Back in December, two different early-stage entrepreneurs got in touch with me, both of whom were looking for equity funding for their projects.  One was marketing a beverage product, and the other was an innovative high tech product.  In both cases their questions revolved around how they could get equity funding, what was involved, what would make someone a good source, and what would determine how much ownership they had to sell to raise the funds they needed.

The bald truth is that pre-revenue companies are disadvantaged when it comes to trying to raise equity from anyone other than “friends and family.”   The lack of an in-market sales history leads any potential investor to demand a lower valuation then the owner typically will accept.  The potential investor needs that lower valuation in order to achieve a high return on his or her investment, to compensate for the risk of failure.  When investor and entrepreneur cannot agree on a valuation, the equity funding does not take place.   It is for this reason, more than any other, that the vast majority of successful start-ups are self-funded.   According to celebrated scholar Amar Bhide’s survey of business owners who made the Inc 500 list, 55% initially capitalized their business from personal savings, 6% from credit cards, 13% from friends and family, 7% from bank loans or mortgages, and only 7% from Angels or Venture Capitalists.

Kickstarter’s success in helping artists, musicians, film makers, game designers and the like fund their projects has captured the attention of those who would use crowd funding to do the same for entrepreneurs.  Kickstarter was founded in April of 2009, and through October of 2012, had led to pledges of $399 million for projects that went on to get funded for the full amount (on Kickstarter it’s all or nothing.)   Importantly, Kickstarter cannot be used to offer financial returns or equity.

Approximately 2/3’s of successfully funded Kickstarter projects have been in the range of $1,000 to $9,999.   Most entrepreneurs looking for initial equity funding for their business need considerably more funds than this.  If they have insufficient funds of their own, they can seek equity from friends and family.  Another alternative is to register with a portal such as CircleUp, which believes “great entrepreneurs deserve funding from passionate investors” and whose technology is “allowing accredited investors to find, vet and invest in companies in a new way.”

To be an “accredited investor” requires demonstrating net worth of at least $1,000,000 (excluding primary residence) or income of $200,000 (or $300,000 including spousal income), criteria which exclude most Americans.  Proponents of Crowd Funding believe that easing this restriction on non-accredited investors will lead to greater funding of entrepreneurial start-ups and faster job creation.

Enter North Carolina 10^th District Congressman Patrick McHenry, currently serving his fifth term, who introduced legislation which evolved into the Crowd Funding provisions of the Jumpstart Our Business Startups (JOBS)  act (H.R. 3606)  which was signed into law by President Obama on 4/5/2012.  The Securities Exchange Commission (SEC) was tasked to create and implement regulations within 270 days, which they failed to do.  An SEC spokesman was quoted by the “NY Times” on 1/6/13 as saying they were “working very hard” on the new rules needed to implement the provisions of the JOBS act.

It is really not in the Security Exchange Commission’s DNA to be comfortable with the new Crowd Funding provisions in the JOBS act, as tightly controlling the exemptions to securities registration regulations has been one of their main lines of defense against securities fraud.  For example, the SEC website page titled “Risky Business: Pre-IPO Investing” cautions pre-IPO investors, “remember, if it’s neither registered nor an exemption, it’s probably illegal.”

With that as a backdrop, it should come as no surprise that the Securities Exchange Commission came out against the Crowd Funding provisions of the JOBS act.   Much to the chagrin of Congressman McHenry, the biggest push against the bill from the SEC came after the House had already passed it by a 390-23 margin on March 8^th of 2012.  This opposition came in the form of a speech by SEC Commissioner Luis Agular, which was posted on the SEC website on March 16, 2012,  and a March 13^th letter from Chairman Schapiro to Senator Tim Johnson of South Dakota and Senator Richard Shelby of Alabama, the Chairman and Ranking Member, respectively, of the Senate Committee on Banking, Housing and Urban Affairs.

The timing of the Security Exchange Commission opposition to the JOBS act Crowd Funding provisions, coming after the House had passed the bill, understandably rankled Congressman McHenry.  To get a flavor for this check this YouTube video of SEC Commissioner Mary Schapiro (now retired) testifying on June 28, 2012 before the House Committee on TARP, Financial Services, and Bailout of Public and Private Programs chaired by Congressman McHenry, starting at 36:40., leading up to 38:53 where Congressman McHenry complains about “being sideswiped by a regulatory body at the 11^th hour” as well as asking Chairman Schapiro “do you have my [mailing] address?”  Despite the flurry of last-minute SEC objections to the Crowd Funding provisions in the JOBS act, the Senate went on to pass it by a 73-26 vote on March 26, 2012.