Final Rules for Investment Crowdfunding — what does it all mean?
The rules are finally in place, opening up the playing field for investing online in 2016, as the US Securities & Exchange Commission (SEC) finally approved new rules for crowdfunding, in a 3-to-1 vote. It has been a long, slow process (welcome to America’s federal government!) since President Obama signed the Jumpstart Our Business Startups Act (JOBS Act) into law on April 5, 2012.
What does it mean to you?
It means that companies can legally raise smaller amounts of money online from a wider base of individual investors, and that individuals can now invest smaller minimums (up to a total of $100,000 per year) into an ever-increasing array of diverse, small businesses, including startups.
The majority of “crowdfunding” is not for equity investment fundraising. There are far more “premium” or perks-based crowdfunding sites (such as Kickstarter or Indiegogo) that provide a useful path to test the market for companies building a consumer-facing product. This works like a type of E-commerce. Investors “buy in” to the company providing necessary bridge capital before the product is ready to ship. In the software industry, this practice is known as “vaporware” … but it has a valid purpose in helping launch innovative new product ideas to the marketplace.
Like the Internet itself, crowdfunding has democratized access to these and other forms of capital. This means there is greater opportunity for minority, women and veteran firms to obtain equity funding.
In the US, the new regulations will not be actionable until 180 days after they’re entered into the Federal Register, which means mid-2016 at the earliest. This method is not limited to the United States, of course, and has become popular in Europe, Asia and elsewhere.
Want specifics? Here’s a summary …
The new Equity Crowdfunding Law (ECF) rules:
1. Permit a company to raise a maximum aggregate amount of $1 million through crowdfunding offerings in a 12-month period.
2. Permit individual investors, over a 12-month period, to invest in total across all crowdfunding offerings either …
a) Their annual income or net worth is less than $100,000, than the greater of $2,000 or 5%, for the lesser of their annual income or net worth.
Example: If an individual investor earned $99,000 Adjusted Gross Income last year, but their net worth (let’s say equity in their home) is $65,000, then in a given year they would be allowed to invest up to $3,250 across all deals.
b) Both their annual income and net worth are equal to or more than $100,000, 10% of the lesser of their annual income or net worth.
3. During the 12-month period, the aggregate amount of securities sold to an investor through all crowdfunding offerings may not exceed $100,000.
With the new Equity Crowdfunding Law, the top 3 ways this type of investing can take off:
1. Participation of non-accredited investors — far greater in number than accrediteds
2. Protection of non-accredited investors with the $100,000 investment limit, so they do not go overboard with their online investments, and
3. Companies, especially startups, will not need to undergo full audit when using the ECF for the first time.
For more on this and up-to-the-minute crowdfunding news, see CrowdFundBeat.com.
Issues & Challenges
- Most companies do not want dozens let alone hundreds of smaller investors as shareholders. Too many “mouths to feed,” an unwieldy capitalization table, can be a communication burden or get in the way of follow-on rounds of investment. Solution: Some sites use a single LLC holding company (selling units or shares in that company) to invest in the target company as a single shareholder.
- Some investment crowdfunding portals are extremely expensive, charging upfront listing fees and 10% or more of funds raised. Even with a more reasonable cost of capital, equity raises mean setting a stock price, which may mean giving up a higher percentage of shares — some platforms charge a brokerage fee that leaves far too little for the founders and cash investors.
- Once listed, it still takes a significant promotional push through social networks to attract investment dollars. There’s really no substitute for being prepared and operating an effective capital campaign, online or otherwise. ECF is no shortcut.
Not every type of fundraising lends itself to using a “crowd” — most fast-growing startups require more than $1 million, there are sometimes concerns about confidentiality (not “broadcasting” trade secrets to unseen and potentially predatory investors), or myriad of other factors may make ECF impractical. The vast majority of capital will continue to come from accredited and professional investors. ECF provides another tool in the entrepreneur’s toolbelt, alongside friends and family, grants, and bootstrapping …
- Equity:
- Offline equity partnerships (direct sale/purchase of shares) from angels, angel groups, PE/VC, family office, corporate investors, etc.
- Regulation D Private Placements — from accredited investors, above $1 million. Reg D requires no SEC approval prior to taking in funds, just a form after the sale of securities.
- Debt (a loan):
- Senior, long-term debt
- Subordinated debt (“sub-debt”) or mezzanine debt — in between equity and senior debt (hence “middle” or “mezzanine”) in terms of risk to the investor
- Combination of debt and equity, or hybrid instruments:
- Convertible notes or debentures
- Topline revenue contracts, quasi-equity, etc.
Conclusion: be sure to use the right tool for the job.
Talk with us about your situation.