Crowdfunding has the potential to democratize the marketplace, allowing the average Joe to be a part of a start-up company’s growth and share the risks and benefits. In turn, bootstrapped small businesses and start-ups could raise much needed capital.
Unfortunately the idea of crowdfunding may be better than the actual thing. Proposed rules place a burden on those small businesses and start-ups and may make crowdfunding an unattractive alternative to traditional routes of capital. Moving forward, the SEC will have to dance delicately. Crowdfunding regulations need to protect unsophisticated investors from dreamers and schemers, but the regulations should also facilitate the raising of capital.
As of now, crowdfunding is restricted to an exchange of perks for capital. For example, a person who “invests” capital in a start-up company can receive t-shirts, prototypes and even meet with the company founders. What those crowdfunders cannot do, however, is provide an investment in exchange for equity in the start-up. Title III of the JOBS Act promises to change that with meaningful reform.
Critics are wondering if crowdfunding will even be worth the hassle and the cost.
Opening early-stage investing to non-accredited investors is a dramatic departure from the existing regulatory scheme. Issuers—start-up companies and the like—are currently able to solicit investments relying Rule 506(c) from wealthy accredited investors under Title II of the Act. As with any private offering of securities, there exists the potential for fraud and abuse of the system. To protect investors and attain the Act’s purpose of helping small businesses raise money, the SEC has imposed rules that regulate Rule 506(c) offerings that are simple and easy to comply with. The SEC has also proposed rules that would regulate crowdfunding, but the regulations are more extensive. Critics of the proposed regulations are wondering if crowdfunding will even be worth the hassle and the cost.
Accredited investors are considered to be more sophisticated and, in a worst-case scenario, able to lose the entirety of their investment. Non-accredited investors, by contrast, do not have the knowledge or resources to appreciate and possibly recover from a risky investment in a young company. For that reason, the JOBS Act places a higher burden on issuers raising capital from the “crowd.”
For example, if an issuer plans to engage in a 506(c) offering with a group of accredited investors, the issuer must file Form D with the SEC before soliciting the investments, disclose the details about the solicitation within 15 days of the solicitation, and verify that each investor is accredited. If that same issuer were to raise capital by crowdfunding, it would have a few more hoops to jump through.
It is possible that the only companies seeking to crowdfunding are those that are the riskiest investments.
Crowdfunding must be conducted through a registered broker-dealer or a registered crowdfunding portal. The issuer must also file a disclosure with the SEC twenty-one days before the first offering and provide annual reports. Furthermore, issuers attempting to raise more than $500,000 will be required to supply audited financial statements.
Of the proposed rules, none have caused as much concern as the auditing requirement. Critics of the rule argue that the up-front costs of a third-party audit will discourage many early-stage companies, which are already strapped for cash, from following through with a crowdfunding offering. Considering that an issuer can only raise up to $1 million within a twelve-month period through a number of relatively small investments, many entrepreneurs and start-up companies are afraid that Title III, if the SEC does not amend it, will deter many future issuers from crowdfunding.
Issuers are not the only party to crowdfunding that is facing stronger regulations. Potential crowdfunders are also limited in ways that accredited investors are not under a 506(c) offering. An individual investor is limited in the amount that he or she can invest over a twelve-month period. For those with an income of more than $100,000, the investment is capped at ten percent of annual income or net worth. For investors with an annual income or net worth less than $100,000, the cap is the greater of $2,000 or five percent.
The crowdfunding regulations may pose a burden to issuers, and issuers that have been successful soliciting investments from accredited investors in the past may continue to do so. Start-ups that are considered to be good investments are more likely to find success in grabbing capital from accredited investors. In turn, it is possible that the only companies seeking to crowdfunding are those that are the riskiest investments.
Crowdfunding may open up the doors to early stage investing, but it could also put the riskiest investments and the investors who can least afford risk in the same bowl. Making crowdfunding more attractive to small businesses and start-ups would hopefully prevent that undesirable outcome.