The Dark Side Of Regulation A+

After just over a month since the Securities and Exchange Commission finalized Title IV of the JOBS Act, and excitement is mounting about what these regulations could mean for small businesses in search of financing in the U.S. The most debated aspect of the rules this season is the recent finalization of Regulation A+.

Proponents of the law say it democratizes the investment process and offers another way for SMEs to gain finance, thus strengthening the economy. The rules, as the SEC said, intend to “provide an effective, workable path to raising capital that also provides investor protections.”

Opponents, however, warn that Regulation A+ will lead to investor fraud, failed startups and a potential private equity bubble as SMEs no longer see the need to go public. PYMNTS takes a look at the potential downside of the regulation that goes into effect less than two months from now.

What The Updates Entail

Last month, the SEC approved alterations to the existing Regulation A provision, which limits the amount of funding SMEs can raise through small public offerings. Regulation A set that limit at $5 million; Regulation A+, as it’s now known, brings up that cap to $50 million.

The updates also revise and loosen the definition of a “qualified investor,” meaning average citizens can partake in the funding, though with certain limits. In addition to the previous restraints placed on SMEs from Regulation A, Regulation A+ also eases the reporting process for business owners to obtain state approval.

Regulation A+ seems like a homerun for small businesses. But experts are now speaking out to warn the youngest of startups that the legislation should be approached with extreme caution.

A Slippery Slope

In a recent article for Entrepreneur, Sally Outlaw, the CEO and Co-Founder of crowdfunding platforms Peerbackers and the Crowdcast Network, sounded off on Regulation A+ and the dangers of startups using the legislation to raise funding. Most notably, she argued, pursuing funding through this avenue means that the business will then become a public company, “and it comes with all the costs, compliance and distractions that this implies.”

Further, due to the requirements to submit documents pertaining to finances and other business matters, Outlaw warned that doing so could be a bad move in a competitive landscape. Instead, she argued, businesses should already have funding from venture capitalists and an existing revenue stream to consider funding through Regulation A+ means.

Crowdfunding expert Dara Albright agreed, telling Outlaw that startups using Regulation A+ could find themselves on a slippery slope. “What we don’t want to see are companies going public before proving their business model,” she told Entrepreneur. “We will just bring back the problems we had with the pink-sheets and penny stock companies that troubled regulators.

Instead, she argued, the legislation could be more beneficial as an alternative to reverse mergers and small-cap IPOs.

Shri Bhashyam, the director of EquityZen, agreed that Regulation A+ is not a wise choice for startups, especially with the vast venture capitalist population. The financial costs and time needed to secure funding through Regulation A+ doesn’t make sense for startups, he said. But even for later-stage SMEs, with a wide array of mutual and hedge funds targeted towards late-stage growth, companies may not be interested in pursuing equity through the legislation. “Until that spigot dries up, there’s not much incentive to be an early adopter of Reg. A+,” Bhashyam wrote.

Investor Impact

Many experts highlight that Regulation A+ has a greater impact on the investor world than it does on SMEs and small business owners’ ability to access funding. Proponents of the legislation describe the new rules as a “democratization” of the investment process, allowing non-accredited investors to purchase shares of a company. Critics, however, argue that this leaves too wide of a margin for investor fraud.

One of the biggest opponents to Regulation A overhaul from the beginning is the North American Securities Administrators Association, more concerned for the potential for Regulation A+ to open to the doors to investment fraud. At the heart of the NASAA’s criticism is Regulation A+’s allowance for a company to bypass individual state review of the investment process, especially considering the “high-risk” nature of the investments.

In a letter to the SEC last December, the NASAA argued that the state review process is an “essential function” to discouraging fraud. “State-level review will help the Commission root out fraud and abuse in this new marketplace and will give investors confidence that securities sold in these offerings are subject to an adequate level of scrutiny,” the NASAA wrote.

This risk could ultimately spell trouble for small businesses down the line, some say. CohnReznick LLP partner Alex Castelli for example, recently warned businesses that they must have reinforcements ready if they are to partake in this type of crowdfunding. “Be prepared to have a large number of small-dollar investors,” he said, “[and] act like a public company. This means being transparent. Hire experienced professionals to help guide you and make sure you stay in compliance with the rules and regulations.” Hiring these professionals and focusing on regulatory compliance, however, may not be feasible to the youngest of new businesses.

Additionally, because of the democratization of investment, many investors will likely lack the education necessary to make smart decisions with their funding. “Investing in private companies is extremely risky, and is not liquid investment,” said Alex Feldman, the CEO and founder of crowdfunding review service CrowdsUnite. “The business doesn’t want to have hundreds or thousands of shareholders who are not happy and want to take their money out,” he told Business News Daily.

Regulation A+ has less than two months until it goes into effect on June 19 of this year, but until then, the debate forges ahead as to how the new rules will impact private equity and the SME landscape across the U.S. Whether Regulation A+ will prove beneficial to SMEs and strengthen the economy, or lead to investor fraud and a slew of failed startups, one outcome is certain: the private investment market in the U.S. will see fundamental shifts before 2016 comes around.