Lots of activity in the blogosphere this week on Crowdfunding, coinciding with debate in the Senate of the so-called JOBS bill (HR3606), which contains various provisions relating to Crowdfunding. I wanted to comment on some of the different perspectives, and in particular, on a series of recent posts in one of my favorite blogs, Baseline Scenario.
In my earlier crowdfunding post, I expressed the opinion that increased regulation over the last 20 years has made it hard for small investors to access the sort of exciting early stage investments that were readily accessible in the public markets 25 years ago. And that we have replaced a system where there was relative equality of access to early stage company investments with a system where you need to be “connected” to access such investments. And I see that as a step backward, and feel the Crowdfunding legislation is a step toward remedying that inequality of opportunity.
I think these points from recent media discussion are relevant.
- This was initially a bipartisan piece of legislation. Passed in the House with only 23 Democrats opposing. The lobbying against it is coming from various other constituencies. So this is not about Democrats vs Republicans. It’s about a conflict between various vested interests.
- According to this Wall Street journal article (OK, they certainly have an axe to grind too), major lobbying is coming from groups like accounting firms that have experienced a huge bonanza in business as a result of the additional audits mandated by Sarbannes Oxley, the costs of which are a big obstacle to small companies tapping the public markets via IPO. And Unions, which according to the article also have a vested interest in the status quo.
- The SEC is against it, as seems to be the CFA Institute (Chartered Financial Analyst Institute: “The Global Association of Investment Professionals”). Now these groups make some good points about the details of the legislation. In general, the concerns seem to be about “weakening investor protection”. This is obviously an important issue. But surely the debate should be about getting the balance right between investor protection, and opening up new opportunities for investors to participate in innovative emerging growth companies (which are the ones for which “investor protection” is being changed).
“The Baseline Scenario” weighs in
What stimulated me to write this post was a series of posts from Prof. Simon Johnson of the Baseline Scenario blog over the last few days. I don’t agree at all with the opinions expressed in these posts, but before explaining why, I want to say that I have been an avid reader of the Baseline Scenario ever since I first found it in the depths of the financial crisis. Until now I have found myself in whole hearted agreement with the opinions. It’s a fabulous blog, and Prof Johnson is clearly far more qualified to opine on matters relating to economics, financial crises and the like than am I.
But, I am not so sure he appreciates the perspective of the startup entrepreneur, or the investor interested in early stage investments.
The first post is called “A colossal mistake of historic proportions: the “JOBS” bill”. Wow. That is quite a headline. I was very interested to see if Prof Johnson’s points might add to my understanding of the topic. Here are the key points of his post, as I understand them (in italics) and my comments.
- The bipartisan repeal of Glass-Steagall led to the rise of the megabanks and the 2008 financial crisis. OK.
- The JOBS bill is also about reducing regulation and thus places the US “on a bipartisan route to disaster”. Not sure I see how this follows. Is the argument that all regulation is good? And the more regulation the better? And that any time any regulation is changed it is a bad thing?
- Passing the legislation in its current form would be a “grave mistake”. Strong opinion.
- The bill is targeted at a “non-problem”, claiming that the economy is being “held back” by regulation. Prof Johnson disagrees with this tenant. I can’t comment on “the economy”. But I can certainly make the observation that the entire startup ecosystem (outside the current frothy Internet space) is being held back by the difficulty of venture investors achieving “exits” via IPO. And that the investor without inside connections is no longer able to deploy capital into early stage companies in the way they could back in the ’80’s (the period held up by Prof Johnson as superior in terms of regulation of the financial world).
- Proponents of the bill claim IPO volume is way down. But that is a function of global trends such as the decline of profitability of small business. OK. Here I am pretty sure I (and others) are right and Prof Johnson is wrong. Ask anyone familiar with the Silicon valley scene and you will hear that it is far harder now to do an IPO than back in the days before the regulatory reforms of the early 2000’s. The big reasons cited are: Sarbannes Oxley adds such large costs that you really need to be quite a large company to afford to become public (eg revenues greater than $100M). And because of changes in the regulations relating to what financial analysts are and are not allowed to do, there is a big shortage of analysts who cover small early stage companies, and thus it is very hard to get analyst coverage as a small public company, and thus hard to maintain the interests of investors, and thus a generally risky move to go public early.
- This will reduce regulatory oversight, thus leading to investors being ripped off more, thus leading to an increase in the cost of capital. This is an assertion. I am not convinced it is correct, and there does not seem to be much supporting argument. But it is certainly a concern. Perhaps a different approach would be to focus on better ways for crowdfunding platforms to be self regulating, rather than just to insist we stick with the status quo?
- Investor protection is good, and having less protection is bad. Expressed this way, how can you disagree? But isn’t the issue about balancing investor protection with the desire to allow investors to access the sort of investments available today only to the “connected few”? And anyway, I think one could make a case that regulations like Sarbannes Oxley do not add much in the way of meaningful protection for the investor in small early stage companies.
- Perhaps the worst parts of the bill are those provisions that would allow “crowd-financing” exempt from the usual Securities and Exchange Commission disclosure requirements. A new venture could raise up to $1-2 million through internet solicitations, as long as no investor puts in more than $10,000 (section 301 of HR3606). The level of disclosure would be minimal and there would be no real penalties for outright lying. There would also be no effective oversight of such stock promotion – returning us precisely to the situation that prevailed in the 1920s. I think Prof Johnson raises some important points. But I think the crowdfunding movement is about leveraging some of the new collaborative tools and crowd sourcing that have become available only recently, and that these can also be deployed to address these concerns. I would see a world where crowdfunding platforms would develop different degrees of “rules” and “oversight” and investors could choose which one to patronize based on their perceived level of risk and regulation.
- We still have too much leverage in our financial system and this bill will allow unrestricted promotion of stocks which is a major step down the path of economic self destruction. This is the “we need to protect those dumb individuals from the predatory Wall Streeters” theme. Is it the government’s job to protect us from all risk? What about people who would prefer to have opportunities to invest in small companies, and make their own risk assessment on a case by case basis for each one? Is closing off this option because we worry about a new wave of “subprime stock scandals” really the right approach?
- The legislation would also undo many parts of the 2002 Sarbanes-Oxley law, which was created in the wake of accounting scandals at the likes of Enron and WorldCom. The assumption seems to be that SarBox is good and undoing some parts of it is bad. Opinions may differ as they say. As far as I can see the proposed changes relate to smallish companies and not at all to the likes of Enron and Worldcom. There are many people who argue SarBox has been quite a bad thing for small companies and that modifying it could have big benefits. The linked to article agrees that changes are desirable, but suggests the current bill applies the “improvements” to a broader group of companies than it should. This sounds pretty reasonable, but the debate here is about the exact thresholds for various aspects of the new law, rather than about its fundamental merits.
- The proposed new rules have been crafted hastily and pushed through in a great rush – presumably because the election season is upon us. OK. May well be true.
- Security industry lobbyists are out in force. Probably. And so are the lobbyists on the other side. Not sure either of those points help understand whether or not the bill, or the more general idea of crowdfunding, is a good idea.
This was followed by “CFA Institute against the JOBS bill“, making these additional points.
- Members of the CFA Institute have an interest in getting this right and are against the JOBS bill in its current form. They think it will reduce investor protection. See comment at top.
- The Motley Fool also is against it, citing: Legalization of Wall St pump and dump schemes; Less clarity in executive compensation; weaker auditing standards. Interesting choice of “authority”.
And, today, JOBS disaster looms, reiterating some points from the prior posts in a “call to arms” against the bill, and suggesting this is somehow a Republican vs Democrats issue. As I mentioned at the beginning of this post, this seems to me more of a battle of different vested interests than a political issue.
Nanny State vs “Connected Insiders”
I think there is a very interesting disconnect going on here. A lot of people worry about the rise of a class of connected insiders who have opportunities denied to the average individual. As pointed out in my earlier post, I see the decline in the ability of a small investor to access early stage investments as an example of this, and am excited about the potential of crowd funding to move things back toward equality of opportunity. But most likely, with broader access comes some additional risk. I think people should be allowed to make that tradeoff for themselves. I think the concept of capping the crowdfunding investments at $10,000 is an attempt to cap that risk.
Now Prof Johnson has written extensively about the capture of society by the financial sector, and so I would have thought he would be sympathetic to this line of thinking. However, the emphasis in his JOBS bill posts is on the use of regulation to prevent risk for investors.
Here is another way to frame the discussion. Today in the US, we make sure “average joe” small investors do not have any risk from investing in early stage startups. We do that by making it effectively illegal for them to make such investments. However, we do allow such investments via a variety of techniques by certain well connected/affluent individuals. The current piece of legislation attempts to make it legal for everyone and not just the connected/affluent, with some attempt to cap the risk. What if we made it legal, and spent our energy debating how to give small investors the right tools to manage the risk?
Thinking about all this makes me ponder these questions:
- Is it really the job of government to eliminate risk for a segment of the population, while encouraging risk (perhaps even socializing the losses) by a segment of connected insiders?
- And if eliminating risk also reduces opportunities, how do we make that tradeoff?
I think these are interesting questions we should be debating as a society. What do you think?
Dis-intermediating the intermediaries
In my opinion, Crowdfunding is all about connecting companies that want investors, directly with investors who want to make investments, and reducing the role of the intermediaries. Of course, this is the classic dis-intermediation that has played out across many sectors of the economy in the last decade. As in examples like video rental, music sale, books, or travel agents, the new tools of the Internet age make it increasingly difficult for the Intermediary layer of the economy to get paid for their role.
The difference in the case of the investment world is that there is a set of laws and regulations that at present stand in the way of this dis-intermediation. It seems to me the JOBS bill is an attempt to reduce those obstacles and allow the disintermediation (ie call it democratization) of investment to take a few more modest steps forward.
It would be surprising if this was not resisted by the intermediaries. My read of recent history suggests the smart move would be to help fine-tune the emerging, dis-intermediated world, rather than to hope we can remain in the world we had back in the 1930’s when the current Security Laws were written. Let’s hope that is the direction the debate goes over the coming months.
- How The JOBS Act Could Change Startup Investing Forever (techcrunch.com)
- Who is protecting the investors in the new crowdfunding bills? (venturebeat.com)
- The Fight Over Crowdfunding’s Potential (businessweek.com)