We Need To Scrap the Dumb SEC Rule That Prevents Small Businesses From Raising Tiny Sums From Hundreds of…

How to start and grow companies.
Oct. 14 2011 7:18 AM

Why You Can’t Invest in My Awesome Start-Up    

The dumb SEC rule that prevents small businesses from getting “crowd-funding” from investors.

How useful is crowd funding?
How useful is crowd funding?

Photo by Stockbyte/Thinkstock.

Imagine an innovative young entrepreneur 300 years ago, looking to start an apple farm or a wheat mill or a shoe shop. How would he have gone about funding it? Perhaps he would have gone to a bank—but banks were scarcer and choosier then and mostly served the very rich. Perhaps he would have gone to a local lord, but let’s say he got turned down. Perhaps, then, he would have asked everyone in his village to chip in a bit of money in exchange for part of the business.

That very old idea is new again, now called “crowd funding.” Kickstarter has tried a version of this, enabling enterprising artists, inventors, filmmakers, and the like receive donations to launch their projects. Person-to-person micro-lending services such as Kiva and DonorsChoose are also thriving in more philanthropic areas. But now the challenge is to extend the model to all kinds of businesses. The hope is that crowd funding will give kitchen-table investors the ability to buy in to a much broader range of opportunities, and will give start-ups access to a whole new pool of capital—the money sitting in every American’s checking or savings account.

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One site that is experimenting with something like this is SlowMoney, profiled by journalist Amy Cortese in her 2010 book Locavesting. SlowMoney facilitates investment clubs that evaluate proposals from farmers and other purveyors of local agricultural goods—a goat farmer looking for a new milking system, for instance, who cannot meet her local bank’s lending standards. The clubs review the proposal and agree to invest, and usually offering small loans with low interest rates.

But true crowd funding is different, because it would enable investors to become partial owners of the business, not just lenders. Under current law, that is often illegal. A longtime Securities and Exchange Commission rule, designed to protect unsophisticated investors, limits the number of stakeholders certain private companies can have. If you hit 500, you often have to go public. That means opening your books to additional scrutiny and your business to the whims of the market. And being public is just not a feasible option for a tiny business looking for start-up funding. Thus, an artist can receive thousands of $5 donations on a site like Kickstarter, but an incorporated farmer cannot accept investments from thousands of interested small-timers.

As part of his American Jobs Act, President Barack Obama has proposed changing the rule to “responsibly” allow start-ups to gather “many small-dollar investments that add up to as much as $1 million.” Promoting the idea, the White House wrote: “Right now, entrepreneurs like these bakers and these gadget-makers are already using crowd-funding platforms to raise hundreds of thousands of dollars in pure donations—imagine the possibilities if these small-dollar donors became investors with a stake in the venture.”

That bill is now dead. But the idea has bipartisan support in Congress. The House Committee on Oversight and Government Reform held a hearing on it, and one Republican introduced a bill to change the rule. Members of Congress are starting to pester SEC officials about it. And a growing number of start-up types are getting vocal about the issue.

Indeed, one proposal to legalize crowd funding actually got crowd-funded itself. Last year, Paul Spinrad used the funding site IndieGoGo to raise money to petition the Securities and Exchange Commission to change its rules with the help of the Sustainable Economies Law Center. (He more than met his fundraising goal, by the way.) Spinrad called for a crowd-funding exemption for businesses raising money in $100 increments—little enough money that an investor getting wiped out would not potentially also lose her retirement savings.

That last part is important. Most start-ups fail. Many lose hundreds of thousands of dollars in the process of doing so. If the SEC does change the rule, it would make sense to ensure that investors cannot put too much money in, in the very, very likely scenario that the business crashes and burns. Still, the idea works in other countries—crowd funding is legal in some European countries, for instance—and properly policed, it would work here.

What kinds of businesses would most benefit from crowd funding? Anyone who can’t get money from the traditional sources, like banks, venture capital firms, credit cards, and friends and family. An enterprising organic farmer might not have strong enough books for a business loan, or rich enough friends to fork over some cash. A brilliant start-up in a dorm room in Milwaukee might not attract the attention of the Silicon Valley incubators, and its young founders might not be able to get an American Express card. Crowd funding could help both of those businesses.

That is ultimately the promise of the idea: It gives a massive pool of investors—basically everyone—access to a wide range of companies. And it gives that wide range of companies access to a massive pool of investors. Crowd sourcing has already changed philanthropy and other financial services. It seems like a good time to let it change how we invest.

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