the worst scumbags on Earth.”
Redefining the Divide Between Public and Private Firms
Private companies with more than 500 shareholders will no longer be forced to register with the Securities and Exchange Commission, as the JOBS Act increases the limit to 2000 shareholders. One of the benefits of staying private is the ability to target financial and strategic updates only to investors who have secured this information as an investment right. Wide reportage before being ready to go public is expensive and puts the company on an uneven playing field with possibly larger competitors, costing jobs concomitantly.
This provision signals a welcome change for Silicon Valley as it provides fundraising flexibility to popular companies that are expanding but do not possess the financial performance that the market would reward, such as Twitter. Additionally, as a result of the Sarbanes-Oxley Act of 2002 (‘SOX’), filing IPO paperwork can be prohibitively expensive for an early-stage company.
Professor Bartlett adds that, “This provision also allows companies to adopt employee compensation structures (such as the issuing of employee equity awards) that might otherwise have been avoided or altered to avoid the 500-shareholder rule.”
‘Emerging Growth Companies’
The JOBS Act creates a new category of companies titled ‘emerging growth companies’ that have less than $1 million in annual revenue or whose publicly traded shares are worth less than $750 million. Such companies would be exempt from some financial and auditing requirements for up to five years after their IPO.
For example, ‘emerging growth companies’ will be obligated to disclose less about executive compensation, two years instead of five years of audited financial statements and sidestep many of the demanding SOX directives – such as hiring an independent auditor to ensure there are proper internal controls over financial reporting.
Silicon Valley tech startups would benefit from this as it will make managing a public company less costly and give the executive team greater freedom. Forbes reports that this provision is not concerned with limiting financial disclosure as “any mature tech startup would have already been through at least several years of annual audits with accredited accounting firms.” Instead, this provision aims to remove the documented internal controls procedures and standardized reporting requirements that can be expensive and burdensome during the post-IPO “honeymoon” period.
During this delicate period, the company would be better off concentrating their efforts and funds on increasing operations, satisfying more customers and fuelling the growth on which new public investors are relying. It is these activities that will result in more assured company and job growth after going public. Further, it supports more logical and constant communication with the SEC and potential public investors within the framework of existing regulations intended to prevent the abuses of the yesteryears.
However, critics argue that loosening regulations on disclosures could expose investors to fraudulent schemes, which could lead to problems later on for companies. “The definition of ‘emerging growth company’ is so broad that it would eliminate important protections for investors in even very large companies,” Mary Shapiro, head of the Securities and Exchange Commission, wrote in a letter to Congress critical of the bill.
Moreover, Kathleen Shelton Smith, co-founder of Renaissance Capital, an IPO research firm, points out that the definition is arbitrary and would categorize 90% of all companies going public as ‘emerging growth companies’. Over the last year, key Silicon Valley IPOs such as Pandora Media and Yelp would be included, while LinkedIn would have been on the fence.
Under present regulations, private companies are only permitted to communicate about funding with accredited investors they already know. This precludes fund-raising pitches in the purview of general audiences or the media.
However, the JOBS Act removes many of the restrictions on advertising and marketing. Start-ups intent on raising money only from so-called “accredited investors” (defined to include invididuals with more than $1 million in assets or income of more than $200,000 per year) will be allowed to inform the public that they are raising money, and demo events will become more transparent. Streaming of demo events to the world will be legal and during pitches, spokespeople will allowed to explain more about where their company is and what they require.
Also, the McHenry Amendment to the JOBS Act will remove restrictions on angel networks (like AngelList) and incubators (like Y Combinator) by permitting them to post financial documents on the web about start-ups they represent. A number of platforms in Silicon Valley currently do this but their legality is questionable.
Professor Bartlett explains that “This aspect of the JOBS Act is likely to have a very significant effect on the fund-raising environment for start-ups. Such marketing combined with the enormous appetite for promising tech firms in Silicon Valley will no doubt bolster interest and increase fundraising opportunities for such companies.”
Furthermore, valuations on hot start-ups may increase as more people learn about those companies. This is a double-edged sword for traditional funding sources in Silicon Valley. It will be harder to get into a good early-stage funding deal on a hot start-up but it may also boost valuations as companies expand, which is advantageous to the early investors.
The JOBS Act will allow banks to include research analysts in the IPO process by writing reports to tout Emerging Growth Companies to investor (such reports were banned after the dot-com abuses in 1999 and 2000).
Professor Bartlett states that, “While raising a number of conflict of interest concerns, the provision will no doubt aid in the marketing of a technology firm’s IPO, which should make the IPO process less daunting for Silicon Valley startups than has been the case in recent years.”
In order for Silicon Valley to continue to be the awe-inspiring technological growth engine of the world, the need to regulate and report must be balanced with the need to promote job creation. The passing of the JOBS Act by Congress is proof that this message is being heard on Capitol Hill, though only time will reveal the true effectiveness of these measures in the US in general and in Silicon Valley in particular.
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