S.E.C. Gives Small Investors Access to Equity Crowdfunding
Entrepreneurs raising money through crowdfunding campaigns have typically rewarded their backers with early access to products and with tchotchkes like T-shirts and coffee mugs.
But under new rules adopted Friday by the Securities and Exchange Commission, they will be able to offer a prize that could be more lucrative: an equity stake in their business.
The rules will allow small investors to buy shares of private companies under the provisions of the Jump-Start Our Business Start-Ups Act. Until the change, equity crowdfunding had been legal only for accredited investors, or those who met required levels of assets and income.
President Obama called the bill, better known as the JOBS Act, “a potential game-changer” for fledgling companies, when he signed it more than three years ago. But the law stalled as regulators struggled to write rules stringent enough to protect investors but flexible enough to allow for meaningful fund-raising.
A set of draft rules released two years ago was widely criticized and deemed almost unworkable by many in the industry, who said that compliance would be too costly and complex. The rules adopted Friday had been substantially revised to address some of those concerns.
The new rules allow companies to raise up to $1 million in a 12-month period through a crowdfunding campaign. Companies will need to provide their potential investors with financial statements, but some first-time issuers and those seeking less than $500,000 will not be required to have the statements audited — an important concession for those concerned about the cost of providing audited financials.
Companies will be able to advertise their offerings in a variety of ways, including posting them on Kickstarter-like portals for investors to peruse. (Kickstarter has said that it is not interested in expanding into equity crowdfunding, though one of its top rivals, Indiegogo, said it is considering doing so.)
Dozens of investment portals have sprung up in recent years, but until now, only accredited investors — those with an annual income exceeding $200,000 or a net worth of at least $1 million — have been permitted to invest in most of the deals advertised on them.
Some of those portals now plan to expand into the nonaccredited market. SeedInvest, a site that has helped 50 funding deals in the last three years, expects to begin offering deals next year to a wider pool of investors.
“There’s no question that there’s a lot of pent-up demand from ordinary investors,” said Ryan Feit, the site’s chief executive and one of its founders. “At the end of the day, that means there will be more capital available for small business.”
The amount of money backers will be allowed to invest depends on their income. Those with an annual income or net worth of less than $100,000 will be allowed to invest up to $2,000 in a 12-month period, or 5 percent of the lesser of their income or net worth, whichever is greater. Those with an income and net worth of more than $100,000 will be permitted to invest up to 10 percent of the lesser of their annual income or net worth.
The equity shares they buy will be risky, illiquid investments. Investors will generally be required to hold on to the shares for at least one year, and there are not yet many marketplaces for those seeking to sell shares in private companies, which are difficult to value.
Some critics are deeply skeptical about the quality of the investments that will be available. “Ninety-nine percent of these deals will prove to be unprofitable,” said Andrew Stoltmann, a lawyer who specializes in securities fraud. “This is a disaster waiting to happen.”
Others counter that the new rules will allow entrepreneurs’ family, friends, customers and professional contacts to invest in ventures that they want to support.
“I think it’s going to really make a difference for businesses that are not especially fashionable for professional investors,” said James Dowd, the chief executive of North Capital Private Securities, a broker-dealer that focuses on private fund-raising. “They want to invest in companies that have the potential to be disruptive to an entire industry. You don’t see a lot of capital flow into ordinary consumer and retail businesses.”
The S.E.C. on Friday also proposed changes to several other fund-raising rules, including those governing intrastate offerings. More than 25 states have adopted their own crowdfunding rules to let local businesses raise money from residents within the state, often with fewer regulatory requirements than the federal rules. The commission suggested striking down a rule that blocked those intrastate offerings from being advertised to out-of-state investors — a quirk that prevented companies from publicizing their fund-raising campaigns on their own websites or on social media sites.
“It’s an absurd thing, but that’s what the law said. It was horrifying,” said Kendall Almerico, a lawyer who specializes in crowdfunding issues. “Fixing this is huge.”
The range of ways in which private companies can raise money from nonaccredited investors has significantly expanded this year. In June, new federal rules took effect allowing companies to raise up to $50 million through a provision known as Regulation A. Those deals carry stricter disclosure and compliance requirements than the crowdfunding process outlined on Friday, which is intended to be much cheaper and faster for issuers.
Taken together, the new federal and state rules give entrepreneurs a much wider set of options for raising money from a diverse pool of investors.
“I’m surprised at how far the S.E.C. went to make it all work,” said Douglas S. Ellenoff, a securities lawyer at Ellenoff Grossman & Schole. “The entrepreneur now has a series of very interesting choices and lots of different options for how they go about their capital formation.”
The S.E.C.’s four commissioners voted 3-1 on Friday morning to adopt the new crowdfunding rules, which are expected to take effect early next year.