Up until last month, crowdfunding was very much a circumscribed enterprise in the U.S. Average-income types could throw a couple hundred dollars at the latest game noir or bathtub cold fusion reactor on Kickstarter or Indiegogo, but rewards delivered through these platforms are purely non-financial—in short, no equity.
To invest in a startup, you either had to be an accredited investor or to wait for the IPO. For all the tech industry's freewheeling optimism, it did learn something from the dotcom bubble: exceptions aside, you don't see fresh-faced, still-in-the-red startups rushing to list on an exchange. Airbnb and Uber have raised billions without going public. Smalltime investors have had few options to cash in on Silicon Valley's manic innovation and startups' sources of capital have been limited to a tiny cohort of rich investors, who, by the way, feel more comfortable putting their money into proven concepts like Uber and Airbnb.
The upshot is that the average investor misses out on the most significant returns from new, disruptive companies, while would-be disrupters are hobbled by the difficulty of finding investors. The JOBS Act, signed in 2012, has changed that, but it took time. It was not until this past March that the SEC announced rules governing equity crowdfunding under Title IV of the act, commonly known as Regulation A+, and the rules did not go into effect until June 19.
Small companies can now raise up to $50 million without listing on an exchange. They can raise money from any and all investors, not just wealthy ones. But as these things always do, Regulation A+ involves some sticky details.
Regulation A+ for Investors
Previously, only accredited investors could fund companies that weren't publicly traded. Accredited here means an individual or married couple with a net worth of at least $1,000,000 or a minimum annual income of $200,000 ($300,000 for a married couple) for the past two years. Primary residences do not count towards that million, but, in most cases, neither do mortgages on that residence take away from it.
Non-accredited investors – aka, anyone – can invest in Regulation A+ offerings. There is no lock-up period under the new rules, but that does not guarantee that investors will be able to find a buyer for their shares. Non-accredited investors can invest 10% of their net worth or annual income in Tier 2 offerings, and any amount in Tier 1 offerings.
Regulation A+ for Entrepreneurs
Speaking of which, Regulation A+ offerings come in two flavors, Tier 1 and Tier 2:
|Tier 1||Tier 2|
|Maximum fundraising in 12-month period||$20 million||$50 million|
|Maximum investment by issuer's affiliates||$6 million||$15 million|
If a company is seeking to raise less than $20 million, either option is available. Both also allow for public advertisement. Tweet, hand out fliers, shout into a megaphone, go on TV – no general solicitation rules here.
Tier 2 requires companies to file audited financial statements as well as annual, semi-annual and current events reports. Tier 2 offerings are not subject to state Blue Sky Laws, although Massachusetts and Montana are challenging this exception in court.
As attractive as it may seem to avoid providing audited financials and frequent status reports by raising funds under Tier 1, those perks come at the price of having to contend with state regulations wherever you have a single investor. These can be stringent to the point of being counterproductive. The most infamous example is Massachusetts's 1980 decision to bar residents from investing in a computer manufacturer's IPO, due in part to its nosebleed valuations, i.e. a ~90 P/E ratio. Hindsight is 20/20, but that company went on to be Apple Inc. (AAPL). (For more, see The Story Behind Apple's Success.)
History explains the less-than-intuitive division between Regulation A+'s two tiers, as well as the nickname "Regulation A+" itself. Non-listed companies have long been able to make public securities offerings under Regulation A, an obscure 1933 rule that provides for up to $5 million in fundraising. Tier 1 of Regulation A+ is essentially a carryover from that rule, but the cap has been raised and the opportunity extended to non-accredited investors. Tier 2 is the news here, because, controversially, it bypasses the states.
Bringing The Two Together: Portals
Whichever tier a company decides to pursue, the time and money involved are substantial. Onevest co-founder Tanya Privé summarized the process via email:
"if a company takes 2 months or so to prepare all of the required filings, offering circular, go through due diligence, get audited financials and disclosures, then submits their issue to the SEC for their qualification, it can take a while before the company will know if they can sell their securities. Meanwhile, it costs about $85K-$100K to prepare all of the offering materials, which is not cheap."
While the new rules remove significant barriers to fundraising, their democratizing effect shouldn't be overstated. The process is still expensive and time-consuming and is really only suitable for companies that already have healthy revenue streams. Most entrepreneurs will need help navigating it.
Meanwhile, from an investor's perspective, where are you supposed to find these companies? How can you be sure that they meet basic objective criteria?
Portals such as Onevest, StartEngine and SeedInvest help startups contend with the approval process and connect investors and entrepreneurs. So far, because of how new Regulation A+ rules are, none of the startups on these platforms has yet completed a funding round. Instead, companies are currently testing the waters, collecting non-binding indications of interest from potential investors.
StartEngine co-founder Ron Miller said on a phone call that the platform currently has five companies testing the waters. In the ten days following the new rules' going into effect, 4000 investors expressed interest in these companies. As for the vetting process, Miller said that StartEngine uses a number of objective metrics to assess a business' viability, but does not use subjective measures or offer any kind of investing advice.
The time, effort and expense involved in raising a round of Regulation A+ funding will probably lead a degree of self-selection, so that only passably serious entrepreneurs will complete the process. Still, filling out reams of paperwork by itself does not make a business model lucrative, and investors should exercise the same discipline when it comes to pre-IPO companies as they would with exchange-listed investments, including research and diversification. (For more, see Diversification: Protecting Your Portfolio From Mass Destruction.)
The Bottom Line
So what has really happened here? Onevest’s Tanya Privé points out that Regulation A+ has opened up a whole range of investments to 99% of the country's population. Crowdfunding has belatedly come to the U.S. equity market, and a few savvy investors may see huge gains as a result. Then again, startups are by nature risky propositions, and quite a few people will probably see their investments wiped out.
But this is not only news for investors. StartEngine’s Ron Miller described the new rule as "the greatest advancement for entrepreneurship in a generation" because it not only opens up vast new sources of capital, but lets companies who test the waters to no avail fail faster than ever. That turnover means a healthier ecosystem overall.
Challenges and uncertainties remain. According to Privé, "the biggest unknown is the time it will take the SEC to 'qualify' offerings." For Regulation A filings, qualification has taken up 300 days in some cases. That may help explain why only 26 companies on average completed Regulation A funding rounds per year, but the increased caps on funding and ability to bypass state regulations – under Tier 2, at least – may help to change the situation.
Miller thinks Regulation A+ may have truly profound effects on the market by converting customers into investors and investors into brand ambassadors. Soon enough, capital may begin to move more freely than it ever has in the past, helped along especially by social media. The introduction of equity crowdfunding might turn out to be an inflection point in how America's business, consumers and investors interact. For now, though, we're still testing the waters.