The Benefits of the JOBS Act Audit/Review Requirements
The proposed rules for Regulation Crowdfunding represent an excellent compromise of effective regulation while not being unnecessarily burdensome. This industry will not exist without effective and thorough regulation and oversight. The types of investments that will utilize Regulation Crowdfunding are inherently high risk; investors will have no tolerance for additional risks of unscrupulous issuers working with little oversight or transparency. Though these regulations cause some up-front costs, these costs will more than repay themselves through providing a viable market with willing investors and higher valuations from reduction of risks.
With the breadth and depth of information available from the history of capital markets, it is easy to see the power and necessity of strong regulation in capital markets. The least regulated markets, such as OTC penny stock markets, have developed poor reputations rendering them to minimal use and causing companies utilizing these markets to acquire deep discounts in their valuations from the increased risks of such markets. Prior to regulation, mutual funds were highly speculative, rarely used investment vehicles. After the stiff regulatory environment instilled through the 1940 Act, mutual funds are now by far the most common investment vehicle. Despite the heavy regulation of the mutual fund industry, it has evolved and increased its efficiency to the point that now many ETF funds have expense ratios south of ten basis points. Additionally, fraudulent financial reporting is all but non-existent in the mutual fund market, demonstrating that regulation does not have to be expensive to be effective. The goal of most private companies is to go public due to the efficiency of the public stock markets. There is a significant premium on publicly available stocks due to the liquidity premium and the public’s trust in these markets. This efficiency is maximized by regulation, rather than constrained by it. Investors have demonstrated they want information, confidence, liquidity, and transparency. All of these are achievable in Regulation Crowdfunding offerings with the right regulation; to provide such the Regulation Crowdfunding rules need to look more like publicly traded stocks and less like private offerings. The proposed rules achieve this.
Regulation Crowdfunding opens a new world of investment to issuers that have previously been constrained to bank loans, friends and family offerings, and the hopes of venture capital investment. All of these sources have additional information that is unavailable to Regulation Crowdfunding investors without appropriate regulation: personal experience with issuer, mutual rapport with the issuer, and/or extensive due diligence by professionals at VC firms and banks. Without such protections, other regulations are necessary to promote a viable market where investors will want to invest. The audit and review requirements are therefore pivotal to the success of this market, as they represent the key outside verification of the issuers’ information that will be available to investors. Many of these small issuers will not have the level of experience and knowledge of financial reporting requirements to properly report and disclose their finances, so without this outside verification issuers’ financials statements will be of little value to investors. Further, without third party verification the likelihood of investment under this regulation is severely limited.
Additionally, the Regulation Crowdfunding market’s reputation is going to be pivotal to its success. Imagine how the reputation of the industry would suffer if soon after its commencement, fraudulent issuers produced false financial statements and issued $1M offerings, only to take that money for personal use. The reputation of the industry would be crushed before it got off the ground. Such a scenario is not likely with the audit and requirements, providing assurance on the biggest, most newsworthy offerings.
The Value of an Audit
Many studies have been conducted over the past couple decades looking into the benefits of audits and their effect on both the value of a company and the likelihood of funding, concluding overwhelmingly that audits significantly increase the value of companies, and more importantly, increase the likelihood of investment. The Wall Street Journal published the results of a University of Chicago Booth School of Business study of 10,000 closely held businesses to the find value of an audit relative to interest rates. The study indicated an average of a 69 basis point interest rate reduction for audited issuers compared to non-audited issuers. Similar findings from multiple other studies have been published (“The Value of Auditor Assurance: Evidence from Loan Pricing” David Blackwell, Thomas Noland, Drew Winters; “The Value of Financial Statement Verification in Debt Financing: Evidence from Private U.S. Firms” Michael Craig Minnis; “The Demand for Financial Statements in an Unregulated Environment: An Examination of the Production and Use of Financial Statements by Privately Held Small Businesses” Kristian Allee, Teri Lombardi Yohn) clearly showing reduced interest rates for issuers with audited financial statement’s available. This demonstrates reduced risk profiles of companies that have been audited from the perspective of the investor.
It should be further noted that while these reductions represent significant reductions in issuers risk profiles, these statistics are relative to bank loans. In the process of approving a bank loan the loan officer performs extensive due diligence to a degree that is far beyond that available to a Regulation Crowdfund investor. For instance, it would be customary for a loan officer to get all historical financial on the business, any affiliated businesses, and each owner, including personal financial statements and tax returns. In the case that significant real estate or equipment was involved, the bank would appraise such or seek broker price opinions on equipment to substantiate the valuation. Further, it is customary for a bank to collateralize bank loans not only to all business assets and real estate, but also to such of the owners, and then require the owners to sign personal guarantees to the full loan amount from personal assets. After all of this due diligence and with all these additional guarantees, the bank still places significant risk reduction value on audited financial statements.
The Blackwell, Noland, Winters study found that about half of the cost of an audit is made up for in interest rate savings. It is reasonable to infer that audit costs would be much lower for start-ups with little financial activity relative to the small businesses in the study which had sufficient financial activity and assets to receive a bank loan. Further, such start-ups in Regulation Crowdfunding would be much riskier than the study’s bank loan recipient companies, thereby increasing the value of an audit. With these reduced audit costs and increased risk reductions, it is reasonable to conceive audits for these issuances to be an overall valuation benefit to issuers, rather than a cost.
The studies also conclude that unaudited companies have significantly higher rejection rates. This is notable relative to Regulation Crowdfund investing; if banks whom can perform extensive due diligence with significant protections are unwilling to lend money to companies based on unaudited information, why would the crowd make such investments when they have little other means of due diligence? The fact is they will not invest without a trusted 3rd party source staking their name and livelihood on the accuracy of the financial statements. Therefore, through reduced rejection rates and thereby increased market participation the competitiveness of investment is increased resulting in an increased likelihood of successful funding.
The Case for Start-up Audits:
Audited financial statements are important for more than just hard numbers, even for a zero revenue start-up. At the earliest stages of operation a company can engage in seemingly minor obligations that have potential for tremendous impact in the near future. For instance, if a programmer for an issuer was granted low dollar stock options as compensation for development services, this information, including all the required disclosures around such, would be of great use to an investor and the omission of such information could create a material detriment to an investor. There is much disclosure that is also audited that could be invaluable to investors, such as: verifying that the business was properly formed, policies, risks, concentrations, explanations of the material account balances explaining any particulars to the issuer, use of estimates, commitments and contingencies, composition of material items in the financial statements, compliance with debt covenants, and related party transactions.
Further, by setting the reporting precedent for newly formed companies they will be better prepared to handle high volume, high complexity financial reporting issues they encounter after funding. Getting a public accountant involved early will serve issuers greatly in developing strong internal controls and financial reporting procedures.
GAAP financials are scaled such that the production of financial statements and auditing of the same would be of minimal time burden and cost. For a pure start-up with no complex transactions or revenue the audit fee would be minimal relative to the value it brings to the investor and transaction.
Debunking the Large Fee Myth
Many industry proponents, articles, and the SEC’s own analysis project constricting audit and review costs for crowdfund offerings. However, with these new exemptions opening a new population to an audit requirement, so too will the audit industry evolve. The existing fee structures represent a largely bureaucratic, inefficient industry that has evolved under PCAOB scrutiny and the fact that audits are only generally currently required for large, highly complex entities. The small and non-complex nature of new companies’ financial activity breeds a need for a new type of CPA firm, efficient, technologically advanced, and cost conscious, like the entities it will be serving.
While some larger firms would tend to agree with the fee estimates for audits and reviews presented in the proposed rules, these fee estimates are overstated relative to new start-ups with low levels of financial activity, and also overstated for the fee levels of the hundreds of smaller boutique public accounting firms across the country preparing to service these offerings. Entities looking to raise under $1M are in the market commonly serviced by local and smaller regional firms, rather than the large national and regional firms. The reduced overhead and efficiency of these firms allows them to operate at much lower billing rates and complete high-quality audits in a fraction of the time of the larger firms. The larger firms simply do not bid on projects of this size for that reason, so their much higher fee estimates are not overly relevant to the discussion of crowdfund audits.
CrowdfundCPA is a network of nimble, efficient small firms servicing start-up and small companies with audits and reviews for a reasonable fee with quick turnaround. CrowdfundCPA can turnaround a pure start-up audit within a week of receiving the necessary documentation and financial statements, with audits as low as $1,500.
Audits as a Tool to Prevent or Detect Fraud
With fraud being a primary concern with Regulation Crowdfund investing, the audit requirement provides investors with a degree of protection from common fraud schemes that could utilize Regulation Crowdfunding. Without the audit requirements, perpetrators of a Ponzi Scheme could use repeated offerings to pay back prior issuance’s investors with new offerings proceeds. The on-going audit requirement would likely identify the transfer of funds into the prior offering books and payments of dividends from such. Another common scheme Regulation Crowdfunding could be susceptible to without an audit requirement is a pump-and-dump-like scheme, without the dumping. Under this scheme companies with no real business plans could get funded using Regulation Crowdfunding, then simply take the proceeds for personal use. The initial audit requirement provides a significant hurdle where such issuers would need to provide substantial evidence of the proper formation of the business and its plans, fund the cost of the audit in front of the offering, and would be unable to falsify historical financial statements to entice investment due to the audit. If the perpetrator made it past this and funded the company using its actual financial information, the on-going audit would likely uncover the personal use of the proceeds and lack of true business activity in the subsequent audits. Having these safeguards in place will serve to protect the integrity of this industry.
Conclusion:
While audits are inherently invasive, costly, and time-consuming, the benefits of an audit are pivotal to the viability of the crowdfunding industry.
The proposed rules for Regulation Crowdfunding represent an excellent compromise of effective regulation while not being unnecessarily burdensome. This industry will not exist without effective and thorough regulation and oversight. The types of investments that will utilize Regulation Crowdfunding are inherently high risk; investors will have no tolerance for additional risks of unscrupulous issuers working with little oversight or transparency. Though these regulations cause some up-front costs, these costs will more than repay themselves through providing a viable market with willing investors and higher valuations from reduction of risks.
With the breadth and depth of information available from the history of capital markets, it is easy to see the power and necessity of strong regulation in capital markets. The least regulated markets, such as OTC penny stock markets, have developed poor reputations rendering them to minimal use and causing companies utilizing these markets to acquire deep discounts in their valuations from the increased risks of such markets. Prior to regulation, mutual funds were highly speculative, rarely used investment vehicles. After the stiff regulatory environment instilled through the 1940 Act, mutual funds are now by far the most common investment vehicle. Despite the heavy regulation of the mutual fund industry, it has evolved and increased its efficiency to the point that now many ETF funds have expense ratios south of ten basis points. Additionally, fraudulent financial reporting is all but non-existent in the mutual fund market, demonstrating that regulation does not have to be expensive to be effective. The goal of most private companies is to go public due to the efficiency of the public stock markets. There is a significant premium on publicly available stocks due to the liquidity premium and the public’s trust in these markets. This efficiency is maximized by regulation, rather than constrained by it. Investors have demonstrated they want information, confidence, liquidity, and transparency. All of these are achievable in Regulation Crowdfunding offerings with the right regulation; to provide such the Regulation Crowdfunding rules need to look more like publicly traded stocks and less like private offerings. The proposed rules achieve this.
Regulation Crowdfunding opens a new world of investment to issuers that have previously been constrained to bank loans, friends and family offerings, and the hopes of venture capital investment. All of these sources have additional information that is unavailable to Regulation Crowdfunding investors without appropriate regulation: personal experience with issuer, mutual rapport with the issuer, and/or extensive due diligence by professionals at VC firms and banks. Without such protections, other regulations are necessary to promote a viable market where investors will want to invest. The audit and review requirements are therefore pivotal to the success of this market, as they represent the key outside verification of the issuers’ information that will be available to investors. Many of these small issuers will not have the level of experience and knowledge of financial reporting requirements to properly report and disclose their finances, so without this outside verification issuers’ financials statements will be of little value to investors. Further, without third party verification the likelihood of investment under this regulation is severely limited.
Additionally, the Regulation Crowdfunding market’s reputation is going to be pivotal to its success. Imagine how the reputation of the industry would suffer if soon after its commencement, fraudulent issuers produced false financial statements and issued $1M offerings, only to take that money for personal use. The reputation of the industry would be crushed before it got off the ground. Such a scenario is not likely with the audit and requirements, providing assurance on the biggest, most newsworthy offerings.
The Value of an Audit
Many studies have been conducted over the past couple decades looking into the benefits of audits and their effect on both the value of a company and the likelihood of funding, concluding overwhelmingly that audits significantly increase the value of companies, and more importantly, increase the likelihood of investment. The Wall Street Journal published the results of a University of Chicago Booth School of Business study of 10,000 closely held businesses to the find value of an audit relative to interest rates. The study indicated an average of a 69 basis point interest rate reduction for audited issuers compared to non-audited issuers. Similar findings from multiple other studies have been published (“The Value of Auditor Assurance: Evidence from Loan Pricing” David Blackwell, Thomas Noland, Drew Winters; “The Value of Financial Statement Verification in Debt Financing: Evidence from Private U.S. Firms” Michael Craig Minnis; “The Demand for Financial Statements in an Unregulated Environment: An Examination of the Production and Use of Financial Statements by Privately Held Small Businesses” Kristian Allee, Teri Lombardi Yohn) clearly showing reduced interest rates for issuers with audited financial statement’s available. This demonstrates reduced risk profiles of companies that have been audited from the perspective of the investor.
It should be further noted that while these reductions represent significant reductions in issuers risk profiles, these statistics are relative to bank loans. In the process of approving a bank loan the loan officer performs extensive due diligence to a degree that is far beyond that available to a Regulation Crowdfund investor. For instance, it would be customary for a loan officer to get all historical financial on the business, any affiliated businesses, and each owner, including personal financial statements and tax returns. In the case that significant real estate or equipment was involved, the bank would appraise such or seek broker price opinions on equipment to substantiate the valuation. Further, it is customary for a bank to collateralize bank loans not only to all business assets and real estate, but also to such of the owners, and then require the owners to sign personal guarantees to the full loan amount from personal assets. After all of this due diligence and with all these additional guarantees, the bank still places significant risk reduction value on audited financial statements.
The Blackwell, Noland, Winters study found that about half of the cost of an audit is made up for in interest rate savings. It is reasonable to infer that audit costs would be much lower for start-ups with little financial activity relative to the small businesses in the study which had sufficient financial activity and assets to receive a bank loan. Further, such start-ups in Regulation Crowdfunding would be much riskier than the study’s bank loan recipient companies, thereby increasing the value of an audit. With these reduced audit costs and increased risk reductions, it is reasonable to conceive audits for these issuances to be an overall valuation benefit to issuers, rather than a cost.
The studies also conclude that unaudited companies have significantly higher rejection rates. This is notable relative to Regulation Crowdfund investing; if banks whom can perform extensive due diligence with significant protections are unwilling to lend money to companies based on unaudited information, why would the crowd make such investments when they have little other means of due diligence? The fact is they will not invest without a trusted 3rd party source staking their name and livelihood on the accuracy of the financial statements. Therefore, through reduced rejection rates and thereby increased market participation the competitiveness of investment is increased resulting in an increased likelihood of successful funding.
The Case for Start-up Audits:
Audited financial statements are important for more than just hard numbers, even for a zero revenue start-up. At the earliest stages of operation a company can engage in seemingly minor obligations that have potential for tremendous impact in the near future. For instance, if a programmer for an issuer was granted low dollar stock options as compensation for development services, this information, including all the required disclosures around such, would be of great use to an investor and the omission of such information could create a material detriment to an investor. There is much disclosure that is also audited that could be invaluable to investors, such as: verifying that the business was properly formed, policies, risks, concentrations, explanations of the material account balances explaining any particulars to the issuer, use of estimates, commitments and contingencies, composition of material items in the financial statements, compliance with debt covenants, and related party transactions.
Further, by setting the reporting precedent for newly formed companies they will be better prepared to handle high volume, high complexity financial reporting issues they encounter after funding. Getting a public accountant involved early will serve issuers greatly in developing strong internal controls and financial reporting procedures.
GAAP financials are scaled such that the production of financial statements and auditing of the same would be of minimal time burden and cost. For a pure start-up with no complex transactions or revenue the audit fee would be minimal relative to the value it brings to the investor and transaction.
Debunking the Large Fee Myth
Many industry proponents, articles, and the SEC’s own analysis project constricting audit and review costs for crowdfund offerings. However, with these new exemptions opening a new population to an audit requirement, so too will the audit industry evolve. The existing fee structures represent a largely bureaucratic, inefficient industry that has evolved under PCAOB scrutiny and the fact that audits are only generally currently required for large, highly complex entities. The small and non-complex nature of new companies’ financial activity breeds a need for a new type of CPA firm, efficient, technologically advanced, and cost conscious, like the entities it will be serving.
While some larger firms would tend to agree with the fee estimates for audits and reviews presented in the proposed rules, these fee estimates are overstated relative to new start-ups with low levels of financial activity, and also overstated for the fee levels of the hundreds of smaller boutique public accounting firms across the country preparing to service these offerings. Entities looking to raise under $1M are in the market commonly serviced by local and smaller regional firms, rather than the large national and regional firms. The reduced overhead and efficiency of these firms allows them to operate at much lower billing rates and complete high-quality audits in a fraction of the time of the larger firms. The larger firms simply do not bid on projects of this size for that reason, so their much higher fee estimates are not overly relevant to the discussion of crowdfund audits.
CrowdfundCPA is a network of nimble, efficient small firms servicing start-up and small companies with audits and reviews for a reasonable fee with quick turnaround. CrowdfundCPA can turnaround a pure start-up audit within a week of receiving the necessary documentation and financial statements, with audits as low as $1,500.
Audits as a Tool to Prevent or Detect Fraud
With fraud being a primary concern with Regulation Crowdfund investing, the audit requirement provides investors with a degree of protection from common fraud schemes that could utilize Regulation Crowdfunding. Without the audit requirements, perpetrators of a Ponzi Scheme could use repeated offerings to pay back prior issuance’s investors with new offerings proceeds. The on-going audit requirement would likely identify the transfer of funds into the prior offering books and payments of dividends from such. Another common scheme Regulation Crowdfunding could be susceptible to without an audit requirement is a pump-and-dump-like scheme, without the dumping. Under this scheme companies with no real business plans could get funded using Regulation Crowdfunding, then simply take the proceeds for personal use. The initial audit requirement provides a significant hurdle where such issuers would need to provide substantial evidence of the proper formation of the business and its plans, fund the cost of the audit in front of the offering, and would be unable to falsify historical financial statements to entice investment due to the audit. If the perpetrator made it past this and funded the company using its actual financial information, the on-going audit would likely uncover the personal use of the proceeds and lack of true business activity in the subsequent audits. Having these safeguards in place will serve to protect the integrity of this industry.
Conclusion:
While audits are inherently invasive, costly, and time-consuming, the benefits of an audit are pivotal to the viability of the crowdfunding industry.