Open season

SOMETIMES revolutions have small beginnings. SeedInvest is a three-year-old company with 20 employees sharing space in a second-tier building near Wall Street. But it has positioned itself to be at the heart of a fundamental change in America’s capital markets.

On June 19th Title IV of the JOBS (Jumpstart Our Business Startups) Act of 2012 goes into effect. It will change how small companies raise money. Those seeking $20m-50m will be able to offer their shares to the public while skipping some of the most costly regulatory requirements that normally involves, including being vetted by state officials, issuing quarterly reports and listing their shares on an exchange.

In the past, firms that did not meet those requirements could only raise money from investors with a net worth in excess of $1m or $200,000 in annual income. Ten thousand people who did pass that test have signed on to SeedInvest’s system. With the lifting of the rules on income, any adult American can now invest in small share offerings, according to Ryan Feit, SeedInvest’s chief executive.

A wide range of companies could benefit. Last year 14% of conventional initial public offerings were for less than $50m; so far this year it is 22%, according to Renaissance Capital, a research and fund-management firm. Such companies can now benefit from crowdfunding, the raising of capital from a large numbers of investors, each contributing small amounts. SeedInvest is among a handful of new electronic platforms that are designed to facilitate the process. In its brief existence, it has already channelled $25m to 40 firms. Qualifying companies must meet certain standards, such as having a functional prototype of any planned product (not just an idea), customers, and reasonable investment terms. Only 1% of applicants pass the test.

Sam Guzik, a California lawyer, predicts many firms will take advantage of a “test the waters” provision in the rules allowing them to float the idea of an offering, discussing it with the media and investors, before paying to have a formal proposal prepared and reviewed by the Securities and Exchange Commission (SEC). In the past, it was feared that such marketing might allow small investors to be suckered by unsubstantiated hype. State officials still have concerns on that score. In 2013, as the SEC deliberated over the rules implementing the act, William Galvin, the secretary of state of Massachusetts, wrote to it to say he was “dismayed and shocked” that state vetting of public offerings would be curtailed. Small offerings, he claimed, were particularly vulnerable to risk and fraud. On May 21st Massachusetts asked a court to block the new rules, and Montana quickly followed suit.

Are their fears justified? One reason for optimism is the experience of Kickstarter, a platform used to raise money for projects in exchange for rewards rather than equity. Kickstarter projects have no disclosure requirements, making it easier to defraud contributors. Nevertheless, after reviewing more than two years’ worth of data, Ethan Mollick of the University of Pennsylvania concludes that fraud is almost non-existent at Kickstarter. The completion rate of projects that receive their desired level of funding is 86%, suggesting that commitments are largely honoured.

Mr Mollick attributes this lack of fraud to what has become known as “Linus’s Law”, after the originator of Linux, a free computer operating system. He argued that mass vetting would quickly expose any glitches. One example on Kickstarter was a fraudulent effort to fund jerky made from Kobe beef. Initially seen as a brilliant idea, it was quickly exposed by potential users who questioned the use of fatty beef for a stringy product, and pointed to the scarcity of appropriate livestock.

Crowds, it appears, are attentive to details. A spelling mistake in an offering document reduces the chances of a Kickstarter funding by 13%. And 90% of the manufacturing projects that were fully funded have ended up becoming functioning firms. Platforms offering a financial return might have a different outcome, of course. But there is no reason to expect that people hoping to make money would be any less exacting than those giving it away.