In historic fashion, investing opportunities for ordinary Americans took on new meaning in the spring of 2016 when equity crowdfunding rules from the Securities and Exchange Commission took effect.
Besides opening up a whole new world to non-accredited investors, Title III of the Jumpstart Our Business Startups (JOBS) Act (Regulation CF) expanded options for entrepreneurs to seek out everyday investors to raise capital and grow their companies via online crowdfunding platforms.
The JOBS Act was designed to help small businesses raise capital by easing certain securities regulations, and although the legislation was signed in 2012, it required the SEC to write new rules. The equity crowdfunding portion of the act that applies to non-accredited investors—known as Title III (Regulation CF)—became effective on May 16, 2016.
By opening up equity crowdfunding to non-accredited investors, Title III gives small businesses and early stage startups an alternative method of raising capital and takes a seat among other initial capital-raise scenarios that typically include bootstrapping, friends and family, angel investors and small business loans.
Until these changes, the sale of securities in private companies were typically only accessible to accredited investors. This meant that to invest in equity crowdfunding, an individual had to have one of the following:
- Annual income of $200,000 a year for the past two years (or a household annual income of $300,000) with the expectation that it will continue
- Net worth of $1 million or more, excluding the investor’s primary residence
Unaccredited investors—those who don’t meet the above criteria—were excluded from making equity investments into privately traded companies.
According to the SEC, about 10 percent of the population, or about 12.4 million households, qualify as accredited investors, although others contend the number is far lower. This means that the vast majority of ordinary citizens were effectively excluded from investing in equity crowdfunding.
But crowdfunding has since evolved from when it was first introduced in the United States over a decade ago. With the introduction of Title III, more investors can enter the market for raising capital. And with only a small portion of accredited investors actively investing in equity shares of private companies, the JOBS Act is viewed as good for both investors and entrepreneurs.
From Wall Street to Main Street
Individuals of modest means now have more freedom to participate in investment options that weren’t available to them before due to previous limitations on non-accredited investors prior to this new legislation. With as little as $10, but more often $100 to $500, investors can now put their money into a startup that they believe has promise to be the next Google, Apple or Facebook.
But this still isn’t an “anything goes” marketplace. The SEC placed limits on non-accredited investors in order to build safety and soundness into this new equity crowdfunding option:
- If a non-accredited investor has an annual income or net worth of less than $100,000, then the investor can invest the greater of $2,000 or 5 percent of the lesser of his or her annual income or net worth.
- If the investor has more than $100,000, then the investor can invest 10 percent of the lesser of his or her annual income or net worth.
These limits are designed to provide important protections to ordinary investors while still opening up an avenue for small businesses to raise capital via online crowdfunding.
Non-accredited investors are protected in other ways as well. The act requires that the sale of securities occur through a funding portal—a third-party intermediary registered with the SEC and FINRA. The intermediary acts as a first line of defense against fraud by conducting due diligence on issuers and curating the campaigns accepted onto its platform.
Investing in startups and small business is still a risky proposition, one in which the investor could lose the entire investment or one in which there may not be an exit option for many years. On the flip side, high risk can also mean high reward.
What the Title III means for entrepreneurs
The philosophy behind the crowdfunding portion of the JOBS Act is that access to capital creates jobs and economic growth, and now businesses have a new way to access to capital that they didn’t have available previously.
With this new opportunity, a company can raise a maximum aggregate amount of $1 million through crowdfunding offerings in a 12-month period. The aggregate amount of securities sold to an investor through all crowdfunding offerings during a 12-month period, meanwhile, may not exceed $100,000.
It should also be noted that there are a number of hoops to jump through, so whether companies will raise financing using Title III in a significant way still remains to be seen, although early dozens of early adopters have decided to give it a try. It will take some time to see if its popularity wanes or grows.
The crowdfunding platforms offering the securities also have a number of requirements they must meet, such as taking measures to reduce the risk of fraud on their sites, providing educational materials to shareholders and meeting requirements for handling investor funds, among others.
There’s plenty to like about the new rules. The use of an online platform can translate into a way to raise money quickly and efficiently while making it relatively easy for everyday investors to buy shares. Businesses raising money this way aren’t prohibited from simultaneously raising money other ways. So a startup could use the crowd to raise $1 million while simultaneously funding through other forms of debt or equity.
The investors who invest in a particular company via equity crowdfunding are likely to become company cheerleaders because as shareholders these investors are vested in seeing the company succeed. Equity crowdfunder SeedInvest views it this way:
“More investors means more supporters. A Reg CF campaign gives a company the ability to turn its users into brand evangelists with a vested interest in the future of that company.”
Reporting requirements give startups and investors an open, transparent and structured dialogue to report and get feedback, SeedInvest notes.
Crowdfunding platforms give Title III a try
WeFunder has led the way on equity crowdfunding under Title III (Regulation CF) rules. As of Jan. 13, 2017, investors on the WeFunder platform had funded $19.3 million in Reg CF offerings that have reached their minimum funding target. WeFunder says its funding account for about 66 percent of the entire universe of Reg CF investment filings. Said another way, that translates into 46 successful offerings on WeFunder that have met minimum fundraising goals.
StartEngine and NextSeed are the No. 2 and No. 3 platforms for Reg CF offerings to date, based on funds raised, according WeFunder’s statistics. Together, they’ve funded 16 companies. SeedInvest, FlashFunders and Republic also are offering CF offerings.
Indiegogo, a well-known rewards-based crowdfunder, is the most recent entrant. It created a joint venture with MicroVentures, an online investment bank and equity crowdfunder for accredited investors, to initiate an equity crowdfunding portal. The venture launched with four Reg CF offerings Nov. 15, 2016, and as of Jan. 13, 2017, had already provided more than $1 million via equity crowdfunding.
An imperfect option
While there are plenty of advantages to Title III, there are also a few drawbacks.
Legal fees and other fees, such as accounting or potential audit fees, may be an issue for small startups. In addition, reporting requirements may be viewed as cumbersome for small companies that have to report annually to the SEC and have to post information about their equity raise on their websites.
Companies can only raise a maximum of $1 million over a 12-month period, and some businesses will decide that amount is too small to be worth the costs and time involved to engage in equity crowdfunding.
TechCrunch notes that a “Fix Crowdfunding Act” was introduced in March 2016, a couple of months before final Title III rules were implemented. Among its fixes is a proposal to raise the funding limit from $1 million to $5 million. Although the legislation passed the House in July, it has never been taken up by the Senate. With a new administration taking over, the future of this legislation to adjust the act is uncertain.
OneVest co-founder and executive chairman Alejandro Cremades published an open letter last May, right before Title III became effective, criticizing the structure and requirements under Title III.
“Nowadays startups on average raise, at a seed stage, in the neighborhood of $2 million-plus. The fact that startups will have a limit of $1 million per year will either force them to be under-capitalized or conduct another type of offering in parallel to raise the remaining capital from accredited investors, which means more costs from a legal perspective,” Cremades said in his letter, published on Crowdfund Insider.
“Moreover, it is a mistake that startups need to take on upfront costs of up to $50,000 to conduct financial audits before fundraising and before even knowing if they would raise any financing at all. It is a significant upfront risk. Plus, let’s say the startups does raise capital via Title III, they will be forced to report to the SEC on a periodic basis, which is certainly not going to be just sending them an email with a brief update on the business. Lawyers will need to be involved and that will cost money, on an ongoing basis,” Cremades wrote.
Funding raising limits and costs are certain to be impediments for some entrepreneurs, but with just a handful of months with the rules in place, we’ve seen fairly robust activity on multiple crowdfunding platforms.
New options for real estate crowdfunders?
To date, there hasn’t been a big rush related to real estate in this new space, but we expect some interest to develop. A real estate developer or real estate investor could make a significant purchase with $1 million raised through equity crowdfunding.
FINRA approved Small Change as a Reg CF funding portal last fall, according to Crowdfund Insider, which said founder Eve Picker is targeting “transformational” real estate projects by connecting developers and investors. As of Jan. 13, 2017, no investment options for non-accredited investors were listed on the website, which also offers deals to accredited investors, but there was a “coming soon” sign for such an offering.
The way that Title III is currently written does not make real estate crowdfunding a very feasible option for non-accredited investors. Even with some mechanisms in place to protect the investor, real estate loans can be complex and hard to evaluate —it’s not as simple as putting your money in and getting it back out. While we here at Patch of Land applaud the expansion of the JOBS Act, in the interest of the investor, we will be staying with Title II and maintain that our investors must be accredited.
Jason Fritton’s article originally appeared in Private Lender magazine: January/February 2017