Today President Obama signs the JOBS act into law. Unless you did nothing but watch basketball for the past month, you know the law sweeps away regulations that made it more costly for companies with less than $1 billion in revenues to go public. It also creates a system through which startups can solicit capital from ordinary (that is, not wealthy) investors, who were previously excluded from the private equity markets. The law won decisive support from both parties in Congress and the President—pretty remarkable these days. The cheering section also includes venture capitalists, investment bankers and securities lawyers, not to mention entrepreneurs. It seems almost heretical not to be thrilled by it.
Both parties seem to be seized by the idea that the only thing standing between entrepreneurs and exponential growth are a bunch of suffocating regulations put in place to coddle investors. Financial regulations are a burden, no argument, but they serve a purpose. We tried getting rid of them early in this century, you may remember, and paid for it with a global financial crisis.
The Law of Unintended Consequences
In other words, cutting red tape isn’t necessarily and invariably an unqualified blessing. It’s more realistic, as Harvard business school prof John Coates put in his Congressional testimony, to view the JOBS Act as a tradeoff: More capital available for honest entrepreneurs in return for more invitation to abuse by crooks. In a weak job market, that may turn out to be a tradeoff worth making, but there are no guarantees. Congress can roll back Sarbanes-Oxley, but they can’t repeal the law of unintended consequences.
Here’s what could go very wrong.
The Law Might Actually Make Capital More Expensive
One way the JOBS Act cuts regulatory costs is to create a new category of company called an “emerging growth company,” an expansive name for any company with less than $1 billion in assets. The new law exempts EGCs from some financial disclosures and compliance audits formerly required of almost all public companies. In other words, in the name of making it easier for companies to go public, we’ve decided to reduce the amount of reliable information investors can get about them. That makes them a little riskier, a little more vulnerable to fraud. Investors might respond by demanding a higher return—or in economist-speak, they might raise the cost of capital for those firms.
Fraud and asymmetric information not only have effects on fraud victims, but also on the cost of capital itself. Investors rationally increase the price they charge for capital if they anticipate fraud risk or do not have or cannot verify relevant information. Anti-fraud laws and disclosure and compliance obligations coupled with enforcement mechanisms reduce the cost of capital.
In other words, to borrow a handy example from last week’s headlines: It will only take a couple more Groupon-style scandals to spook IPO investors and make capital less available to companies that want to go public. Now, maybe such scandals will never happen, but the history of financial markets suggests that if you open the door to abuse, someone will walk through it.
Crowdfunding Might be a Solution to a Problem That Doesn't Exist
Crowd funding is one of the more romantic parts of the law: It uses cool social media, it empowers startups, and it’s all very forward looking. In his post on Inc.com, Sherwood Neiss, one of the original thinkers behind how crowd-funding might actually work in our securities system, explains why it is relatively fraud proof.
For all its populist appeal, though, it’s not exactly the ideal way for to raise money. Having to corral hundreds of unsophisticated investors from time to time is not likely to be a productive way for a founder to spend his or her time, and having to share ownership with a bunch of mom-and-pops is not likely appeal to venture capitalists in later funding rounds.
Depending on the quality and reputation of the crowd-funding portal you choose, in fact, you might be better off bootstrapping, says Ryan Caldbeck, a former private equity analyst turned crowdfunding entrepreneur. “Some entrepreneurs could conceivably get in trouble,” he warns. “They won’t recognize that funding through some portals could hurt their reputation in the venture capital market or understand the problems of dealing with investors who don’t realize they’ve made an illiquid investment.”
The economic argument for crowdfunding seems to rest on the belief that if every startup founder could get cash, thousands of new companies would form and millions of unemployed workers would be rocketed back to work. A system that makes it hard for job creators to lay their hands on cash needs fixing.
But that might not be entirely true. The current system forces founders to refine their ideas and prove their dedication before (more or less) seasoned venture capitalists and bankers acting as gatekeepers. The JOBS Act is an improvement only if it brings to life deserving companies that the current system would have overlooked. The mere fact that the current system weeds out bad ideas and dilettante entrepreneurs does not necessarily mean it’s broken. Arguably, it means it’s working.
Still, we’ve resolved to fix it with the JOBS Act, at the expense of the unknown numbers of unsophisticated investors who will lose their shirts investing in startups they don’t understand. A few busted investors may be worth the cost in jobs created and growth companies funded—I hope so—but as the President puts his pen to the law today, he should acknowledge that it’s not a sure thing.