The Securities and Exchange Commission (SEC) voted in 2015 to approve Title III of the JOBS Act, opening up equity crowdfunding to non-accredited investors. What this means for startups and other early-stage companies looking to boost funding through the sale of equity is that they will now be able to sell investments in their businesses to the general public–with the ability to raise up to $1 million per year without registering with the SEC.
Until this rule was enacted, only accredited individual investors who meet specific wealth thresholds were allowed to fund startups, and of course institutional investors such as venture capital (VC) firms could as well. For new businesses seeking capital, this will almost certainly be a game changer. You can read a PDF of the full text of the final rule on the SEC’s website. (For more, see: 3 Things All Self-Directed Investors Should Know.)
For individuals looking to get an early stake in the next "big thing" these new rules open the door to opportunities that have historically been out of reach for over 80 years. What it also means is that it will be easier than ever to put your money, and your financial future, in potential jeopardy. The level of risk inherent in this type of investment is huge, and the SEC’s decision to open up this market to the public, despite mechanisms they intend to enforce for the security of investors, may ultimately lead to incidents of fraud and embezzlement. Even legitimate operations may unintentionally mislead casual investors into making financial mistakes.
The key points of these new regulations include provisions for both investors and businesses seeking funding. Businesses are capped at $1 million per year in equity crowdfunding before being obligated to register with the SEC, and will be required to make disclosures when offering securities to the general public.
Investors are somewhat limited as to their participation in this market. Those with a net worth or annual income below $100,000 are able to invest the greater of $2,000 or 5% of the lesser of their annual income or net worth, and those with net worth and annual earnings above $100,000 are able to invest up to 10% of the lesser of their net worth or their annual income. In any 12-month period, an individual investor may not purchase an aggregate amount of crowdfunded equity in excess of $100,000.
All of these rules apply to amounts in aggregate, and do not limit the number of companies one can invest in, so investors can invest in as many companies as they wish, or put all of their crowdfunded equity investment allocation into a single business. (For more, see: Portfolio Returns: What's Reasonable to Expect?)
Such offerings must be made through registered broker-dealers or through portal intermediaries – online services that allow individual trading, and which must be registered with the SEC. Both brokers and portals are obligated to vet both the companies seeking funding and the individuals who wish to invest in them, and individual investors generally will be required to hold their crowdfunding securities for one year. Individual retail investors are limited to putting a total of $100,000 per year into crowdfunded offerings.
What to Consider
This is exciting news for many people on both sides of these potential transactions, but before you start trying to figure out which startup to put 10% of your paycheck into, it is important to consider both the volatile nature of startup companies and the reasons why businesses might prefer crowdfunding to soliciting traditional VC or angel investment. Just one example is that companies seeking less than $100,000 through crowdfunding won’t have to have the financial statements their executives draw up be independently audited.
First of all, investors should be aware of the level of risk involved in funding startups – and it is substantial. Most startup companies fail, dissolving entirely and leaving their financial backers with nothing but an expensive lesson in modern business. The term “most” doesn’t mean the likelihood that any given startup will fold is simply better than 50/50, either. The real figure is closer to nine out of 10 new businesses, or just better than a 10% chance that any given startup will survive at all, let alone thrive and yield returns for its investors. (For related reading, see: Why Investors Can Be Their Own Worst Enemy)
Under the new crowdfunding regulations, investors generally may not sell their equity within a year of purchase (if they can sell it at all), so given the typically brief life cycle of startup companies, the likelihood of the company folding before investors can try to unload their equity is very high. Although a traditional stock might lose value in a day of trading, stockholders can sell at the end of that day and walk away with what remains of their initial investment.
Traditional stocks give investors the ability to monitor the value of their shares and liquidate them if they choose to, but the cold comfort of knowing you can walk at any time with some fraction of your initial investment is absent from equity crowdfunding. Even if the startup you invest in does well, you will have purchased equity in the company, typically a convertible note – not a share of stock.
Unless the company goes public, what you will own is a stake in the business, and your ability to profit from it depends entirely on the willingness of others to purchase your stake. Even in the best-case scenarios possible through crowdfunding, the equity that investors purchase in these early stages will very likely be highly diluted by the time it is even theoretically possible to liquidate.
On the corporate side, there are many reasons why companies choose to delay or avoid seeking investment from venture capital firms or angel investors, and one of the biggest is a desire to retain full control of the business. VCs and angels typically invest in a company only if they get a say in the operation of the company, allowing them to use their experience to influence the direction their investment. Startup founders are often hesitant to accept input from even the most seasoned investors if that direction goes against something the founders intend to do, regardless of the merit of the activity the investors are counseling for. (For more, see: Market Timing Fails As a Money Maker.)
While entrepreneurs frequently claim that institutional investment stifles creativity and innovation, investors are right to insist on the ability to influence the practices of businesses they back with six, seven, or even 10 figures of their own capital. Crowdfunding equity solves this dilemma for startup owners, relinquishing some of their share in their businesses but giving up zero control. Naturally, many in the startup world are pitching the coming revolution in crowdfunding as a democratization of investment that will grow the economy and boost innovation in all sectors.
What they seem to be keeping silent on is the inability for investors in crowdfunded equity to exercise measures of corrective action should the companies they invest in begin making questionable decisions. The prevalent narrative here is that these new rules will give average folks the same access to opportunities that were once reserved for institutional investors.
What is conveniently omitted is that crowdfunded equity gives investors less control over the companies they now own a part of than even the limited voting rights typically associated with ownership of common stock. Coupled with the inability to resell crowdfunded equity for a year, this means many investors will watch companies they backed spiral downward with no recourse at all, not even the option to sell at a loss. (For more, see: How to Avoid Common Investing Problems.)
To put it bluntly, the level of risk inherent in purchasing crowdfunded equity in a startup is beyond what many people would refer to as a safe investment. It would perhaps be more prudent to think about buying equity in startup companies in terms of how much you are willing to lose, not how much you might earn if all goes well.
Still thinking about investing in startup equity crowdfunding? Even if a startup company has a brilliant new concept that you firmly believe will disrupt their competition if all goes well, challenges ranging from internal conflict to regulatory issues have the potential to stop that rising star dead in its tracks.
All investing involves some level of risk, but investing wisely means taking your personal risk tolerance into account while diversifying your holdings to insulate you from volatility in any one investment vehicle. Although higher-risk investments may in some cases offer higher potential returns, your financial future and the stability of your financial plan depend upon minimizing your exposure to overall risk above a certain level.
Unless you know both your own risk tolerance and the potential impact of any financial loss, you may not realize the true consequences of a bad investment – or conversely, the potential gains you could make if everything works perfectly. So before you start scouting around for the next Silicon Valley superstar to get in on the ground floor of, make sure you have a comprehensive personal financial plan developed around your goals, needs and true, calculated tolerance for risk in investing. (For more, see: Don’t Buy What You Don’t Understand.)