Another idea for fixing America's equity crowdfunding legislation: "Individual Crowdfunding Accounts"

My immensely generous friend and Startup Trivia co-conspirator, Joe Wallin, tweeted last night that Jon Stewart's idea for promoting entrepreneurship - as recounted yesterday in the New York Times - reminded him of something I’ve said, having to do with cultivating an environment where it is okay to fail.

I think Joe's referring to a recent series of posts on this blog about Kickstarter (including this post; see also Jonny Sandlund's excellent guest post making a similar point), and how Kickstarter may be overreacting as the company confronts instances where development projects, funded successfully through the platform, later fail to deliver the goods. The general theme of the critique is: make sure you don't outlaw failure.

Make sure it is okay for backers, too, to participate in failures.

That accomodation is something completely missing from Title III of the JOBS Act, the ostensible equity crowdfunding legislation (commonly supposed to reflect Representative Patrick McHenry's wildly popular bill that drew Representative Barney Frank's support in the House and also the support of the White House; the supposition is mistaken, as the Senate gutted McHenry's bill and the House acquiesced).

When it comes to equity crowdfunding for non-accredited investors, the JOBS Act is so frightened of failure, it equates it with fraud. Title III piles on one unworkable condition after another, some conditions contradicting others. Perhaps most nefariously, Title III creates a new, untested civil right of action against the officers and directors of a crowdfunding issuer. And as an example of conditions within Title III that are contradictory, how's this: funding portals are supposed to get into the personal business of each investor, to make she does not exceed her annual crowdfunding limit, accross all platforms; but the portals also have to guarantee that individual's privacy.

Notice how serial entrepreneurs and the angel investors who back them aren't cowed by failure. Angels know that at least half the startups they back won't yield any investment return at all. That's okay. Failures are experiences that everyone builds on. You might even say that successes are often built on the lessons learned in prior failures.

And when it comes to jobs, failed companies provide jobs before they fail, and they provide experience employees use to find other jobs.

Equity crowdfunding advocates need to stop with the co-opting of the nascent industry by broker-dealers (who are used to being heavily regulated) and go back to the drawing board. They need to get Rep. McHenry's attention, and say, look, you did us a good turn with your original bill. But the Senate killed it and there really is nothing the SEC can do to fix that awful legislation. Go now and get us legislation that looks more like what you achieved for angels, with your amendment that made it into Title II of the JOBS Act.

Angel investors don't have to worry about annual investment limits. Angel investors don't need any special rights to sue entrepreneurs. They know failure comes with the territory, and that failure, in and of itself, is not tantamount to fraud.

The objection from state regulators and consumer advocacy groups, of course, is going to be that whereas accredited investors may be able afford the losses they expose themselves to when they invest in startups and risky, uncertain ventures, non-accredited investors cannot.

Fair enough. Let's double down on the paternalism to protect non-accredited investors from themselves. But let's do it in a way that will let an honest experiment with equity crowdfunding proceed.

Here's the idea:

Individual Crowdfunding Accounts (or "ICAs," an acronym intended to bring IRAs and 401(k) accounts to mind). They need not be tax-advantaged (though they could be).

The essential paternalism - and the entire investor protection element - is this: each individual is allowed to invest in deals under an equity crowdfunding exemption, but only from funds that are designated to her Individual Crowdfunding Account. And there is a strict limit to how much money an individual can put into her ICA.

Let's say an individual is allowed to put up to $2000 per year in her Individual Crowdfunding Account. She can add to it year after year, and she can withdraw from it at any time, for any reason, or for no reason. But she cannot invest in equity crowdfunding deals, other than from this account. Again, this restriction is the essential and necessary investor protection element in the supposed new, and more viable, equity crowdfunding exemption. And it is the only investor protection element. The others - top down disclosure, FINRA standards, invasive checking of incomes and investment, etc. - are too unwieldy, take the crowd out of crowdfunding, and deny non-accredited investors the dignity of participating in America's innovation and entrepreneurial economy.

Let's walk through the ups and downs of the hypothetical non-accredited investor's hypothetical ICA over the course of a few years.

Assume she funds her full limit of $2,000 into her ICA year one, and she makes an investment that first year of half that amount in a particular startup that makes an offering in reliance on the equity crowdfunding exemption. In year two, she puts another $2000 into her ICA. She then has $3,000 in her ICA, available for investing (or withdrawal). Let's suppose in year three, her year one investment has a liquidity event, yielding her a 10x return. Assuming she maxes out her annual contribution limit in year three, she now has $15,000 in her Individual Crowdfunding Account, representing the $5,000 in contributions she as yet has not put to work in any deals, and the $10,000 she received from the company she backed in year one.

Next, let's suppose she wants to withdraw the entire $15,000 to fund a business she has started for herself. Or to make a down payment on a home. Or to pay college tuition for herself or for a child. She can do any of these things. It is her money. She can withdraw it at any time and put it to any purpose, or to no purpose. But once she withdraws the $15,000, she has $0 in her individual crowdfunding account, and so she can't make any more investments under the equity crowdfunding exemption. Not until she makes another contribution, up to her annual limit.

She is also free to fail. If instead of taking that $15,000 to put to her own purposes, she invests it all in a deal that goes south, she loses the full amonut. Absent outright fraud on the part of a company, she is estopped from suing the entrepreneurs. One of the tradeoffs for being able to fund an ICA is that the investor must sign a legally binding statement that says the investor knows she is likely to lose all of the money in her ICA. The whole point was that ICA would be play money.

Extremely serious play money. The kind of play of which authentic lives are made.

This just in: Docracy has posted video of last night's event on equity crowdfunding. It was a great experience. I learned a ton from my co-panelists, Larry Baker of Bolstr and David Rose of Gust. And I met several extremely smart people afterwards and had a great brainstorming session afterwards with Veronica Picciafuoco, Jonny Sandlund and Larry Baker. It was that conversation, mixed with a second pint of Pearl Necklace Oyster Stout, that yielded the idea of the Individual Crowdfunding Account.