Right now, most participants in U.S. private placements must be “accredited” investors, meaning $200,000 annual income over multiple years or $1 million in net worth, not including your primary residence. These numbers have not changed since 1982, though inflation in the intervening decades has more than halved the real wealth they represent.
This means your mother, who owns a vacation home on Cape Cod, may be getting phone calls from boiler room broker-dealers. The wealth standard means your mother is considered qualified to evaluate such offers; a more sophisticated, but less wealthy individual is not.
Pending legislation addresses that. The Fair Investment Opportunities for Professional Experts Act is a revision to the 2014 JOBS Act. If you have a financial services license or are determined by the Securities and Exchange Commission (SEC) to have qualifying education or experience, it would allow you to invest, regardless of your wealth.
Proof of use versus proof of knowledge
The proof of knowledge approach is problematic. The advantage of the wealth-based standard for accreditation is it’s clear and straightforward. A knowledge-based standard is more subjective, leading to potential disputes. Such a subjective standard may or may not open investment opportunities for people otherwise excluded by the wealth-based standard, but it’s sure to bring more revenue for lawyers.
Instead of a standard based on education or experience, the SEC ought to adopt a standard based on use — i.e. their contributions of time and talent that precede the investment. Call it “proof of use.”
The early growth of Facebook and internet protocols like HTML are analogies often used in crowdfunding and in crypto assets. If the volunteer developers who built the open-source internet protocols had been able to invest in them, they would be today’s internet moguls, alongside Jeff Bezos and Mark Zuckerberg. Meanwhile, early adopters, sellers and evangelists contributed tremendous value to Facebook and Amazon. If they had been able to invest, they’d have participated materially, too.
So-called “gig economy” platforms Airbnb and Uber have made similar recommendations to the SEC. Airbnb did so in a September letter to the SEC, advocating an update to rules governing equity-based employee compensation, which would allow them to distribute stock to hosts that use its platform without running up against the public-reporting limit of 1,999 shareholders. Uber had conversations in 2017 with the regulator, advocating similar changes for granting stock to its drivers. (In other venues, Uber has successfully argued its drivers are nothing like employees.)
I’m suggesting something a little different. If we are going to re-imagine a next generation of Facebooks that grow without information silos and monopolistic ambitions, network users must be able to contribute capital. Regulators could make this possible if they open the door for users who have been active with a product for a significant period of time to actually buy its stock.
Long-term, active use is a more objective standard than knowledge. Picking stocks based on individual experience as a professional or a consumer is also a time-honored principle, going back to one of Peter Lynch’s often-repeated mantras: “Invest in what you know.”
I’m not the first to suggest this. A journalism project called Civil used “proof of use” to describe how it would quiz would-be investors about journalism and their project, before allowing a purchase of the CVL token offered in an initial coin offering that sought to raise $24 million in a two-week crowdsale. The quiz and the other steps involved did not make it easy, even for veteran journalists.
Before selling any of their stock, Civil’s crowd-investors would have to take some action using the token. Voting on funding for a journalism project was one example offered (though this probably makes Civil’s token more like a security, not less). In this way, Civil hoped to be perhaps the first token crowdsale to legitimately demonstrate a so-called “utility token” exclusion from potentially applicable securities laws.
Civil’s crowdsale didn’t fail because of its self-imposed sophistication standard, or because the idea of a “utility token” is naïve in any business other than Chuck E. Cheese’s. It failed because it was trying to raise $24 million in two weeks for a community journalism project. It did raise $350,000, which to this former journalist sounds like a smashing success.
Real proof of use would be putting Civil’s $5 million seed round to work, demonstrating user traction — then opening its offering to its crowd of passionate users.
Proof of use = proof of users
Proof of use would have the added benefit of limiting the crowdfunding option only to companies that can actually attract users. Proof of that traction would be financed by wealthy investors who can bear the risk; for the growing company, proof of use would open a new financing option and a better path to reward its early adopters.
Right now, there is so much private money chasing deals, the best have no need to resort to crowdfunding. Broadening the accreditation standard only creates opportunities for bottom-tier deals or much less knowledgeable investors, or allows venture capitalists to front-run the entire crowd. This they already often do in crypto issuance, allowing their name on the deal to pump interest among retail investors who don’t realize they’re buying the opportunity at a higher price.
Proof of use would provide an additional fundraising avenue for products and services that are showing traction with users — one that would carry the added benefit of motivating the user base, besides the capital it brings. Right now, despite the billions raised by ICOs, users are scarce — only about 24,000 are active daily, across more than 2,000 decentralized applications, or Dapps.
I can think of three projects that have approached us at New Alchemy that would benefit from a reform like this. It would be a miracle if U.S. legislators and regulators were able to pull it through in time for their fundraises — which means they will likely exclude U.S. investors, again. I hope there will be better options for the next few that come along.