Why I Support the SEC's Tentative Plan to Raise a Key Crowdfunding Threshold

On Monday, the Securities and Exchange Commission’s Small Business Capital Formation Advisory Committee, a key organization within the financial market’s regulator, voted to recommend raising the threshold for requiring reviewed financial statements under Regulation Crowdfunding from $124,000 to $350,000. Let me explain why I enthusiastically support that recommendation!

What Is a Reviewed Financial Statement?

One of the pernicious problems associated with reviewed financial statements is that the name “reviewed” fails to describe what it is to anyone but a CPA. It sounds a bit like I’ve handed my financial statements to an auditor and asked them to peruse them and then stamp them “reviewed.” That is completely wrong!

Auditors do much of the work of an audit to conduct a review, which makes the process expensive. But it still isn’t an audit and doesn’t come with an audit opinion. So, the review lacks the credibility of its more formal sibling and is still quite expensive—think $5,000 to $10,000 for a small business. It is about half the cost of an audit.

How Do Investors Use Reviewed Financial Statements?

In my experience as an investment banker helping entrepreneurs raise capital in the millions of dollars, investors don’t request audited or reviewed financial statements. If a young company needs capital, the thinking goes, there are more productive uses than audits or reviews—which won’t grow revenue.

Before the passage of the JOBS Act in 2012, I’d heard of but don’t recall ever seeing a review. If investors or other stakeholders genuinely require assurance, they don’t stop with a review. If they don’t need that assurance, they rely on management reports. I’m not saying reviews were never used, but I am saying that they were rare.

Today, when a Silicon Valley entrepreneur goes through Y-Combinator, the prominent accelerator that supports hundreds of fledgling companies every year, they typically raise $1.5 to $2 million at graduation. Audits and reviews are simply not part of the discussion. Smart investors don’t rely on them.

Why I Support Raising the Threshold to $350,000

Barriers to Capital Raising

The review requirement as written today penalizes some of the people we most want to serve with Regulation Crowdfunding, including social entrepreneurs, small business owners, diverse founders and community builders.

Expense

The cost of a review must be paid before the client receives the report. Often, the audit firm that conducts the review will require at least half the fee upfront. If you run a small business, regardless of your operating history, looking to raise a relatively modest amount—less than $350,000—you may not have a spare $5,000 to $10,000 laying about for a review. This simple fact is the primary point of discouragement for small businesses wanting to raise capital.

Delay

It is also time-consuming. For instance, if your tax preparer isn’t a qualified CPA, you’ll have to find a firm, negotiate fees, give them time to conduct the fieldwork and allow time for the report to be prepared. That cycle would typically take 30 to 60 days—if it isn’t peak season. If you’re in a hurry to raise capital, that could create a frustrating delay.

Investor’s Needs

Bankers don’t typically require small businesses to provide reviewed financial statements. Instead, they rely on internally prepared financials along with tax returns—most often prepared by professionals.

So, we know that small business lending banks don’t routinely use reviewed financial statements, and angel investors and VCs don’t regularly require reviews or audits.

Why should crowdfund investors be the ones who require this expensive step? The policymakers seemed to think that we crowdfund investors need to have our hands held. That isn’t bananas. Many crowdfund investors are noobies.

There are virtually free ways to address that, including requiring entrepreneurs raising under Reg CF to share their tax returns (redacted to protect private information like tax ID numbers). That, combined with certified GAAP financial statements, is more than adequate financial disclosure in most cases.

The financial statements are only a small part of the puzzle. Investors should be—and are—looking at management teams, social and environmental impact, competition, market, operational risks and much more. Lack of reviewed financial statements should not be a constraint on effective investing.

Big Impact

I want to be careful not to get carried away, but let’s look at a bit of data I pulled from KingsCrowd, which tracks all regulated investment crowdfunding offerings.

Since Reg CF was implemented in 2016, 5,186 offerings have been successfully funded.

The vast majority, 3,924 raised $350,000 or less. That’s 75.6 percent that were under $350,000. This is a huge part of the market. But it could have been much bigger.

Nearly two-thirds, 65.9 percent, of the offerings under $350,000 were also under $124,000.

A rule change could enable 100 more small businesses to raise critical capital between $125,000 and $350,000 every year. Maybe more than that. Every new entrant into the market gives investors more to choose from. They also tend to draw in new investors who may experience success and decide to invest more in other companies.

If just 100 new companies raise an average of $250,000 each year, that adds about $25 million of capital to this market—roughly five percent of the annual levels we’re seeing now. What if this simple rule change tripled that estimate?

As the market grows, it will become healthier. More savvy investors will participate. More people will make money in the business, becoming capable of contributing more to the success of the marketplace.

Ultimately, crowdfunding’s proven ability to better support women and minorities can be extended to more businesses, more communities and more people can thrive and prosper as a result.

The data on social impact is a bit more vague, but I believe that crowdfunding also better supports social entrepreneurs—like yours truly—working to solve environmental problems, improve global health and support efforts at economic inclusion.

This recommendation, if implemented, would be a big win for the SuperCrowd! Please join me in sharing this message to encourage the adoption of the rule.

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