Solicitation 2.0

The SEC is right to rethink rules around ‘general solicitation.’ The startup world will always have ‘fraudsters,’ but does it need so many ‘finders?’

One of the most perplexing ordeals faced by anyone who moves to New York City for the first time is renting an apartment.

In nearly any other city in the world, the pairing of a renter with available space is a straightforward and efficient market function. Not so in Manhattan, where rental listings are guarded by a cabal of brokers and superintendents who ask for your tax returns, your parents’ tax returns, a financial guarantee from your uncle in Queens, three months up front and a 15 percent fee on the first year’s rent. And then the apartment you wanted goes to the person who showed 10 minutes earlier.

It’s a bizarre, unnatural economy, but whaddaya gonna do? That’s housing in New York. A superstructure of rules originally designed to protect renters ended up distorting the market and allowing a huge population of middlemen to erect tolls between demand and supply.

A similar inefficiency is a play in the startup economy, where demand for capital cannot by law be connected with supply except through intricately designed protocols. In this case, Rule 506 of Regulation D bans “general solicitation” when a company is seeking investors without registering the offered securities with the SEC. The rule is, or course, designed to protect investors from fraud and abuse.

But Reg D was designed in the pre-internet age, and the US economy is missing a trick because of it. There has to be a better way for people building companies to connect with potential investors while also safeguarding against malfeasance.

The SEC has this missed trick on its mind, as evidenced by a letter that commission chairman Mary Schapiro recently sent to Congress. “I recognize that some continue to identify the general solicitation ban as a significant impediment to capital raising,” Schapiro writes. “I also understand that some believe that the ban may be unnecessary because offerees who might be located through the general solicitation but who do not purchase the security. .  . would not be harmed by the solicitation.”

This is an important admission – it is wrong to sell a poor widow shares in your risky startup company. It is not wrong if the poor widow happens to merely learn about the offering – so what? Schapiro goes so far as to recognize the commission’s awareness of the “crowdfunding” concept – the ability of companies and projects to raise capital by gathering small investments from many people, a method that the internet would easily facilitate. She says the SEC is “considering whether an exemption from the registration requirements of the Securities Act is appropriate for capital formation strategies like crowdfunding. . .”

She moderates this news by noting that the general solicitation ban may make it “more difficult for fraudsters to attract investors or unscrupulous issuers to condition the market.”

To be sure, making life difficult for fraudsters is a good thing. An unregulated internet crowdfunding marketplace would immediately turn into a cesspool of chicanery in which fools with laptops and PayPal accounts would be separated from their money by unscrupulous startup hawkers. And so issuers would still need to be held to the same anti-fraud and qualified-investor rules as currently exist. But while the SEC considers the difficulties of policing a potentially gigantic crowdfunding network, it might also consider the teeming, barely regulated population of capital finders to which the general-solicitation ban has given rise.

Blake Allen, a partner in the San Diego office of law firm Duane Morris, who advises entrepreneurs on raising capital says, “When I meet with startup companies, they say, ‘OK, I want to raise some money  – how do I talk about my offering and find some investors?’ And I say, ‘Well, it’s not that simple. You have to approach people that you currently have a relationship with.”

This frustrating discovery often leads entrepreneurs into the arms of professional capital introducers, many of which are entirely legitimate and provide valuable services. But some are unlicensed and see in their clients a free option to earn a fee for success at raising  just about any sum of capital. “I can’t even tell you how many finders I see. There are tons of them because the need is so great,” says Allen. “Companies without wealthy contacts can be hard pressed to raise money, and doing it legally can be challenging. The finder pitch is, I will help you bring capital into your company for a cut of the capital. This generally would require them to be a licensed broker-dealer, but many are not. And God knows what some of these unlicensed guys are saying in the market.”

The attorney’s observation reminded me of an email that once was forwarded to me. It was from a capital-finder based in Los Angeles who was trying to bundle individual-investor capital for a Round E financing of a telecom equipment maker. The pitch said, “I predict we will make 7 times our money.”

Where startups are banned from effectively connecting with a broader audience of potential investors, middlemen step in to do the job. The SEC certainly will have its work cut out trying to prevent fraud in a Craigslist VC market, but in the meantime the New York apartment rental model isn’t working so great, either.