The need for CPA audits and reviews is expected to explode based on the Jumpstart Our Business Startups (JOBS) Act stock offering exemption. Section 4 of the Securities Act of 1933 is amended to permit crowdfunding investments in the stock of companies defined as emerging growth companies (EGC) of up to $1,000,000. Non-accredited investors may invest 5% of their annual income that is under $100,000 or $2,000 each.
The JOBS Act, signed April 5, recognizes crowdfunding as an offering of unregistered securities through a registered Internet intermediary website or broker from a large pool of investors. With only eight months remaining before the SEC issues its final standards for crowdfunding, the time for CPAs to begin preparing is now.
Different offering amounts have different SEC standards. If an EGC plans on raising between $100,000 and $500,000 their financial statements would have to be reviewed by a CPA. Those looking to raise more than $500,000 and up to $1 million are required to have their financial statements audited.
To invest in an exempt EGC, “you are limited on crowdfunding to 5% of $100,000 net worth or income. If the net worth is [between] $100,000 and $1 million, its 10%,” said Executive Director and founder of the National Crowdfunding Association (NLCFA), David Marlett.
Prior to enactment of the JOBS Act entrepreneurs and charities had success on the Internet raising money from contributors in exchange for rewards or completed products. Carl Esposti, founder of crowdsourcing.org runs the research firm Massolution which identified 452 crowdfunding platforms (CFPs) worldwide. Esposti told CPA Magazine that these CFPs raised almost $1.5 billion in 2011.
To learn about the impact of the JOBS Act and what it could mean for CPAs, we talked with Marlett a little more. Marlett is an attorney and non practicing CPA who describes himself as being like a vampire hunter who’s job is to weed out the hucksters they may be involved in crowdfunding.
“This entirely revolutionizes our financial system, this eight-decades-old law since the 1933 SEC act,” said Marlett. “The industry will need counsel on how much equity to give away. January 1, the gates are open. They [the SEC] may take longer. It’s good it didn’t start yet because nobody knows what they are doing. There would be too much fraud.
“For CPAs with an entrepreneur interest, it’s a brave new world. If you are a guy like me it raises your spirits. So much of the economy is determined by expectations. How we feel about hope. Now a startup company can believe, ‘I have the opportunity to be like everyone.’”
Douglas S. Ellenoff, a member of the law firm Ellenoff Grossman & Schole LLP, attended meetings between several department heads of the SEC and the crowdfunding industry in April. Ellenoff told CPA Magazine a $25 to $35 thousand audit fee for a private placement (including due diligence), which has been normal over the last 20 years, will be too high for a crowdfunding deal.
“For a SPAC audit fee of $25,000 to $35,000 for a blind pool investment where you are auditing nothing, the auditor has to be concerned with the risk involved,” said Ellenoff. “I believe there will be people [CPAs] who will spread their costs over several [crowdfunding] deals and get the opportunity to provide them.”
Richard Salute, a CPA with JH Cohn in New York, told CPA Magazine that you can’t speculate on the audit costs.
“99% of the time there must be comfort given outside of the financials,” said Salute. “There are also tax implications for the investor and the entity. The real question is going to be that historical information is not as essential as the business plan and how management can execute the plan. I believe the entity needs to create adequate transparency. This will separate the wheat from the chafe. There may be sustainability plans that predict a near term business model, which will help toward valuation which will drive this asset class.
“[SEC] Chairwomen Schapiro wants the rules to be clear to protect the investors. The secret sauce is the efficiency of the raise. It tries to take friction out of the process. Under Reg. A, you did not have to issue financials.
“To my way of thinking, it’s not just the fees; it’s the value you attribute to the stock, if you are getting a quid pro quo. An audit under generally accepted auditing standards requires 100-300 hours at $150 an hour, up to $250 an hour. A review would be much less, but you can’t speculate on it,” Salute warned.
Not everyone is a crowdfunding fan. Some believe the legislation increases the likelihood that individuals will invest in startups and lose money because the companies are riskier. The director of investor protection at the Consumer Federation of America sees Crowdfunding as something that has precisely the same place in the average person’s investment portfolio that lottery tickets do. Salute found this statement disappointing.
“If it is seen as a lottery ticket, it reduces the job formation possibilities and detracts capital formation,” said Salute.
The JOBS Act prevents States from policing crowdfunding offerings until an alleged fraud has been committed. People will now need to do more research before they use the online sites.
“Yeah, so there is going to be fraud,” said Marlett. “Every individual has a criminal intent sometimes. It [the JOBS Act] can’t limit this. So we do have rules to limit investors, to immediately know when the limits are reached. Humans are very creative about cheating each other.
“I have been in the boiler rooms where the idea is to take your money, to strategize, to come up with these things. We need to protect the grandmother who invests $2000 and then is asked for more money the next year. The danger is not grandmas’ $2000, but the over regulation that makes it [funding] too expensive.
“Here is what I find so fascinating. Crowdfunding has taken off in Europe for two years; and donated crowd funding [in the U.S.] mainly in 2011, the two main websites, indiegogo.com and kickstarter.com raised $180 million. The fraud rate has been 2%. The daylight effect that the Internet brings us, limits it to 2% without regulation. I am so enthused by that. Human nature has its devious side, but social media is protecting us against ourselves. So fraud should not be a limiting factor.”
This changing startup environment has revealed a tremendous opportunity for CPAs. The JOBS Act will now introduce new entrepreneurs to the world of professional accounting much earlier causing a rise in demand for CPAs.
“The existing companies may be able to raise money more easily, but there will be more startups,” said Marlett. “CPAs can make money just getting companies ready. The minimum $100,000 [level] may not even have a CPA.
“Insurance agents and attorneys are interested in this but CPAs are the ones poised to make the most money. Suddenly the issuer cannot just use QuickBooks. You can be an entrepreneur CPA on the Internet to get companies dressed up for the dance. This now commonizes finance for the average person. I would not be surprised if QuickBooks did not have a direct export to the portals.”
This new market focus for CPAs will require new skills and the enhancement of old skills. Marlett explained the finer details.
“The secret sauce of crowdfunding is thirds. The perfect balance, the golden mean of the Greeks was the perfect thirds,” explained Marlett. “Number one is the pledge you [the investors] are making to an escrow agent, but you [the crowdfund issuer] have to reach your ask. There have to be [say] 99 others willing to make the pledge. It helps encourage investment. The issuer cannot spend it because the escrow agent will hold it. Number two is the 2% fraud, which empirical data shows [crowdfunding] reduces fraud. Number 3 is [when] right around 40% of pledges are made then the total will be made. Who makes the 38% and who makes the final 62%? The original [group] are friends, family and community. So [then] the unknowns become interested. This is the perfect balance the Greeks believed.
“If most of these are $499,000 deals to limit the audit, then the deal will take about 10-15% in fees. For example, Kickstarter charges 3-5%. Portals may be regulated by SEC. It would be better to keep the fees closer to 10%. You may need 5% for key man insurance, which may become required by the SEC. There will be an accreditation program for portals, and crowdfunding models.”
Marlett emphasized how important it is for CPAs to mobilize, be proactive and take this new challenge head on immediately.
“The one message is to come join us, help us do this right now,” urged Marlett. “The first rules will come out in 60 days, and there will be 90 days of comment after that. Advisors said they will need to be audited, and that is it. It is a tremendous opportunity to be ringleaders in this new space. I need the CPA world to help us help them.”
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