Written by Alex Lash
Mom and Pop, you can now buy shares in the bakery down the street, or in your son’s girlfriend’s sister’s tech startup. That, in effect, was the message the U.S. Securities and Exchange Commission sent today, voting to give retail investors the right to buy shares in tiny private startups through so-called crowdfunding mechanisms.
Crowdfunding, until now, has mainly helped small U.S. companies and individuals such as filmmakers and inventors raise cash through donations. A legion of websites, such as Kickstarter, Indiegogo, Experiment, RocketHub, and others, have hosted a vibrant exchange between fledgling companies and their well-wishers. Not many companies that reaped seed money from crowdsourced donations have gone on to raise institutional venture capital. One example is the citizen science firm uBiome.
Crowdsourced fundraising has also generated some controversy. Glowing Plant, which accepted funds on Kickstarter in exchange for engineered seeds that grow into, yes, glowing houseplants, sparked an uproar over its spread of genetically modified organisms.
The new crowdfunding rules, approved today by SEC commissioners 3 to 1, now make clear what has been somewhat murky: How tiny startups will be able to offer, not just small thank-you gifts to contributors like seeds or T-shirts, but equity to crowdsourced investors. It was the final piece of the law known as the JOBS Act—Jumpstart Our Business Startups—to fall into place.
President Obama signed the JOBS Act into law in 2012, and it is widely considered a major catalyst for the three-year IPO boom that followed, thanks to its looser restrictions on taking companies public—the “IPO on-ramp” part of the bill.
The JOBS Act also outlined a path forward for equity crowdfunding, with some rules such as a $1 million cap per year on any single company’s crowdfunding effort. But the SEC has been slow and deliberate—maddeningly so, to its critics—in making changes or creating more specific regulations, wanting to balance the needs of cash-hungry startups against the protection of so-called mom-and-pop investors who might see their life savings wiped out by bad bets.
Thanking her staff for its work, SEC chair Mary Jo White this morning called the effort “extraordinarily complex rulemaking.”
“The SEC has done a nice job balancing adequate controls with nimbleness,” said Tobin Arthur, CEO of funding portal Angles, which has forged ahead with the crowdfunding of healthcare companies for a more specialized set of investors.
To those following the long process—more than three years since President Obama signed the JOBS Act, and two years since the SEC first drafted the proposed crowdfunding rules—much of what the SEC greenlighted today was not a surprise.
For example, the JOBS Act language put a $1 million cap on the amount a company can raise within 12 months. It also placed a limit on what an investor can bet, based on his or her income and net worth, from a minimum investment of $2,000 up to a maximum of $100,000. Those caps did not change today, and they might constrain what kinds of startups seek crowdfunded cash in the future.
But there were surprises. The biggest, perhaps, was that first-time issuers will not have to prepare their financial records for a formal audit. “There was no hint of this exemption,” said Morrison & Foerster attorney Anna Pinedo. “It’s a very constructive change. I know companies were worried about the cost, and many companies thinking about crowdfunding are going to be new to the realm of SEC disclosures and filings.”
Two types of companies will be permitted to facilitate “securities-based” crowdfunding by introducing companies to potential investors online, and both will have to register with the SEC. The first category is conventional broker-dealers, and the second is a new class of SEC registrants called a funding portal.
Both will be subject to oversight, just as in traditional investment situations. Some responsibility for vetting the companies making securities offerings will fall upon the portals, although those portals will also be allowed to take equity in the companies they list as compensation for their work—as long as they receive shares under the same terms as everyone else buying the shares.
That responsibility could end up being a marketing tool, as the number of platforms vying for investors expands. “Oh my gosh, there’s going to be so much competition,” said Bill Clark, CEO of Austin, TX-based MicroVentures. “We’ll really have to tout our track record more and then really explain to people: there’s a big difference between us and a platform that will list any company.”
The SEC rules will go into effect 180 days after they are published in the Federal Register, and portals will be able to register with the SEC on January 29, 2016. It should not take long for competitors to throw their hats in the ring. In a written statement today, Indiegogo CEO Slava Rubin said, in part, “We’re now exploring how equity crowdfunding may play a role in Indiegogo’s business model.” [This paragraph was updated with the correct timeline for the SEC rules.]
While the federal equity crowdfunding rules were being formulated, some states fashioned their own workarounds. (California, however, with its fertile start-up culture in both tech and biotech, is not one of those states, though funding portals there have been test-driving other openings created by the SEC under the JOBS Act.)
The SEC also made changes today to some of its older rules that govern intrastate equity sales. It wasn’t immediately clear how the new federal rules would affect what one SEC commissioner lauded as a “natural experiment” that the states have been conducting with crowdfunding. The commissioner, Republican economist Michael Piwowar, was the only nay vote against the new crowdfunding rules, calling them “a complex web of requirements.” He cautioned that the need to comply with both state and federal statutes could now make state-based crowdfunding efforts “difficult.”
Whether the audit exemption for first-time issuers eases small-company concerns, and whether the move to sell shares via crowdfunding starts with a trickle or a flood, remains to be seen. There are plenty of other details that have yet to play out. For example, companies are already able to bring on board a very small number of nonaccredited investors. Under the new crowdfunding rules, will companies want to bring on potentially hundreds of investors who might make downstream decisions difficult? As an example, “if you try to raise another round of funding, you might have 300 people to go through for qualification,” Clark said. “If a VC wants to invest in the next round and sees there may be people who could be problematic for whatever reason, they may pass on the deal.”
—Bernadette Tansey and David Holley contributed to this report.
This article was edited by the staff at Manhattan Street Capital. It was first published on Xconomy National, October 30th, 2015
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Rod Turner
Rod Turner is the founder and CEO of Manhattan Street Capital, the #1 Growth Capital service for mature startups and mid-sized companies to raise capital using Regulation A+. Turner has played a key role in building successful companies including Symantec/Norton (SYMC), Ashton Tate, MicroPort, Knowledge Adventure, and more. He is an experienced investor who has built a Venture Capital business (Irvine Ventures) and has made angel and mezzanine investments in companies such as Bloom, Amyris (AMRS), Ask Jeeves, and eASIC.
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