HR 3606, jobs, capital, and policy’s folly

Two stories crossed my desk this morning. My gut reacted the the first one even before I could make sense of it, the second explained why. They had to do with entrepreneurs, venture capital (lower case), and jobs policies.

Last week, the House passed H.R. 3606, the Jumpstart Our Business Startups (JOBS) Act. Essentially, the bill enables entrepreneurs to raise capital more easily and it passed with strong bi-partisan support because (1) it allows the democrats to believe it will create jobs by creating startups, and (2) it allows the republicans to believe it will create jobs by deregulating, er, opening the (smaller) financial markets.

There are countless ways in which this bill will enable outright fraud and anyone who has worked with small but public companies should recognize this immediately. One example is

Title III, Entrepreneur Access to Capital. This part of the bill would provide an exemption for crowdfunding, by permitting offerings up to $1 million ($2 million in some cases), provided that investor contributions are limited to $10,000 or 10% of the investor’s annual income, whichever is less. Requirements targeted at investor protection are imposed on the issuer and/or the intermediary involved in the crowdfunding effort.

In other words, those seeking to start a company can now raise money online and from a broader range of fools, er, investors. The nice thing about getting investors into startups is that, since most fail anyway, losing someone else’s money doesn’t seem that fraudulent.

Former SEC Chief Accountant Lynn Turner testified before the Senate Banking Committee:

“The proposed legislation is a dangerous and risky experiment with the U.S. capital markets, and the savings of over 100 million Americans who depend on those markets. The evidence does not support the need for it. In fact, it contradicts it. I do not believe it will add jobs but may certainly result in investor losses. … As a result, I do not support the various bills including the IPO on ramp and crowd funding legislation.”

But it’s not just fraud that worries me. The second bit of news I read this morning was a report on Entrepreneurs Job Growth Expectations from the Global Entrepreneurship Monitor (GEM), a consortium of university researchers around the globe who track entrepreneurial activity. Scott Shane, Professor of Entrepreneurial Studies at Case Western Reserve University, notes the obvious: “A much larger fraction of entrepreneurs expects to create jobs than actually do. This difference means that policy makers need to take entrepreneurs’ job creation plans with a grain of salt.”

The study recognizes that most entrepreneurs will not defraud individual investors. Most entrepreneurs are simply overconfident. They think they will grow big and fast and most don’t. We’re not even talking huge big, just big enough to have more than 0-1 employees.


Granted, it takes a certain confidence to make the entrepreneurial leap. And more to take other people’s money while doing so. But unfortunately that’s often all it takes. It doesn’t take ability, or opportunity, to make the leap.

It does, however, take those other resources to be in business 5 years down the road. When Lynn Turner was testifying, she also noted:

When I served on a Colorado Commission that explored why so many small companies were failing in Colorado at the time, and how their success rate could be improved, we found that access to capital was not the primary cause of failure. Rather it was a lack of sufficient expertise and management within the company including in such areas as marketing and operations. While access to sufficient capital for any company is important, I have found that those emerging companies with better management teams and proven products, or products with great growth potential, are able to obtain it. Those are the types of companies VC’s and private equity seek out.

I have written earlier about how the Valley of Death — describing the lack of capital for growing companies — represents a great misconception of entrepreneurial policy. Companies die when they run out of money, but for startups that’s not the cause, it’s simply the symptom. Most new ventures die because, as Lynn Turner notes, they spent their money chasing the wrong idea, the wrong customers, or with the wrong team.

To think that America would have more jobs because we’ll have more entrepreneurs with more access to more (unsophisticated) investors and their money is Rube Goldberg policy at best.

Addendum (3/18/12):

I am adding here some more recent comments by others much more qualified than I am: Jay Ritter, finance professor at U. of Florida who has studied the IPO market and small companies for the last two decades, and John Coates, a professor at Harvard Law School who studies corporate securities.

In his testimony before the Senate Committee on Banking, Housing, and Urban Affairs, regarding HR3606 and related Senate proposals, Ritter offered this commentary:

In thinking about the bills, one should keep in mind that the law of unintended consequences will never be repealed. It is possible that, by making it easier to raise money privately, creating some liquidity without being public, restricting the information that stockholders have access to, restricting the ability of public market shareholders to constrain managers after investors contribute capital, and driving out independent research, the net effects of these bills might be to reduce capital formation and/or the number of small [emerging growth company] IPOs.

Coates’s testimony, seconded by Commissionar Luis Aguilar of the SEC, adds another (deeply skeptical) perspective,

While [the proposals] have been characterized as promoting jobs and economic growth by reducing regulatory burdens and costs, it is better to understand them as changing … the balance that existing securities laws and regulations have struck between the transaction costs of raising capital, on the one hand, and the combined costs of fraud risk and asymmetric and unverifiable information, on the other hand. Importantly, fraud and asymmetric information not only have effects on fraud victims, but also on the cost of capital itself. Investors rationally increase the price they charge for capital if they anticipate fraud risk or do not have or cannot verify relevant information. Anti-fraud laws and disclosure and compliance obligations coupled with enforcement mechanisms reduce the cost of capital.

… Whether the proposals will in fact increase job growth depends on how intensively they will lower offer costs, how extensively new offerings will take advantage of the new means of raising capital, how much more often fraud can be expected to occur as a result of the changes, how serious the fraud will be, and how much the reduction in information verifiability will be as a result of the changes.

Thus, the proposals could not only generate front-page scandals, but reduce the very thing they are being promoted to increase: job growth.

Additionally,Coates and co-author Robert Pozen wrote a useful piece in the Washington Post (Bill to help businesses raise capital goes too far that further explains the folly of this piece of legislation.