The Architecture of Extractive and Generative Ownership

Extractive Ownership                                      Generative Ownership

One day we will look back and ask why did everybody’s ‘stuff’ look just like everyone else’s, only in a different color or surface design? Something’s going on. The uniformity of mass production and the narrow range of centrally-mandated design choices are loosening their hold on us.

Manufacturing, how products are designed and by whom, is changing in profound ways.

Computer-controlled tools like 3D printers, milling machines and laser cutters are mostly available in costly, high-end versions, but there is a movement to create affordable versions of these tools that sit on the desktop. Admittedly, these desktop tools have fewer capabilities than their industrial counterparts, but they are already powerful enough to do remarkable things. Several projects for developing better and cheaper laser cutters have been funded through the crowdfunding website Kickstarter, each for several thousand dollars. MakerBot Industries, founded in 2009 makes consumer-priced 3D printers and offers kits to build them for about $1,000.

Publisher Tim O’Reilly’s Make Magazine, started in 2005, caters to a 21^st century hobbyist culture. It promotes making, crafting and tinkering as a type of grassroots movement. Make Magazine and its annual fairs have popularized an ‘open source’ approach to sharing designs and ideas.

Communal workshops, called ‘maker spaces’, are popping up around the country and indeed, around the world.  Many maker spaces are chartered as not-for-profit Fab Labs and Hackerspaces, or for-profit TechShops. There’s even an emerging trend where public libraries are hosting maker spaces as in the case of the Fayetteville Free Library in New York State.  Many of these maker spaces offer classes to their members and the public on topics such as electronics, programming, crafts and many other skills. Various consortia of these maker spaces are interconnected via the internet, so they can share ideas and best practices.

New companies like Shapeways and Ponoko, founded in 2007 and 2009, respectively, give users online personal factory services. Users upload or select product design files, and the service fabricates the design into a three-dimensional object and ships the finished product to the user.

A Few Thoughts on 3D Printers

In traditional mass production, it is difficult to produce small batches of a product because of the re-tooling costs. To obtain ‘economies of scale’ requires sacrificing product design and re-design flexibility.

In contrast, 3D printers can alter the printed shape of each unit produced without incurring the costs to re-tool and re-balance the production line.

3D printers apply successive layers of material until the desired object emerges (‘printed’), without the use of specialized tooling. These devices are fascinating to watch and there is an almost science-fiction like quality to watching a finished, three-dimensional part emerge in real-space. It’s a popular category on YouTube.

Industrial 3D printers have existed since the 80’s and their high cost (ranging from several hundred thousand dollars to more than a million dollars) has kept them confined to large institutions that can afford them. They’ve been used mainly in the aerospace, medical and automotive industries to produce prototypes for testing design assumptions, rather than used to produce large quantities of the finished product directly.

It’s likely that in the next few years, 3D printers will be developed that can economically produce high unit runs of finished goods, while altering the printed shape of each unit produced. If 3D printing, or ‘additive manufacturing,’ as it is also called, becomes a mainstream system for directly producing finished goods, it may supplant our current system of mass production and break the link between shape complexity and cost.

I have blogged before (“Memberships as Securities”) about how in some states, the definition of a security is so broad that almost any attempt to raise money including pre-selling, no interest loans, memberships, gift certificates, etc. could fall within the purview of the securities laws.  California was the first state to adopt this alternative, broader definition of a security, and 16 jurisdictions have followed.  The test used in these states is called the risk capital test and basically says that any time an offering is made to the public that asks people to put money at risk to fund a business venture, it will be considered a security.  (Note that states that use this test also use the more common test of whether there is an expectation of a profit – they apply both tests and if something meets the definition of a security under either test, it will be deemed a security.)  To illustrate the principle, here is a summary of two cases in which the courts found the capital raising strategy to NOT be a security.  The take home message seems to be that you need to have something valuable like diamonds or gold securing your investors’ money if you want to fall outside the securities laws in California!

In Moreland v. Department of Corporations, the court found that the sale of gold ore and a contract to refine the ore was not a security under the risk capital test even though “the promotional materials given to the public by appellant included the following statement: ‘The reason for selling the gold at this price is to raise the capital for a new milling and refinery plant . . . .’”[1]  The Department of Corporations argued that the intended use of the proceeds demonstrated by this statement satisfied the requirement under the risk capital test that the funds “be used for a business venture or enterprise.”[2]  The court disagreed, stating, “Superficially, this may be so since the construction of a mill and refinery is essential to the conduct of appellant’s intended mining, milling and refining operations. However, it is equally true that every purchaser of a product from a seller, who reinvests the proceeds of the sale in his business operations, contributes to a seller’s business capital. Notwithstanding, such a contribution is an investment in the purchased product and not a contribution of risk capital to a business enterprise within the normal scope of securities regulation.”[3]

In Hamilton Jewelers v. Department of Corporations, the court held that the following offering did not constitute a security under the risk capital test: “’Hamilton Jewelers invites you to invest in a ONE CARAT DIAMOND for only $500, and if anytime [sic] within a three year period you elect to return the Stone, Hamilton will return to you the full purchase price plus 5% interest calculated daily from the date of purchase.  A diamond investment of $500 will return $578.81 in cash at the end of a three year period.’”  The court reasoned that even though the offer to pay interest on an investment would normally fall within the definition of a security, in this case the investor’s capital was not at risk because the investor had a diamond worth at least $500.  The court stated, “The customer, being adequately secured, would have placed no ‘risk capital’ with Hamilton; and, therefore, the transaction would not come within the regulatory purpose of the Corporate Securities Law even though 5 percent interest might ultimately be paid to the customer.”[4]

The mainstream’s view about small business is nicely encapsulated in the 1960s cult classic, “Bambi Meets Godzilla.”   In 90 mesmerizing seconds Tokyo’s all-star quickly dispatches the cute Disney character with a single, pulverizing stomp.  Similarly, the conventional wisdom suggests that small businesses, while cute and pleasing for communities, don’t stand a chance against rigors of global competition.  That’s the message of James Surowiecki’s piece, “Big is Beautiful,” in The New Yorker, 31 October 2011.  “These days….” he complains, “the fetishization of small business continues apace.”

Wanting to appear fair, Surowiecki begins by admitting that “some of the support derives from real virtues that small companies offer—diversity of choice, connection to local communities.”  He seems to be unaware of the growing academic literature that local small businesses also help communities grow incomes, improve equality, attract tourists, create walkable communities, enhance environmental protection, and encourage voting participation.

“But the truth is,” insists Surowiecki, “that, from the perspective of the economy as a whole, small companies are not the real drivers of growth.”  He can only arrive at this stunning conclusion by ignoring the evidence from recent studies by the Kauffmann Foundation on the critical job-creating roles of small, start-up businesses.  So instead he turns to international data.

“One can see this by looking at the track record of the world’s economies,” he writes.  “The developed countries with the highest percentage of workers employed by small businesses include Greece, Portugal, Spain, and Italy—that is, the four countries whose economic woes are wreaking such havoc on financial markets. Meanwhile, the countries with the lowest percentage of workers employed by small businesses are Germany, Sweden, Denmark, and the U.S.—some of the strongest economies in the world.”

A critical reader of Surowiecki’s column is then stuck, because he gives no reference for these data.  Those who do study industry structure around the world track SMEs – small and medium enterprises.  (What’s a medium-scale enterprise in most countries is regarded as small in the United States.)  A nice summary of the percentage of the workforce involved in SMEs was prepared by Marta Kozak of the IFC in 2005.  Among the things her data show:

-          The smallest percentage of the workforce in SMEs actually can be found in the former communist countries like Armenia (26%), Latvia (21%), Slovenia (20%), Georgia (7%), and Ukraine (5%).  None of these countries are pargons of economic stability or growth.  Nor are other big-business countries like Malawi (38%), Guatemala (32%), Tanzania (25%), or Thailand (18%).

-          Surowiecki is correct that the four currently unstable countries of Europe have a high (>70%) SME presence.  But an equally strong SME presence can be found in economic powerhouses like Korea, Switzerland, New Zealand, China, and Japan.  Where’s the causality?

-          Surowiecki is completely wrong about Denmark (which is at 78% SME) and Germany (70%).  And mostly wrong about France (63%).

-          Indeed, among the OECD countries, the highly wobbly U.S. economy stands as having one of the lowest representations of SMEs  (about 51%).

“This correlation is not a coincidence,” concludes Surowiecki.  “It reflects a simple reality: small businesses are, on the whole, less productive than big businesses.”  In fact, the absence of a correlation and Surowiecki’s mispresentation of the actual data is not a coincidence either.  It reflects the unreliability of his scholarship.

Next, Surowiecki turns to a World Bank study of 99 developing countries, written by Megahana Ayyagari et al (“Small vs. Young Firms Across the World,” April 2011, Policy Research Working Paper 5631).  He neglects to mention the principal finding of that paper:  “Overall, we find that small firms and mature firms have the largest shares of job creation but large and mature firms have the largest share of job losses.  Even in countries which had a net job loss we find small firms creating jobs.”

Indeed, the World Bank study offers more evidence for the power of small businesses in churing out new net jobs – annual created jobs minus lost jobs – than the Kauffmann Foundation research does for the United States, “The US evidence suggests that small mature firms have net job losses whereas in developing countries we find that small mature firms have the largest share of job creation.  Moreover, in countries that have had net job losses in the economy as a whole, it is only the small firms, especially small mature firms that have net job gains.”

Surowiecki focuses on another, tiny part of the study, however, to make a debating point about productivity—“that large firms had significantly higher productivity growth.”

Again, the World Bank study is more nuanced that Surowiecki is: “SMEs with 5-100 employees irrespective of age have significantly lower productivity growth than the larger firms.  While the mid-sized firms (101-250 employees) that are <2 years old or 3-5 years have as good or slightly higher productivity growth than the largest mature firms, the mature mid-sized firms (101-250 employees and 6+ years) have significantly lower productivity growth than the largest mature firms.”

So it turns out that the best contributors to productivity growth are not large-scale companies, but medium scale and young.  Small companies don’t do as well in the developing country context, compared to those in the OECD countries, because their proprietors are less well educated and their access to capital is more limited.  One can think of other special problems that small businesses in the global south face that their northern counterparts do not.  Southern small businesses lack access to the internet and basic technology.  Their labor pools are disorganized.  Limited transportation and communication infrastructure limits their ability to export.

After his around-the-world-tour with fictitious data, Surowiecki returns to the United States.  “And in the U.S. the connection between size and productivity is, as a 2009 study showed, especially close. Big businesses are also better able to make investments in productivity-enhancing technologies and systems; in the U.S., for instance, big companies account for the vast majority of R. & D. spending.”  He doesn’t give any clues about what 2009 study he’s referring to, but there’s enough literature out there to accept his facts but refute his conclusion.

Yes, larger businesses generally have higher labor productivity.  Another way to think of it is that they apply more capital relative to labor.  But if higher labor productivity means less employment, it doesn’t necessarily improve national well being.  Higher labor productivity once meant higher wages, but that’s no longer the case.  One of the key phenomenons of recent years is the dramatic growth in the productivity of U.S. firms, and the stagnation or decline of wages.  When managers extract greater compensation packages and shareholders extract greater profits, the productivity gains do not translate into better pay.

In the long run, higher labor productivity may be necessary but insufficient for higher incomes.  By subjecting themselves to greater accountability from stakeholders like employees, customers, and shareholders, smaller firms, particularly those that are locally owned, actually can ensure that productivity gains result in higher incomes.  This may help explain why several regression analyses of the United States show that communities with higher densities of small business experience higher income growth.

A year ago, for example, in the Harvard Business Review, a graph appeared with the headline “More Small Firms Means More Jobs.” The authors, Edward L. Glaeser and William R. Kerr of Harvard, wrote, “Our research shows that regional economic growth is highly correlated with the presence of many small, entrepreneurial employers—not a few big ones.”

Here’s another piece of evidence:  The workforce associated with small businesses, when one accounts for the skyrocketing of home-based businesses, actually has been growing over the past decade.  That’s hardly the mark of diminishing competitiveness.

Finally, big companies may account for most U.S. R&D spending, but small businesses spend proportionately more of their budgets – and generate 15 times more patents per unit business than do larger businesses!

Surowiecki’s bias against small business comes from a Mad Men view about economies of scale.  What he overlooks – and I document extensively in The Small-Mart Revolution – are a dozen global trends that are shrinking economies of scale.  Global distribution systems have become unwieldy and inefficient.  Rising energy prices will make global transportation unacceptably expensive for heavy nondurable goods like food, wood, and building materials.  The internet is giving small businesses the ability to do anything from anywhere.  Homeland security concerns are placing a premium on local self-reliance.  Alliances of local businesses are learning how to compete through collaboration (Tucson Originals, for example, is a group of local food businesses that lower costs through collective purchasing of local foodstuffs and cooking equipment).  And so on.

Ignoring the ways in which monopolies wreck free markets and gouge consumers, Surowiecki praises the innovations of monopolists like A&P last century and Wal-Mart in this one:  “Because A. & P. invested in its own warehouse-and-delivery system, it was able to improve inventory management, which is essential for any retailer. While its competitors were taking four months to turn over their inventory, A. & P. was doing it in five weeks. Walmart, similarly, invested heavily in making its supply chain more efficient, and it was directly responsible for a sizable portion of the productivity boom of the nineties.”

There’s no question that big companies can drive some innovations.  But many others – like the deployment of low-tech energy efficiency measures – require small firms operating at the community level.  Even in the area of supermarkets, the innovations pioneered by A&P and Walmart could be adopted, even improved, by small competitors.  Independent IGA markets, for example, blend advantages of local grocery stores with inventories provided by highly efficient global purchasers like SuperValu Inc.

Perhaps the only observation Surowiecki makes that is remotely true is that “it’s harder for small businesses to innovate in these ways…when credit is tight, as it is now.” And it underscores why reforms in local investment, as Amy Cortese documents in her great book Locavesting (and as I’ll elaborate in my forthcoming Local Dollars, Local Sense) are key to improving the competitiveness of local small business.

Does does this also mean, as Surowiecki suggests, that small businesses are not interested in expanding or innovating?  “A recent study by the economists Erik Hurst and Benjamin Pugsley,” he writes, “shows that only a tiny fraction of small-business owners have any interest in becoming big-business owners, or even in bringing a new idea to market. Most are people who simply want to run a small company, do work they enjoy, and have some control over their own financial lives.”

The Hurst-Pugsley study is filled with fascinating data about the inclinations of small-business entrepreneurs, but the results are easy to overinterpret.  Small business owners may not want to become big business owners, but does that necessarily mean they do not want to modestly grow their companies, their products, or their bottom lines?  As the Association for Enterprise Opportunity has shown, even a slight expansion of every small business in the country would solve the nation’s unemployment problem.

Moreover, might small businesses be relatively unambitious because they are keenly aware of the myriad ways public policy opposes their expansion?  Might they be frustratred that the anti-trust division of the Department of Justice, like Suroweicki himself, has given a free pass to monopolists like Wal-Mart?  Or that securities law favors big-dollar investors?  Or that tax laws favor interstate sellers?  Might this unequal playing field drawn certain kinds of entrepreneurs, and push away others?  And might more fair rules draw more ambitious entrepreneurs into local businesses?

“It’s hardly a coincidence,” Suroweicki concludes, “that in the decades after the Second World War, when ordinary American workers became part of the middle class, very big companies employed a huge percentage of the workforce: in the early seventies, one in five non-farm workers worked for a Fortune 500 company.”  In fact, this history is a reflection of the fact that U.S. companies dominated the global economy between World War II and the 1970s.  Large economies of scale were the norm.  Today, that era is ending.

Despite the rhetorical “fetishization” of small business, U.S. policymakers continue to neglect them.  Economic development programs overwhelmingly favor the attraction of nonlocal big business, and President Obama’s stimulus program prioritized big business benefits and tax cuts.  The catastrophic results of these priorities are plain for everyone to see.  Small may not be beautiful to James Surowiecki, but at least we know it works.

By Michael Shuman

In his 1974 opinion in Geduldig vs. Aeillo, Supreme Court Justice William Rehnquist asserted that discrimination on the basis of pregnancy was not tantamount to discrimination on the basis of sex.  His classic sentence expressing this tortured logic was:  “Pregnancy is of course confined to women, but it is in other ways significantly different from the typical covered disease or disability.”

It is a similar twisting logic that leads Jared Bernstein to conclude, in a New York Times op-ed (“Small Isn’t Always Beautiful,” 23 October 2011), that even though start-up businesses critical to job growth tend to be small, small businesses themselves do not matter.  Come again?

I like and admire much of Jared Bernstein’s work, but he really doesn’t understand the case for small business.  Having spent much of his professional life in the labor-funded Economic Policy Institute, Bernstein comes to most economic discussions with a visceral skepticism about small businesses generally (because many have historically supported Republican policy agendas) and a comfort with large businesses generally (because they are more likely to be unionized).   One wishes he were more aware of new small-business organizations like the Business Alliance for Local Living Economies (BALLE) that embrace labor rights.

Bernstein’s piece is valuable for two reasons.  It’s a nice summary of a common skeptical view of small business to which small-business supporters like us need to respond.  Second, it’s clear evidence that our arguments – about the importance of small businesses in economic development – are gaining strength and therefore, from Bernstein’s standpoint, need to be rebutted.

Over the last year, research funded by the Kauffmann Foundation (among others) has proven that small businesses are the “engine of job growth.” According to one widely circulated paper by E.J. Reedy and Robert Litan, entitled “Starting Smaller; Staying Smaller; America’s Slow Leak in Job Creation”:  “Conventional wisdom about job growth tends to focus on the jobs that are being created at existing (typically big) companies.  But as a wealth of new research has shown, new businesses are vital contributors to a health jobs market.”

Bernstein attempts to debunk this:  “In fact, according to path-breaking work by the economist John C. Haltiwanger and his colleagues, once they accounted for the outsize contributions by new and young companies, they found ‘no systematic relationship between net job growth and company size.’”

Weirdly, the Kauffmann researchers based their conclusions on the exact same paper.  Does the Haltiwanger paper actually say the opposite of what Reedy and Litan claim?  Hardly.  Here’s one of its conclusion:

“We find some evidence in support of the popular perception that small businesses create more jobs along the following lines.  If one looks at the simple relationship between firm size and net growth rates, there is evidence that net growth rates tend to be higher for smaller as opposed to larger businesses….Using our preferred firm size classification ….the inverse relationship between net growth rates and size remains but is not overwhelming.” (p. 29)

In other words, small businesses are superior job creators, just not quite as superior as some advocates have previously suggested.  The key finding of the paper – which Kauffmann made its own headline – is that the age of the firm is a more robust variable than size.

“Our findings suggest that it is particularly important to account for business startups.  Business startups account for roughly 3% of the U.S. total employment in a given year.  While this is a reasonably small share of the stock, it is large relative to the net flow….Startups tend to be small so much of the truth to the popular perception is driven by the contribution of startups, which are primarily small, to net growth.” (p. 30)

The research doesn’t negate the role of small business, it sharpens it.  It underscores that small start-up companies are the key to job growth in our economy.

So what about the line in Haltiwanger’s paper, which Bernstein highlights, that there’s no ‘no systematic relationship’ between net job growth and company size?  What it means is that if, through statistical analysis, you subtract the impact of “new and young firms,” there is no relationship between firm size and job creation.  But that doesn’t change the fact that most “new and young firms” also happen to be small. Bernstein is implying a conclusion that’s the opposite of the evidence.

Bernstein next says, accurately, that “57% of total compenstation is paid out by companies of 500 or more employees, with most of that coming from the largest, those with at least 10,000 employees.”  Since small businesses pay less, he seems to be implying that they are less relevant to national prosperity.

It is true that larger businesses pay more in wages – about 29% more in the 2008 data Bernstein is using.   But the following facts suggest caution in how one interprets the wage differential:

-       The spread between larger and small business pay and benefits has been steadily shrinking, as U.S. manufacturers move overseas and large Wal-Mart stores paying minimum wage spread across the U.S. interior.  This difference could well end in the coming decade.

-       There’s huge variation within each size class.  Many small businesses, like law firms and hedge funds, certainly pay way-above-average compensation.

-       Small business proprietors tend to pay themselves very low wages as they are building up the company.  “Annual payroll” does not take into account non-pay equity accumulation.  Likewise, people working for small businesses tend to be thinking about the growth potential as they forego their full salary potential.

-       One explanation of the differences between large and small businesses is how they match labor to capital.  Larger businesses apply more capital, less labor; smaller businesses apply more labor, less capital.  Is it really a benefit to society to have more capital intensive businesses?  Is it a pro-labor position to suggest that the higher unemployment that arises from replacing labor with capital is a virtue?

Bernstein then tries to belittle the role of small businesses by reporting that “new research by the Treasury Department finds that small businesses…account for just 17% of business income, and only 23 percent of them pay any wages at all.”

In fact, this research – “Methodology to Identify Small Business and Their Owners” by Matthew Knittel et al. – is not about the economic potential of small businesses, it’s about new ways to identify them.  It’s an effort to develop a new methodology that the authors readily admit “will differ [from the definitions used by the SBA] because they are based on different data sources and concepts and used for different purposes.” (pp. 2-3) So, sure, if you define the universe of small businesses more narrowly, their income and payroll fractions of the economy will be smaller.  Big deal.  It’s not that the Treasury Department has in fact discovered that the existing universe of small businesses contributes less to the economy.

Even within this narrower universe of small businesses, the Treasury Department report shows that net income rate per dollar of receipts of small business is roughly equal to all businesses (p. 26), which underscores the yet unrealized potential of investing in small businesses.

It’s worth noting, finally, that Bernstein doesn’t review or engage with the studies most familiar to local business advocates.  He may not even know about them  These studies show:

-       That communities with a higher density of small businesses tend to have higher income growth, more equality, better voting participation, more entrepreneurship, more tourism, and more smart growth.  (See, e.g., Edward L. Glaeser and William R. Kerr, “The Secret to Job Growth: Think Small,” Harvard Business Review, July–August 2010.)

-       That from the perspective of communities, a local business (typically small) contributes two to four times more to local economic development than do nonlocal businesses. (See, e.g.,  various studies at www.civiceconomics.com )

-       That from the perspective of government-led economic development, small businesses produce more jobs per unit dollar than do larger nonlocal businesses.  (See my 2006 book The Small-Mart Revolution.)

If one adds the lessons of these studies to those of the Kauffmann Foundation, government agencies at all levels would be smart to focus economic development efforts on companies that are small, local, and young.   Bernstein’s position that small businesses do not matter, driven by a Rehnquist-like logic to avoid admitting the obvious,  sadly prevailed within the Obama Administration in its big-business stimulus policies, and is one reason why the President’s job creation record has been so disappointing and our economy continues to stagnate.  Only if and when policymakers begin to focus their stimulus efforts on the key needs of local business – local capital, local entrepreneurship, and local purchasing – will we finally be able to jump-start the nation’s economy.

Corporations are not necessarily inherently evil – the corporate form is a tool that can be used for great things.  Some of the benefits of the corporate form are the limitation of liability for the owners, continuity that allows the activities to continue as individuals come and go, and more options for raising capital.  While the limitation of liability of the owners has resulted in horrible corporate behavior, it also has facilitated the growth and development of great businesses, like Equal Exchange, a worker-owned fair trade coffee and chocolate corporation.  Without the limited liability feature of corporations, it would be very hard for people of limited means to join together to conduct inherently risky activities.

A Problem with the Corporate Form

There are some problems with the current model of corporations.  One of them is “shareholder primacy” – the obligation of corporations to maximize shareholder profit at the expense of other stakeholders like workers, community, and environment.

First, it’s important to understand that shareholder primacy is not actually something that boards of directors have to worry about on a day-to-day basis.  Legally, boards of directors do not have to maximize shareholder profit with every decision they make – they have wide latitude under the Business Judgment Rule doctrine.  However, when a board is considering selling the company, there is case law (from Delaware) that states that the board has a duty to only consider shareholder profit and nothing else.

Constituency Statutes

Some states (about 30) have adopted “constituency statutes” that specifically authorize or even require boards to consider factors other than shareholder profit when making decisions, even regarding change of control.

The following is an example of one of these statutes:

“A director of a corporation . . . shall consider, in determining what he reasonably believes to be in the best interests of the corporation, (1) the long-term as well as the short-term interests of the corporation, (2) the interests of the shareholders, long-term as well as short-term, including the possibility that those interests may be best served by the continued independence of the corporation, (3) the interests of the corporation’s employees, customers, creditors and suppliers, and (4) community and societal considerations including those of any community in which any office or other facility of the corporation is located. A director may also in his discretion consider any other factors he reasonably considers appropriate in determining what he reasonably believes to be in the best interests of the corporation.” Connecticut General Statutes 33-756(d).

Unfortunately even the existence of a constituency statute may not always be enough to prevent hostile takeover by a multinational corporation that has no intention of preserving the founders’ values.  The fear of shareholder lawsuits can be enough to prevent a board from accepting a lower offer from a prospective acquiror that is more value-aligned.

Charter Provisions

Some businesses like Upstream 21 in Oregon have incorporated charter provisions that “bake in” the requirement to consider all stakeholders when making decisions (and not just shareholder profit).  Unfortunately, most lawyers would advise that it is too risky to adopt such provisions in states (like California and Delaware) that do not have constituency statutes (because the obligation to maximize shareholder return under state law would be in conflict with the charter provisions)

Upstream 21 included the following provisions in its charter:

• Each director is required to sign an agreement stating that he/she shall discharge the duties of a director in a manner the director reasonably believes to be in the best interests of the Company and the best interests of the Company is defined to include the Company’s and its subsidiaries’ social, legal and economic effects on their employees, customers and suppliers and on the communities and geographic areas in which the Company and its subsidiaries operate; the long-term as well as short-term interests of the Company and its shareholders; and the Company’s and its subsidiaries’ effects on the environment.

• When evaluating any offer of another party to purchase the Company or merge, the directors are required to consider the following: the social, legal and economic effects on employees, customers and suppliers of the Company and its subsidiaries and on the communities and geographic areas in which the Company and its subsidiaries operate; the economy of the state and the nation; the environment; the long-term as well as short-term interests of the Company and its shareholders, including the possibility that these interests may be best served by the continued independence of the Company; and other relevant factors.

• There are four classes of voting stock for the board of directors, outside investors, employees, and other shareholders

• When shareholders vote on any matter such as the election of the board, each share is entitled to one vote but when the shareholders must vote on one of the following actions (“Extraordinary Actions”), different voting rules apply (described below)
  • Amendments to the articles of incorporation
  • Amendments to the bylaws
  • Conversion
  • Merger
  • Share exchange
  • Dissolution
  • The sale, lease, exchange or other disposition of all or substantially all of the Company’s property
  • Removal of a director

• An Extraordinary Action may only be approved if (1) a majority of all shares entitled to vote on the action, without regard to class or series, vote in favor of the action AND two-thirds of all shares of any two series of Class A Common Stock entitled to vote on the action, voting separately by series, shall not vote against the action; OR (2) two-thirds of all shares of any two series of Class A Common Stock entitled to vote on the action, voting separately by series, vote in favor of the action.

B Corporations

B Labs, a nonprofit that rates corporations on social responsibility, requires corporations that want to become certified “B Corporations” to adopt a charter provision requiring the board to consider stakeholders other than shareholders: “including, but not limited to, the long-term prospects and interests of the Company and its shareholders, and the social, economic, legal, or other effects of any action on the current and retired employees, the suppliers and customers of the Company or its subsidiaries, and the communities and society in which the Company or its subsidiaries operate, (collectively, with the shareholders, the “Stakeholders”), together with the short-term, as well as long-term, interests of its shareholders and the effect of the Company’s operations (and its subsidiaries’ operations) on the environment and the economy of the state, the region and the nation.”

New Entities

Some state have adopted statutes creating new entities that are required by law to be driven by a socially beneficial purposes and not the maximization of shareholder profit.  These statutes include low-profit limited liability companies (L3Cs), benefit corporations, and flexible purpose corporations.  The movement to have states adopt benefit corporation statute is being led by B Labs, the same nonprofit that certifies B Corporation.  This new form has already been adopted in Maryland, Virginia, New Jersey, Hawaii, Vermont, and, most recently, California.  It is expected to be adopted soon in several other states including Colorado, New York, North Carolina, Michigan, and Pennsylvania.

What is crowdfunding?

Crowdfunding is basically the opposite of the mainstream model of business finance. In the mainstream model, when you need to raise capital you go to a bank, a wealthy individual (often known as an angel investor), or a venture capital fund. You rely on one, or very few, large funders for your project. With crowdfunding, you open up funding opportunities to a much larger audience and may end up with tens or hundreds of funders. There are several advantages to this method of funding:

• You have more people that are invested in your success and are likely to support you.
• You create an opportunity for non-wealthy, nonprofessional investors to put money into something they feel excited about.
• With a large number of small investors, it’s unlikely that any of them will expect to be able to control the way you operate.
• With a larger potential pool of funders, you have a better chance of actually raising the amount of money you need.

The main downside is that there are some legal constraints that can get you into trouble if you aren’t careful.

Legal traps for the unwary

Offering any kind of investment opportunity is an activity that is highly regulated by both state and federal law known as securities law. These laws were passed early in the last century to protect investors from slick pitch artists who traveled across the country selling worthless investments. Kansas adopted the first securities law in 1911 to “keep ‘Kansas money in Kansas’ and help local farmers and small businesses rather than enriching ‘New York Stock Exchange speculators and gamblers.’”

Ironically, these laws now make it almost impossible to invest in small businesses in our communities and pretty much compel us to invest in the New York Stock Exchange. In the name of protecting investors, securities laws now make it very difficult to raise money with crowdfunding.

The basics of these laws is that before any investment opportunity can be offered, the person making the offering must file extensive disclosure documents with the federal government, as well as any state in which the offering will be made. There are some exemptions to this general rule, but even the exemptions take securities law expertise to comply with. The result is that anyone offering an investment opportunity may have to spend thousands in legal fees and filing fees before even being able to mention it to any potential funders.

Generally, if you bring on a large, wealthy investor, the legal compliance required is minimal because the law assumes that these people and companies need much less protection (they are defined as “accredited” investors under the securities law). The moment you want to offer an investment opportunity to the public and to non-wealthy investors, the legal requirements become far more onerous.

Failure to comply with these requirements can, at a minimum, result in having to return all your investors’ money. At worst, there could be civil and even criminal penalties.

Best practices for crowdfunding within the law

There are ways to do crowdfunding within the law. Unfortunately, under the current legal regime, the options are fairly limited. As discussed below, this all may be about to change very dramatically!

1. Falling outside the securities laws

The easiest and lowest cost strategy is to raise money using a method that is unlikely to fall within the legal definition of a security.

Unfortunately, this definition is quite broad, especially under the laws of many states. For example, even if you offer an investment opportunity in which your investors do not expect any financial return and do not receive any ownership share of your business, this still may be considered a security if your investors are expecting something in return and there is some risk that they will not get what they are expecting. Under this definition, if you were starting up a café and you sold gift certificates for the café as a way to raise your start up capital, this could be seen as a security in certain states. Similarly, if you borrowed money to start a new business and did not promise any financial return (in the form of interest) but did promise to return your lenders’ principal, this could also be considered a security.

So how can you raise money in a way that almost certainly will not be considered a security? Ask for donations! If it is completely clear that there are absolutely no strings attached to a contribution of funds, it is highly unlikely that any state would consider the securities laws to be applicable. Web sites like Indiegogo and Kickstarter provide a platform for doing this and have helped many people reach their funding goals. On these platforms, people sometimes offer “perks” in exchange for contributions. To our knowledge, none of these offerings has been subjected to scrutiny by securities regulators to date, but it is possible that even the offering of a perk in exchange for a donation could convert these offerings into securities in the eyes of some state governments. And of course when you are raising money on the internet, you can be scrutinized by the regulators of all 50 states!

The moment you offer anything in return to your donors and there is some risk that they will not receive it, there is a chance that your state will consider what you are offering to be a security. (This is not the case under federal law where if the investor has no expectation of a financial return the securities laws do not apply.)

What if you’re not sure whether what you want to offer your funders will be considered a security under your state’s laws? You can write a letter to the department within your state government that is responsible for securities regulation describing what you plan to offer and request a “no action letter.” This is a letter stating that the securities regulators will not take enforcement action against you based on your description of what you plan to offer. If you receive a no action letter (which usually does not require the payment of a fee), you are good to go.

2. Legally compliant platforms

There are two crowdfunding web sites that have spent tens of millions of dollars in legal fees so that they can offer crowdfunding opportunities that are compliant with state and federal securities laws. These are Prosper and Lending Club. You can use these web sites to raise money from the public in the form of debt (i.e. loans that must be repaid as opposed to other kinds of investments where repayment is usually contingent on the company’s success).

3. Co-ops

Many state securities laws contain exemptions for cooperatives. For example, a cooperative in California that sells memberships to the public for no more than $300 each is exempt from the California rules regarding securities offerings. Co-ops in Colorado are exempt regardless of the membership contribution. If you choose to form a co-op, it’s worth exploring whether your state might have an exemption from the securities offering requirements that will make crowdfunding possible for you. Note however that this will only work if you are exempt from federal securities registration requirements because you do most of your business within the state where you are located, you are formed under the laws of that state, and you only offer securities to the residents of that state (this is know as the federal intrastate exemption). Also, if you are a farmers co-op that has received tax-advantaged status from the IRS under Section 521, lucky you. You are exempt from both federal and state securities registration requirements. This is what allows the co-op Organic Valley to raise money from the public without having to spend millions of dollars in compliance costs.

4. Private offerings

A private offering is a legal term which means that you do not advertise your investment opportunity to the public. These kinds of securities offerings are less highly regulated than ones advertised to the public because of the belief that public advertising creates a greater risk of fraud. Being unable to advertise to the public seems inconsistent with the idea of crowdfunding, but not necessarily! Gather Restaurant in Berkeley successfully used a private offering to raise funds from approximately 100 investors. If you have relationships with a lot of people who might be willing to invest in your idea, this strategy can work. However, these kinds of offerings generally do require working with a lawyer, although the costs are much lower than for a public offering.

5. Direct public offerings

A direct public offering involves making the required filings with relevant regulators that allow you to offer your investment to the public. This can sound overwhelming, but many states have made an effort to make this process accessible to small businesses. Many small businesses have successfully completed the process with minimal or no legal support. Because you are required to file offering documents and application forms with the state, the state regulators will make sure that you complete these documents correctly before you begin your offering. Once you have a sign-off from the state, you can be fairly confident that you’re legally in the clear (this assumes of course that you have been honest in the documents you submitted!).

New developments

By now you are probably outraged to learn that most crowdfunding is either illegal or prohibitively expensive. You are not alone! In July 2010, Sustainable Economies Law Center sent a letter to the Securities and Exchange Commission, the federal body charged with regulating securities, with a modest proposal. Why not exempt very small securities offerings from the onerous requirements that make it almost impossible for all but the nation’s biggest businesses to raise money from the public? We proposed an exemption for capital raises of up to $100,000 with a maximum of $100 contributed per investor. The SEC received over 150 letters of support for the proposal. Other similar exemptions have been proposed and the idea got the attention of some members of congress who held hearings on crowdfunding. A proposed bill, HR 2930 (McHenry), would exempt offerings of up to $5 million with a maximum of $10,000 or ten percent of net worth per investor and would exempt such offerings from state-level registration requirements. Meanwhile, President Obama recently proposed a similar exemption. And SELC has begun to make requests for a similar exemption from state securities regulators.

Stay tuned – crowdfunding may become much easier very soon!

Note: Sustainable Economies Law Center is working on various tools to provide information about securities laws that is practical and understandable for non-lawyers. Please check our web site for updates.

1) File a Form 1 with the SEC.  This is basically filing an application to become a “Self Regulatory Organization” or “SRO” - which would mean that the organization would be asking permission from the SEC to become a new stock exchange – and further asking that the SEC grant special permission to allow it to list small companies using a lower listing standard (small capitalization) thas is not normally allowed today.  This would require some very compelling arguments to convince both the SEC and any state regulator (if such a state allowed for a blue sky exemption) to allow for such a lower listing standard, including justifications as to how the exchange would prevent fraud and abuse (SEC and state regulation staff have a bias that smaller securities offerings are likely to involve fraud).

One central and very important aspect of filing to become an exchange with the SEC will be to show them that you have a robust and well conceived regulatory group in place that has state-of-the-art surveillance and compliance tools at the ready.  The SEC does not easily grant new SRO licenses – they can take up to 3-6 years before they approve applications – but they will NEVER approve one unless you show that you have the regulatory people and systems in place to detect trading abuses and fraud.

And, even if you can convince the SEC to grant this special permission, you then need to consider working with each of the states where a company seeks investors.  Many if not all states have their own minimum listing standard bars that they are not very flexible about.  In the case of a local stock exchange, this might be easier in that you are only proposing that local (i.e. within one state) companies list and trade.  And in that case, you only have to convince one state to go along with the same lower listing standards and fraud prevention ideas.

2)  Partner with an existing SRO and apply for a lower listing standard from the SEC and the relevant states.  The reasons this is the better approach than the first one is that a) you already have the SRO license in place, b) you have the regulatory group in place, and c) the only thing you would then need to focus on is convincing the SEC (and state(s)) that you have a well thought out proposal for preventing abuses while allowing small companies to list.  You would also likely be showing that you only intend to MARKET to a particular regional geographic location (and therefore keeping the trading as “local” as possible.

3) Work with a Broker Dealer (perhaps one set up by the government) to file with the SEC to get an ATS designation (alternative trading system) – then have the companies that want to list do Direct Public Offerings.  Once approved, get the companies listed on the ATS – which will allow secondary trading.

He will work with the SEC to create an exemption for public securities offerings of $1 million or less, with individual investment capped at $10,000.

Thank you to Sustainable Economies Law Center, Paul Spinrad, Woodie Neiss, and so many others for making this happen!

For details, see http://crowdfundinglaw.com/