CONTENTS Introduction 1 Crowdfunding 3 JOBS Act of 2012 4 Crowdfunding at the state level 5 Opening 401(k)s to intrastate crowdfunding 7 Conclusion 8 About the author 8 research or product development or seek out new customers. Enabling small businesses to access the capital they need is an urgent priority of public policy. Yet small businesses are R STREET POLICY STUDY NO. 36 having a harder time getting capital through the traditional June 2015 financial system. Banks are less willing to lend to small businesses than ever before, both because of deteriorating creditworthiness after the recent economic downturn and because small-business FREEING INVESTOR CAPITAL lending is simply no longer as profitable. More stringent banking regulations impose additional costs and the wave FOR SMALL BUSINESS of bank mergers (particularly, the decline of community banks)3 has diminished the local knowledge of community Oren Litwin businesses that used to be banks’ competitive advantage.4 Additionally, lacking a strong secondary market for small- INTRODUCTION business loans, in contrast to the market for conforming mortgage loans,5 banks are unwilling to carry small-business Something has gone wrong with small business in America. lending risks on their books. The business of banking instead For the first time since statistics were kept, the rate of busi- has turned disproportionately to providing consumer and ness failure now exceeds the rate of business creation.1 It housing loans.6 isn’t that businesses are failing more often than usual; rather, new business creation has slowed markedly and the rate con- 3. Institute for Local Self-Reliance, “Access to Capital for Local Businesses,” April 15, tinues to slow further. At a time when the labor-force par- 2014. http://ilsr.org/rule/financing-local-businesses/ ticipation rate is at multi-decade lows,2 the moribund state 4. Karen Gordon Mills and Brayden McCarthy, “The State of Small-Business Lending: of small business is alarming. Credit Access During the Recovery and How Technology May Change the Game,” Harvard Business School, July 22, 2014. http://www.hbs.edu/faculty/Publication%20 Files/15-004_09b1bf8b-eb2a-4e63-9c4e-0374f770856f.pdf Summarized in Karen As with any large problem, there are many contributing fac- Mills, “Why Small-Business Lending Has Not Recovered,” Forbes, Aug. 4, 2014. http:// tors. A critical one has been the shortage of capital for busi- www.forbes.com/sites/hbsworkingknowledge/2014/08/04/why-small-business-lend- ing-has-not-recovered/; Robert Adams and Jacob Gramlich, “Where Are All the New ness investment, particularly for small businesses. Without Banks? The Role of Regulatory Burden in New Charter Creation,” Federal Reserve, sources of capital, new businesses with irregular cash flow 2014. http://www.federalreserve.gov/econresdata/feds/2014/files/2014113pap.pdf ; Rework America (Markle Economic Future Initiative), America’s Moment: Creating (or none at all) often are unable to meet payroll, invest in Opportunity in the Connected Age, W.W. Norton, 2015: pps. 97-100, 108; cf. Eugene Fama, “What’s Different About Banks?” Journal of Monetary Economics, Vol. 15, 1985: 29-39; cf. Milton Marquis, “What’s Different About Banks—Still?” FRBSFEconomic Letter, April 6, 2001. <http://www.frbsf.org/publications/economics/letter/2001/ 1. Source: U.S. Census, Business Dynamics Statistics. See also Ian Hathaway and el2001-09.html> Robert E. Litan, “Declining Business Dynamism in the United States: A Look at States and Metros,” Brookings Institution, May 2014. http://www.brookings.edu/~/media/ 5. America’s Moment 93, 103 research/files/papers/2014/05/declining%20business%20dynamism%20litan/declin- ing_business_dynamism_hathaway_litan.pdf 6. America’s Moment 92-3. Of course, the supposed safety of housing loans became the foundation for a dizzying superstructure of derivatives, culminating in the 2008 2. Bureau of Labor Statistics, “Labor Force Participation Rate,” United States Depart- banking crisis. Perhaps a reasonable level of riskiness in banking would have been ment of Labor, June 2, 2015. http://data.bls.gov/timeseries/LNS11300000 healthier overall. R STREET POLICY STUDY: 2015 FREEING INVESTOR CAPITAL FOR SMALL BUSINESS 1 To some degree, loan-guarantee programs offered by the in investible assets, individual income of at least $200,000 Small Business Association mitigate the risks to banks and or household income of at least $300,000 per year).13 The make them more willing to lend to new businesses. Indeed, SEC’s Accredited Investor regulations have been justified SBA-guaranteed loans grew to more than $30 billion in the on grounds that investments not validated by national regu- 2011 fiscal year, compared to $17.9 billion in FY2009 and $22.6 lators are too risky for typical unsophisticated investors.14 billion in FY2010.7 After a slowdown, lending recovered to Instead, regular investors are generally told to invest in pur- almost $30 billion in FY2014. During that year, the SBA also portedly “safer” publicly traded securities. At a time when provided the bulk of the $5.5 billion loaned to small busi- many decry growing inequality, there is a certain irony that nesses by Small Business Investment Companies (SBICs).8 federal law reserves the most important class of investments to the wealthiest investors.15 However, SBA eligibility rules tend to require that poten- tial borrowers must be unable to secure financing from any Only about 8.5 million Americans meet today’s Accredited other source. Rather than supporting those startups with the Investor requirements. The SEC is considering revisions to best prospects, the SBA’s eligibility rules tend to select for the standard that may cut that number by at least half.16 And marginal businesses.9 Moreover, the volume of such loans few Accredited Investors actually are involved in venture is insufficient to meet the market’s needs. In the 2014 Small capital or angel investing,17 as such investments carry sub- Business Credit Survey, more than half of small and startup stantial risk and government regulations make them non- businesses reported they were unable to secure any bank transferrable before an initial public offering.18 They are thus credit at all.10 Many small businesses instead rely on business not suitable for many who desire predictable investments credit cards. About 37 percent of small businesses surveyed and liquid assets. All told, the American venture-capital in May 2012 reported they relied on credit cards, which car- sector invested more than $33 billion in private companies ried an average interest rate of 15.6 percent.11 in 201319 and $48 billion in 2014.20 By contrast, U.S. IPOs raised $55 billion21 and $85 billion22 the past two years, while Some types of small businesses draw outside investment defined-contribution retirement plans invested $133 billion from the venture capital community, but this is a very limited and $153 billion in the securities markets.23 Even state lotter- pool. Federal regulations on the securities industry restrict who can own investments not registered with the Securi- 13. Office of Investor Education and Advocacy, “Investor Bulletin: Accredited Inves- tors,” U.S. Securities and Exchange Commission, Sept. 23, 2013. http://www.investor. ties and Exchange Commission (SEC) and publicly traded on gov/news-alerts/investor-bulletins/investor-bulletin-accredited-investors the securities exchanges. For the most part, venture capital 14. See, for example, the attitudes expressed by SEC Commissioner Luis Aguilar in is carried out under the exemptions of Regulation D of the “Revising the ‘Accredited Investor’ Definition to Better Protect Investors,” U.S. Securi- Securities Act of 1933,12 which ensure that average investors ties and Exchange Commission, Dec. 17, 2014. http://www.sec.gov/news/statement/ spch121714laa.html are prohibited from participating. To be involved in ven- 15. Cf. America’s Moment 4. ture capital, you must either be an institutional investor, or an “Accredited Investor” (someone with at least $1 million 16. Luis Aguilar, ibid. http://www.sec.gov/news/statement/spch121714laa.html; GAO- 13-640, “Securities and Exchange Commission: Alternative Criteria for Qualifying as an Accredited Investor Should be Considered,” U.S. Government Accountability Office, July 2013. http://www.gao.gov/assets/660/655963.pdf 7. SBA News, “Jobs Act Loan Incentives Led to Record SBA Loan Approval Volume,” U.S. Small Business Administration, Oct. 5, 2011. https://www.sba.gov/content/jobs- 17. That is, investing in startups (often for friends and family) without going through a act-loan-incentives-led-record-sba-loan-approval-volume-supporting-over-30-bil- formal venture capital fund. lion-0 18. Some in the SEC support the idea of a “venture exchange” that would permit non- 8. SBICs are privately managed investment funds that are exempt from registering public shares to be traded. See Luis Aguilar, “The Need for Greater Secondary Market with the Securities and Exchange Commission (SEC) provided that they invest speci- Liquidity for Small Businesses,” U.S. Securities and Exchange Commission, March fied percentages of their portfolio in small business loans, per the Small Business 4, 2015. http://www.sec.gov/news/statement/need-for-greater-secondary-market- Investment Act of 1958. See “Agency Financial Report Fiscal Year 2014: Today’s SBA: liquidity-for-small-businesses.html Smart, Bold, Accessible,” U.S. Small Business Association, Nov. 17, 2014. https://www. 19. Wilmer Hale, “2014 Venture Capital Report.” http://www.wilmerhale.com/upload- sba.gov/sites/default/files/aboutsbaarticle/1-FY%202014%20Agency%20Finan- edFiles/Shared_Content/Editorial/Publications/Documents/2014-WilmerHale-VC- cial%20Report.pdf; Cf. “Investing in an SBIC,” U.S. Small Business Association, https:// Report.pdf www.sba.gov/content/investing-with-sbic 20. PricewaterhouseCoopers/National Venture Capital Association, “Annual Venture 9. America’s Moment, pg.104. Capital Investment Tops $48 Billion in 2014, Reaching Highest Level in Over a Decade, 10.