Make It Easy for Startups to Sell Stock

This is the fifth in a series of articles that will examine ways to help entrepreneurs who are seeking to start small businesses in the wake of the pandemic to access the capital they need. The first article in this series provides an overview of the challenges facing would-be entrepreneurs in the coronavirus economy. The second article concerns offering small businesses guaranteed access to credit. The third article examines the rules governing investors in startups. The fourth article concerns easing restrictions on lending by small banks.

The coronavirus might have dampened economic growth and activity, but the nation continues to produce entrepreneurs with new and creative business ideas. WhatsApp, Uber, and Venmo are examples of companies that started during difficult economic times. Nearly all entrepreneurs need capital to develop their ideas, and most of them borrow from family, banks, or credit card companies for initial financing.

Theoretically, startups can also turn to selling securities on stock markets to raise capital, but very few new businesses actually do this in the earliest stages. Apple, for instance, started in April 1976 and did not form a corporation until the following year. A major reason for the delay is that the securities world is a regulatory maze full of traps.

Policymakers can help eliminate the maze and give entrepreneurs more financing options. One of the best ways to do this is for Congress or the Securities and Exchange Commission (SEC) to add a new method of raising capital to the federal securities laws. This change could create a simple, lightly regulated method for early-stage companies to sell securities to raise a limited but reasonable amount of money. This would spur economic growth, productivity, and employment, and it could be done without sacrificing investor protection.

Currently, the four types of securities offerings relevant for our purposes are registered offers, Regulation A offerings, crowdfunding transactions, and Regulation D offerings. None of them afford startups an easy way to raise funds. Registered offers are costly, slow, and burdensome; Regulation A offerings have many of the same disadvantages. Crowdfunding transactions have layers of regulatory requirements and restrictions, and private offerings under Regulation D depend on sales to investors who meet sophistication or wealth tests.

The fix I propose would sweep aside nearly all regulatory restrictions, conditions, and requirements for startups. It would exempt them from the rules for registered public offerings and from nearly all the other federal and state obligations on companies selling securities. Only a few rules would apply, and they would be aimed at helping a new business find funding without sacrificing investor protection.

The exemption would be limited to brand-new, small enterprises. Only companies with $250,000 or less of revenue in the preceding fiscal year would qualify. When a company began to earn more revenue and wanted additional capital, it would need to use one of the more traditional methods of selling securities or borrowing.

The proposed exemption would be limited to an aggregate offering price of $250,000 for securities during any 12-month period. This limit would be sufficient to fund a large number of startups, since many new businesses begin with only a small amount of money. Indeed, according to one study, an average young firm has approximately $78,000 in financial capital. An SEC study of the use of the crowdfunding exemption found that completed offers raised approximately $208,300 per offering.

The new exemption I propose would require no disclosures. It would allow each issuer and its investors to decide how much information to provide and what form disclosures should take. This feature would keep regulatory obligations to a minimum but not deprive investors of essential information. Most new businesses do not have much to disclose beyond the business plan and the background of the founders. In addition, most businesses find it easy to communicate with initial investors, since they are often a small group of family, friends, or savvy, risk-taking sponsors such as angel investors.

The streamlined approach of the new exemption might create a worry that scoundrels and fraudsters would take advantage to steal other people’s money, but the SEC’s experience with other exempted offerings has been that surges of misconduct have not occurred. The previously mentioned SEC study on the crowdfunding exemption did not find a significant amount of bad behavior. Additionally, when expanding the availability of the exemption for sales to accredited investors, the SEC said it had not seen evidence of widespread misconduct in exempt offerings.

Nonetheless, investors want assurances that the information they receive about an issuer and its securities is truthful. The new exemption would make available one of the private claims in the Securities Act, which allows a buyer to recover the amount paid for a security if the seller made a false or misleading statement and which relieves the buyer of many litigation burdens. State and federal anti-fraud laws would also apply.

The approach outlined here would help innovators with new business ideas meet their initial capital needs, which would aid the economic recovery from the COVID-19 recession. It would also offer many small investors the chance to get in on potentially profitable companies at the very beginning.

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Read the Full Article here: >Mercatus Center