The JOBS Act and middle-income investors: why it doesn't go far enough.

• Author: Williamson, James J.
• Position: Jumpstart Our Business Startups Act

The 2008 recession sparked broad calls for tighter financial regulation. (1) Yet, at the same time, small businesses and entrepreneurs lobbied to loosen restrictions on the funding of start-ups. (2) Frustrated by stagnant credit markets and limited access to capital, advocates pushed for reforms that would ease restrictions on investment and thereby encourage economic growth and job creation. (3) The result--the 2022 Jumpstart Our Business Startups (JOBS) Act--allows small businesses to raise capital through "crowdfunding," the acquisition of small amounts of money from a large number of investors, for the first time. (4) One of the Act's key provisions, the so-called "crowdfunding exemption," will allow start-ups to obtain investment from a broad spectrum of investors without the cumbersome and expensive SEC registration requirements normally demanded of public equity issuers. (5) Lawmakers and commentators alike have hailed the potential of the JOBS Act to increase the flow of funding to start-ups, (6) while offering middle-class investors financial opportunities previously available only to the wealthy. But, unfortunately, the Act contains a critical shortcoming that will limit the ability of middle-income investors to take advantage of these new opportunities. Because most scholarly commentary on the JOBS Act has focused on the possibility of fraud under the crowdfunding exemption, (7) it has largely overlooked the potential benefits available to investors and the harmful effects of a flaw in the Act that prevents diversification. This Comment addresses this omission.

Part I describes the landscape of early-stage investing and SEC regulations limiting this practice to wealthy investors. It also discusses how the JOBS Act loosens those restrictions. Part II considers the failures of the JOBS Act and argues that its bar on investment funds will prevent diversification and keep middle-class investors from taking advantage of the benefits of the Act. Finally, Part III explores the legislative history of the JOBS Act and shows that the provisions excluding investment funds cannot be justified by legislative purpose or existing policy rationales. Overall, this Comment argues that because of these defects, the individuals who are supposed to be among the intended beneficiaries of the Act will be blocked from realizing its benefits.

1. EARLY-STAGE INVESTING AND THE JOBS ACT

   The JOBS Act was designed to allow a wider class of Americans to invest in start-ups. Start-up investing, referred to as "venture capital," offers the potential for exceptional returns, as investors provide risky early financing to young businesses that appear ripe to grow quickly. (8) Some venture capitalists focus on the most turbulent and potentially most profitable part of the market by investing in extremely young companies, a practice typically referred to as "angel funding," and its providers as "angels." (9)

   The Securities Act of 1933 severely restricted how all companies, including these early-stage ventures, could raise funds. The 1933 Act prohibited any offering or public sale of a security unless it was registered with the SEC or satisfied one of the statutory exemptions to the registration requirements. (10) Registration is expensive and time-consuming, thus effectively requiring smaller, growing firms to rely on an exemption in order to raise capital. (11) Several important exemptions allow "private sales" (12) to wealthy "accredited investors" without registration. (13) An individual can qualify for accredited investor status by acquiring a net worth of $1 million or earning an annual salary over $200,000. (14) This exemption allows wealthy venture capitalists to angel invest, while also barring middle-class investors. Thus, before the JOBS Act, small companies seeking to avoid expensive SEC registration could generally seek funding only from wealthy investors who learned of the start-up in a private sale, that is, through a close-knit network. (15)

   To broaden their funding base beyond the traditional angel network, some start-up companies began to seek ways to skirt the regulations of the 1933 Act. Companies explored various methods for crowdsourcing capital online without violating SEC rules. The two most common avenues were to seek advance product sales, as with the online portal Kickstarter, (16) or to use certain types of debt. (17) Both strategies, however, proved to be unworkable for most companies. Advanced sales platforms are used to sell products, not to fund abstract research or development, (18) and debt often requires scheduled interest payments, which are difficult for a cash-poor start-up to make. (19) Although some entrepreneurs did attempt to use online crowdsourcing tools to raise equity, (20) the SEC's definition of security was so broad as to implicate virtually any mechanism where a purchaser shares in the profitability of the enterprise, thus triggering the registration requirements. (21) True equity investments would allow small businesses the chance to achieve a broader funding base, but they remained blocked by the 1933 Act's restrictions.

   In 2012, the JOBS Act amended the Securities Act of 1933 to finally allow for crowdfunded equity. Specifically, the JOBS Act created a new class of "emerging" companies (22) that could engage in crowdfunding while remaining exempt from registration requirements. This crowdfunding exemption--section 302 of the JOBS Act--allows emerging companies to raise up to a total of $1 million annually from individuals who do not meet the "accredited investor" threshold. (23) As a check on fraud, the amount that companies can raise is limited by the quality of their financial controls. For example, the full $1 million is available to companies only if their financial statements are audited by an independent public accountant, (24) whereas a company may raise under $100,000 by providing little more than an income tax statement and unaudited financials. (25) Similarly, the Act established limits for investors as well. Investors may devote only up to five or ten percent of their income, depending on whether they earned more than $100,000 in the previous year. (26) Furthermore, all investments must take place under the aegis of an approved broker or online portal. (27) Within these guidelines, anyone--not just wealthy, accredited individuals--can invest in the equity of start-ups. By increasing access to venture capital investing, the JOBS Act appears to offer significant benefits to middle-class investors. The vast majority of Americans, who do not qualify as "accredited investors," (28) will now be able to make their own investments in emerging companies. Although this investing is risky, it offers the potential for exceptionally high returns. Early-stage venture funds have outperformed the benchmark Dow Jones Small Cap Index and the S&P 500 over the past 5-year, 15-year, and 20-year periods. (29) More importantly, this new asset class can provide enhanced portfolio diversification. With venture capital, investors can diversify away from publicly traded stocks and savings accounts, and protect a portion of their savings from a market downturn and low interest rates. (30) A key failing in the Act, however, will effectively prevent middle-class investors from reaping these benefits.

2. THE FAILURE OF THE JOBS ACT TO ALLOW DIVERSIFICATION

   When the JOBS Act was passed, the final version included a little-discussed provision that will limit the ability of middle-class investors to participate in venture investing. (31) Section 302(b) prohibits "investment companies" from operating under the Act, preventing companies that make investments for others from offering mutual fund-type products. This exclusion will make it very difficult...