Funding for startups passed a new milestone this month when small retail investors became eligible to put their money to work on platforms that specialize in crowdfunding of equities. But stringent regulations mean the financing is most likely to appeal to startups still in the seed stage of fundraising.
How did the ruling come about?
The new funding avenue was made possible by Title III of the Jumpstart Our Business Startups Act, commonly known as the JOBS act, which was signed into law by President Obama in 2013. It took the Securities and Exchange Commission more than two years to write the 650 pages of regulations putting Title III into effect.
This is the first time since the federal government began regulating stocks in 1933 that there has been a way for companies to sell shares to non-accredited investors without registering for an IPO with the SEC — and the agency was careful to balance consumer protection with company access to capital.
Under the rules, retail Investors became eligible to buy shares on one of the equity crowdfunding platforms such as Microventures or Seedrs on May 16. Before that date, only so-called accredited investors — those with net worth of $1 million or who earn $200,000 a year — were eligible to buy shares on the platforms. Now, under Title III rules, investors who earn under $100,000 can invest up to $2,000 a year.
What does the ruling mean for my startup?
The SEC rules that emerged for retail crowdfunding turned out to be very stringent, with a company limited to raising a maximum of $1 million in any 12-month period. The regulations also specify that startups are required to use a single platform for their stock offering.
The belief was that companies at the seed stage lacked the resources to hire expensive legal help, so that by requiring them to use a platform, the platform would be able to provide a detailed description of the information that is required to be disclosed.
The required disclosures include a business plan and a financial statement from the company. If the company is raising more than $100,000 it is required to have its financial statement “reviewed" by a Certified Public Accountant, but it does not need to arrange an audit.
One interesting change was that the SEC amended the statutes on liability to include the online portal selling the equities. So the portal as well as the company could face penalties for misstatements or material omissions in their offering.
Who will benefit?
Because many venture firms have recently set their sights on later stage companies and seed financing from angel investors has been increasingly hard to get, the new crowdfunding possibilities are likely to be seized upon by companies in the seed stage. It's primarily for people who are just getting started, who have a good idea such as a breakthrough mobile app but no staff to turn the concept into reality.
But crowdfunding is also available to companies at later stages, such as when institutions invest at the A stage but then decline to invest more. Often the company is in a scramble to find new investors.
What are the drawbacks?
One drawback to crowdfunding is that the shares are restricted in the first year and can't be transferred. That means there will most likely be little chance of a robust secondary market for these shares developing.
The regulations also ban the companies from making a general solicitation to the public, and apart from a one-page statement of intent, companies are limited to communicating about their offerings solely on the platform.
What is the outlook for the future?
Despite these limitations, crowdfunding is on a roll. Massolution, a research firm, said that crowdfunding may soon overtake venture capital as a source of financing for startups. It said crowdfunding was expected to raise $34.4 billion last year on a global basis. The U.S. crowdfunding market, still the largest globally, reached $9.5 billion in 2014, a growth rate of 145 percent. But the majority of the deals were for crowdfunded lending rather then equity sales.
Crowdfunding platforms are hoping that the SEC will relax the rules for retail investing when it becomes clear that the industry has been efficient at weeding out frauds and other dubious firms. Since nearly two-thirds of legitimate startups fail in their first two years, according to industry research, the market already confronts investors with a lot of risk.
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