Explained: How changing financial rules will affect technology startups -- and could amp up your exposure to those fledgling companies.
This week, possibly as soon as tomorrow, the Senate is likely to pass the JOBS (Jumpstart Our Business Startups) Act. It has already passed the House, and most of the influencers in Silicon Valley are in favor of the bill. It will certainly change the way the Valley works. But not for the reasons many people think.
The JOBS Act is a collection of bills that were rolled up into one act in the House: H.R. 3606. The Senate was working on variations of some of the components included in 3606, but sources say that the most likely outcome is that 3606 is what will pass in the Senate without substantial changes.
Here are the bill's key provisions and how they will impact Silicon Valley.
The sexiest component of the JOBS Act is how it opens up the possibility for startups to raise money from small investors. Currently, the law says that only "accredited investors" may invest in private offerings. Accredited investors in the U.S. must have a net worth of at least one million dollars exclusive of their primary residence. (It's the 1 percent who fund startup businesses.)
Under JOBS, anyone may invest up to $10,000 a year, or up to 10 percent of their net income if they earn less than $100,000 a year, in private companies. This means everyone could participate in the funding of startup businesses to some extent. This may lead to an increase in funding of small businesses and thus employment, which is a key selling point of the JOBS Act.
The crowdfunding provision is important to small business growth nationwide, but it is unlikely to make a big impact to the funding situation in the bubble of Silicon Valley. For tech startups here, there is a lot of smart money looking for new places to land, and these funding sources can not only write sizable checks, they can offer startups other material benefits: connections, tactical and strategic advice, and partnerships with other startups in their portfolios.
Startups are likely to prefer raising funds from these professional sources. Furthermore, professional investors are more likely to protect the confidential information that must usually be revealed in order to win funding. So tech startups will likely stick with the current system for raising the majority of their working capital.
However, the crowdfunding provision may provide a useful marketing tool for startups. It's not unlikely that even a well-funded startup will set aside a small block of shares for crowdfunding, since these offerings are likely to be talked about in current (and new) sources, and since true fans of a company could become even bigger boosters if they were able to buy into the company's future success. See also Kickstarter, which is currently being used by some product teams for publicity more than for fundraising.
Sources I talked with said that in other regions, crowdfunding could really help "taco trucks" and other mom-and-pop small business raise the funds they needed to get started.
Most small businesses fail, including tech startups. While investors will be protected from losing everything they own under the JOBS Act, it's also likely that many small investors will feel bilked when their investments end up worthless. Scams are possible, as is a rise in small investor lawsuits.
Many Silicon Valley demo events, including high profile events like Launch, may be technically illegal.
Under current regulations, private companies are only allowed to talk about funding with accredited investors they already know. Doing fund-raising pitches in front of general audiences or the media is not legit.
With the JOBS Act in place, startups will be able to tell the world they're raising money, and demo events will become more transparent. It will be legal to stream them to the general public, and during pitches, spokespeople will be able to say more about where their company is and what they need.
The McHenry Amendment to the JOBS Act will also loosen restrictions on angel networks like AngelList, and incubators like Y Combinator, by allowing them to post financial documents online about the startups they represent. Several platforms in Silicon Valley already do this, but the legality is arguable. It's one of the reasons Naval Ravikant, co-founder of AngelList, speaks in such a measured, careful way when talking about his site. (AngelList is a big sponsor of JOBS the Act.)
The transparency provisions in the JOBS Act bring some current financial regulations into the modern era of open and free communications. It's possible that these changes will encourage startups to conform to stricter financial standards, since their documents may be available to more people.
It's also possible that valuations on hot startups will go up, since more people will be learning about companies. This is both good and bad for traditional funding sources in Silicon Valley. It will make it more difficult to sneak into a good early-stage funding deal on a hot startup; but it may also increase valuations as companies grow, which works to the benefit of the early money.
The outcome: Frothier seed-stage funding battles.
Two provisions of JOBS give pre-public companies more control over if, when, and how they go public.
First, companies that do not wish to enter the public markets will find it easier to stay private. No longer will having 500 shareholders be forced to register with the SEC. The new limit is 1,000 investors, with company employees excluded.
Silicon Valley likes this change a great deal. It gives fundraising flexibility to companies that are popular and growing but don't have the financial performance that the market would reward. Think Twitter. Also, filing IPO paperwork can be prohibitively expensive for an early-stage company, thanks to the Sarbanes-Oxley Act of 2002, which was enacted to protect the market from companies not mature enough to be in it.
On the other hand, another provision of JOBS will let companies go public, if they wish, more easily than they can at the moment, by removing some of the accounting restrictions now in place for freshly-public companies. "Emerging companies" with under $1 billion in revenue can, for up to five years from IPO, sidestep some of the Sarbanes-Oxley directives. This is a bit of a give-back on transparency, since it will reduce the amount of reporting required for these companies, but again, Silicon Valley likes it since it will make running a new public company less expensive and give the executive team more freedom.
In sum: Finance is following the technology curve
Recent changes in technology and economics have made everything about launching a technology company cheaper-- from buying Web hosting to hiring freelancers to manufacturing. The JOBS Act follows the trend: it lowers the cost of raising money. It will also buying shares of companies easier for individuals, just as the technology changes have made buying companies' products easier.
However, access to money fuels greed which fuels fraud and lawsuits, and there will be repercussions to JOBS. Some individual investors, who are currently walled off from this part of the economy, will get hurt. Some due to their own ignorance, some because they are taken for a ride. One supporter of the JOBS Act I talked to said that in spite of the good things it brings us ("It makes it easy for a solo engineer to start a company"), it will also put individual investors back on the edge of the startup bubble when ("not if," he said) it pops.
As of today, the Senate is debating the JOBS Act that the House passed. Projections are that it will be put to a vote tomorrow and it is likely to pass. If and when it does, the amount of information you will be exposed to about startups will begin to increase, dramatically. And so will your opportunity, perhaps, to do something with that information.