The Jumpstart Our Business Startup Act (“JOBS Act”) allows a for-profit business to access equity based financing through crowdfunding. Crowdfunding generally entails small investments into startup companies from a large group of individuals through offerings over the Internet. The provision was designed to “get small businesses and entrepreneurs back into the game by removing costly regulations and making it easier for them to access capital.”
Targeting unaccredited investors, the offerings involve a significant degree of risk, including an increased potential for fraud. The legislation sought to address some of these concerns through the imposition of an annual investment cap. Expressed as a percentage of income or net worth, the cap was set too high to serve as an adequate protection for investors. In particular, the JOBS Act mandated that the Commission apply the definition of income from the accredited investor standard, a provision with an entirely different purpose.
This paper will first examine the definition of income in the context of accredited investors. Next, it will address crowdfunding, particularly the investment cap set out in the JOBS Act. The discussion will include the legislative history for the requirement. Finally, the paper will analyze the potential problems with the investment cap as an investor protection mechanism.
The Securities Act of 1933 (“1933 Act”) regulates stock offerings. Securities sold in public offerings must be registered with the Securities and Exchange Commission (“SEC”). The 1933 Act contains a number of exemptions from registration including one for private placements. These offerings were mostly limited to sophisticated investors, an uncertain and often subjective term.
In 1974, the SEC sought to provide some certainty with the adoption of Rule 146, a safe harbor for private placements. To meet the sophistication requirement, issuers had to have a “reasonable belief” that investors were capable of assessing the risks and merits of the offer, either alone or in conjunction with financial advisors. The Small Business Investment Incentive Act of 1980 added an exemption from registration for offers and sales solely to “accredited investors” but included only a vague definition.
The SEC adopted a more objective definition of accredited investors in Regulation D (“Reg. D”). In defining accredited investors, the SEC opted for a test that looked to either an investor’s income or net worth. With respect to income, the SEC originally proposed to use adjusted gross income. Investors with $100,000 in adjusted gross income as reported for federal income tax purposes would qualify as accredited. After review, however, the final rule looked to “income” rather than “adjusted gross income.” This change effectively instituted a gross, rather than net, income standard.
The SEC, however, had concerns with the use of gross income as a substitute for investor sophistication. As a result, the Commission doubled the threshold amount to $200,000. Moreover, the threshold had to be met for a sustained period, with the final rule requiring investors to earn $200,000 “in each of the two most recent years” and to have a reasonable expectation of earning that amount “in the year of the investment.” The income test was intended to ensure that “only such persons who are capable of evaluating the merits and risks of an investment in private offerings may invest in one.”
The Commission provided little interpretive guidance on the definition of income. The term did not include “unrealized capital appreciation.” On the other hand, “contributions to a profit sharing plan or pension plan should be considered as income for purposes of Rule 501(a)(7) to the extent that a participant's rights to benefits attributable to such contributions are vested.” Commentators argued for a lowering of the income and net worth thresholds. In response, the SEC added a joint income test but otherwise declined to make any revisions in the absence of compelling data demonstrating that individuals with lower incomes and net worth were financially sophisticated.
III. The JOBS Act Title III: Income Test
Title III of the JOBS Act regulates crowdfunding. Crowdfunding exempts from registration the sale of up to $1,000,000 in securities by non-reporting companies during any 12-month period. Unlike Rule 506 of Reg. D, the provision specifically targets unaccredited investors. 
The crowdfunding provision sought to provide protections for these investors without excessively burdening the capital raising process. Companies were subjected to modest disclosure requirements and Internet portals were required to educate investors about the risks of crowdfunding offerings. Congress mostly sought to protect investors by limiting the amounts they could lose in crowdfunding ventures through the imposition of an annual investment cap.
A. JOBS Act Legislative History: Income Test
Crowdfunding is intended to provide a simple and cost effective way for startup companies to obtain capital. It allows startups to pitch an idea and solicit financing from anyone with Internet access. Crowdfunding represents “an opportunity, and in certain cases the only chance, for unproven startups to attract investors.” The approach also provides an alternative to venture-capital firms that often insist on a controlling interest in the company.
Crowdfunding legislation originally surfaced in the House. On September 14, 2011, Representative Patrick McHenry proposed H.R. 2930, “The Entrepreneur Access to Capital Act.” The bill sought to exempt certain small offerings made over the Internet. To protect investors, the legislation contained some modest disclosure requirements and an investment cap that limited purchases in an offering to the lesser of $10,000 or 10% of income. Income, however, was not defined.
In the Senate, Scott Brown of Massachusetts proposed a crowdfunding bill that contained an investment cap of $1,000. Senator Brown explained that “while many wonder who will be the next Steve Jobs, crowdfunding legislation wouldn’t leave us waiting for one person, but thousands.” The relatively low amount was designed to allow “ordinary” investors to participate in non-public offerings while limiting their risk to an amount they could afford to lose. Senator Merkley introduced a crowdfunding proposal in December 2011 that capped investments at the greater of $2,000 or 4% of income if the investor had an income greater than $50,000 but not more than $100,000, and 8% of income if the investor’s annual income exceeded $100,000. Once again, income was not defined.
The House of Representatives adopted the JOBS Act on March 8, 2012, and included the provision sponsored by Congressman McHenry. On March 13, 2012, the Senate adopted a crowdfunding amendment co-sponsored by Senators Merkley, Brown, Bennet, and Landrieu. This version changed the annual caps to the greater of $2,000 or 5% of income for investors with an income or net worth below $100,000 and 10% of income for amounts above that threshold. Total investment in any one year could not exceed $100,000.
The cap adopted in the final legislation differed from earlier versions in two significant respects. First, the version computed the investment caps based not only on income but also on net worth. Second, the legislation defined both terms. The definitions of income and net worth were to be the same as those used in connection with the standard for accredited investors. The JOBS Act passed the Senate on March 22, 2012, the House on March 27, 2012, and was signed by President Obama on April 5, 2012.
Crowdfunding investments have a high level of risk. Primarily involving startups, many will fail. Over a ten year period, about two-thirds of startups are unsuccessful. Investors also confront the risk of fraudulent offers.
The risk associated with crowdfunding did not go unnoticed in the legislative process. One congressman pointed out that failure was an inherent part of capitalism and that “9 out of 10 of these [companies] will go out of business—will lose their money—and maybe 1 out of 10 will make a lot of money.” Nonetheless, he viewed crowdfunding as a mechanism that “allow[ed] middle class families the same opportunities that millionaires have always had to lose their money.”
Congress sought to mitigate these risks primarily through the imposition of an investment cap. Investors could only invest an amount they could afford to lose. Yet the investment cap did not accomplish this goal. By incorporating the term “income” from the accredited investor standard, Congress relied on a concept that was developed for an entirely different purpose. In the context of accredited investor, income was a threshold designed to ensure sophistication and the ability to assume the risk of loss. Those meeting the income threshold for a sustained period of time were viewed as having the ability to evaluate the merits of an investment or the resources to retain the necessary expertise.
Crowdfunding, in contrast, targets unaccredited investors. The income test is intended not as a threshold for assessing sophistication but as a mechanism to determine an amount that an investor can invest and, by extension, afford to lose. Such a computation, however, ought to take into consideration the amounts expended on necessary living expenses such as rent, contributions to retirement plans, or payments for college tuition. Because these expenses are not taken into account in computing income under the accredited investor standard, they cannot be factored into the definition of income for purposes of crowdfunding.
The result is that crowdfunding allows investors to invest more than they can afford to lose. According to the U.S. Department of Health and Human Services, the poverty line for a family of four is $23,050. Under the investment cap in the JOBS Act, this family could invest $2000. Yet it is unlikely that such a family could afford to invest, much less lose, that amount.
Similarly, the median family income in 2010 was $50,220. The average family of four with two kids under five years of age spent between $6,288 and $12,168 per year in 2009 just on food. Rent in the U.S. averaged $804 per month, or a total of $9,648. Given other necessary expenses such as health care, transportation, clothing and utilities, these families often have little excess income that they can afford to lose. Nonetheless, under the cap in the JOBS Act, they can invest up to 5% or $2,511.
Nor will these caps be easy to enforce. Web portals were given responsibility for ensuring that investors did not exceed the annual limits. This will be difficult. For one thing, an investor’s circumstances will frequently change. An investor can lose a job or suffer a reduction in income. The amount that can be invested, therefore, will vary. Portals will need to conduct an analysis of the investor’s income at the time of every crowdfunding investment. In addition, investors may open more than one account and invest through multiple portals. To properly ensure that investment caps are not exceeded, portals will need to share information. Currently, however, no centralized system exists for reporting investments in crowdfunding.
IV. Going Forward
The Internet holds considerable promise with respect to raising capital. Crowdfunding has the potential to allow some non-reporting companies to access equity markets through small contributions by a large number of unaccredited investors. Nonetheless, as currently configured, the crowdfunding exemption facilitates offerings by high risk startup companies without imposing meaningful limitations on the amount that can be invested.
The SEC has been assigned the task of implementing the crowdfunding exemption. The Commission, however, has no latitude with respect to the definition of income. It must use the definition in place for accredited investors. The Commission cannot, therefore, adopt a definition that seeks to limit investments to an amount that investors can afford to lose.
A possible solution would be to amend this provision and remove the requirement that income be defined in accordance with the accredited investor standard. Instead, the SEC should be given the authority to define income in a manner consistent with the underlying purpose of crowdfunding. This would allow the SEC to adopt a net income standard that took into account deductions for necessary living expenses. The definition would, therefore, more accurately reflect the policy behind the investment cap of protecting unsophisticated investors from investing more than they could afford to lose.
Alternatively, the Commission could provide a safe harbor for portals with respect to the obligation to monitor crowdfunding investments. The safe harbor could exempt from monitoring those portals that imposed their own cap at significantly lower levels than those provided in the JOBS Act. A portal might, for example, limit individuals to an investment of no more than $500 in any single offering and no more than $1000 for any 12 months period, irrespective of the investor’s actual income or net worth.
*. J.D. Candidate 2013, University of Denver Sturm College of Law.
. H.R. 3606, 112th Cong., § 302 (2011-2012) [hereinafter JOBS Act]; BuckleySandler LLP, Crowdfunding Offers Attractive Financing Alternative, But SEC Must Give More Clarity, Thomas Reuters Accelus (Aug. 21, 2012, 12:00), http://accelus.thomsonreuters.com/articles/crowdfunding-offers-attractive-financing-alternative-sec-must-give-more-clarity.
. Michael L. Zuppone, Demystifying the Recently Enacted Crowdfunding and Private Offering Reforms: Opportunities for Issuers and Investors, Stay Current, a Client Alert from Paul Hastings, 1, 1 (April 2012), https://www.secondmarket.com/discover/wp-content/uploads/2012/01/Stay-Current-Demystifying-the-Recently-Enacted-Reforms-Paul-Hastings.pdf; see JOBS Act, supra note 1 (allowing individuals with an annual income under $200,000 to invest in private offerings).
. Small Business Incentive Act, H.R. 7554, 96th Cong. § VI (1980) (“any person who, on the basis of such factors as financial sophistication, net worth, knowledge, and experience in financial matters, or amount of assets under management qualifies” as an accredited investor).
. Revision of Certain Exemptions from Registration for Transaction Involving Limited Offers and Sales, Securities Act Release No. 6389 (Mar. 8, 1982) [hereinafter 1982 Release] (Regulation D was passed in the wake of the SEC’s reevaluation of the “impact that its rules and regulations have on small businesses […]” and to “simplify existing rules and regulations, to eliminate any unnecessary restrictions […] in order to facilitate capital formation consistent with the protection of investors”).
. Proposed Revision of Certain Exemptions from the Registration Provisions of the Securities Act of 1933 for Transactions Involving Limited Offers and Sales, Securities Act Release No. 6339 (August 7, 1981).
. Id. at 9-10. Commentators argued that adjusted gross income did “not include certain deductions or exempt income,” thereby excluding “many sophisticated investors who can reduce their gross income below $100,000 through legitimate tax planning measures.” Id. at 10. The adopting release contained one example of a possible calculation. 1982 Release, at 9. (“One possible method of computing income is as follows: individual adjusted gross income (assuming that had been reported on a federal tax return) increased by any deduction for long term capital gains under section 1202 of the Internal Revenue Code (the "Code"), any deduction for depletion under section 611 et seq. of the Code, any exclusion for interest under section 103 of the Code, and any losses of a partnership allocated to the individual limited partner as reported on Schedule E of Form 1040 (or any successor report)”).
. Prohibition of Fraud By Advisors to Certain Pooled Investment Vehicles, Securities Act Release No. 8766 (Dec. 27, 2006) [hereinafter Prohibition of Fraud by Advisors]; 1982 Release, supra note 16, at 10 ( “in measuring income only in the most recent tax year, the category included investors who had a nonrecurring peak in income for that year”).
. SEC Interpretive Letter re: Raymond, James & Associates, Inc. (Dec. 19, 1984); 1982 Release, supra note 16, at 9. The Commission cautioned, however, that income did not mean revenues. A single business owner could not use the revenues from a business without deducting the operating expenses.
. Rule 506 of Reg. D limits offerings to no more than 35 unaccredited investors. 17 CFR 230.506. Moreover, because of the additional costs and risks imposed on an offering by the inclusion of unaccredited investors, they are often excluded from offerings under the exemption. See Finger, supra note 10, at 738, 748-49.
. Id. (“For this new market to flourish, it’s important that every participant has confidence in the integrity of the system. My legislation puts parameters on risk by limiting investments to $1,000 per person and $1 million in total capital. It also provides strong protections to make certain that investors are not deceived about the possible risks associated with a new venture.”)
. Id.; Crowdfunding, 158 Cong. Rec. S1877 (March 21, 2012). Senator Brown stated “[t]he other thing we need to make sure we are doing as a country is continuing to innovate and drive innovation across the United States because it is those companies--the ones that are created tomorrow, the ones that are created next week--that are going to create new jobs in this country. That is going to drive our median family income up instead of down.”
. Scott Shane, Start-Ups Consistently Fail, Forbes, http://www.forbes.com/sites/scottshane/2011/08/17/start-ups-consistently-fail/. Another study indicated that approximately 40% of startups fail. See Carmen Nobel, Why Companies Fail and How Their Founders Can Bounce Back, Working Knowledge (Mar. 7, 2011), http://hbswk.hbs.edu/item/6591.html [hereinafter Why Companies Fail].
. See Brown, supra note 6; JOBS Act, supra note 1, at §4A(a)(3), (4)(A-(C) (requiring web portals to provide certain information about the business, such as a business plan or tax returns and requiring that investor answer questions regarding their understanding of the investment).
. Compare State Housing Facts, Find The Data (2012) http://acs-housing-state.findthedata.org/ (citing the US Census Bureau). For example, in California the average rent is $1,163 per month equaling $13,956 per year.
. Craig Denlinger, Speculation on New SEC Chairman’s Implications to Crowdfunding, HealthTechHatch (Nov. 30, 2012), https://www.healthtechhatch.com/blog/speculation-new-sec-chairman%E2%80%99s-implications-crowdfunding; Jason Best & Sherwood Neiss, SEC Uses JOBS Act to Set Up New Roadblocks to Crowdfunding, Entrepreneur (Aug. 21, 2012, 10:47am), http://venturebeat.com/2012/08/31/sec-uses-jobs-act-to-set-up-new-roadblocks-to-crowdfunding/ (commenting on self-certification, where an investor signs “self-certifying” that they understand the investment and have the necessary wealth to participate, as a continued method of determining an investors ability to invest under crowdfunding). This would, of course, effectively eliminate the investment cap protections.
. President Obama, supra note 53 (“[T]he websites where folks will go to fund all these start-ups and small businesses will be subject to rigorous oversight. The SEC is going to play an important role in implementing this bill”).