What if you had invested $100 in Google, Inc. (GOOG) really early? Not on the first day of public trading, but even before the initial public offering when it was just a scrappy startup with a handful of employees. Imagine what your investment would be worth today. You can only imagine this scenario because traditionally, the law has not allowed average citizens to invest in startups. However, recent changes in U.S. Securities and Exchange Commission regulations have now changed all of this. Startups will soon be able to raise money through equity crowdfunding—soliciting money, even in small amounts, from average investors in exchange for equity or ownership in the company.
Startup companies and small business typically raise money from banks, private equity firms and venture capitalists. Their fundraising was restricted to so-called accredited investors. These are individuals who make more than $200,000 a year or have a net worth of more than $1 million. The government considers these accredited investors to be sophisticated enough to make savvy investments, unlike those who don't meet this standard and might be taken advantage of by those touting unsafe investments.
The U.S. Securities and Exchange Commission’s adoption in early 2015 of equity crowdfunding rules, initiated by President Barack Obama’s 2012 Jumpstart Our Business Startups (JOBS) Act, is paving the way for smaller investors to get in on the startup action, in the form of equity crowdfunding through suitable online platforms.
How It Works for Small Investors
However, the SEC is not giving up the reins entirely. While anyone will be able to invest, no matter what their salary or net worth, the SEC will place restrictions on how much you can invest. If you are not an accredited investor, this regulation restricts your crowdfunding investment to 10% of your income or net worth, whichever is higher, every year. The SEC has placed this limit to protect investors—early stage companies are notoriously risky and enthusiastic investors could stand to lose their entire investments. (Read more in SEC: A Brief History of Regulation.)
How It Works for Companies
Small companies that are looking to raise up to $50 million in securities over a 12-month period can make use of the equity crowdfunding provision to make a streamlined public offering. They will have to meet SEC requirements relating to disclosure and eligibility and also undertake the required reporting. These requirements also provide protections for investors.
The SEC rules identify two different tiers of offerings: Tier 1 refers to securities offerings of up to $20 million. Of the $20 million, associates of the security issuer cannot offer more than $6 million worth of securities. Tier 2 offerings covers securities offerings of up to $50 million. In these cases, affiliates of the issuer cannot offer more than $15 million of securities. In addition, existing security-holders can’t sell more than 30 percent of the issuer’s total offering in an initial offering.
If a business is looking to raise up to $20 million, it could opt for either the Tier 1 or the Tier 2 route. While both these routes are subject to SEC scrutiny, Tier 2 offerings are also subject to more rigorous disclosure and reporting provisions, such as a provision to provide audited financial statements and also to provide periodic reports.
Exemption from Blue Sky Laws
In the case of a Tier 2 offering, the new rules also provide that the issuers don’t have to register their offering with each state in which they are looking to offer securities. This eases the administrative burden for issuers who previously had to adhere to Blue Sky Laws, state regulations for protecting investors against securities fraud. Tier 1 offerings don’t have such an exemption, so it seems that’s one reason for businesses to favor the Tier 2 route to crowdfunding.
Not All Small Companies Can Qualify
The SEC doesn’t allow all companies to go through this streamlined securities offering process. Only companies that have their main business operations in the United States or Canada qualify. And they should not be investment companies or companies without a particular business plan. Companies looking to sell interests in oil and gas don’t meet the SEC standard to go this route. Companies should also be in good standing with the SEC and not previously disqualified.
Cutting out the Middle Man
The government hopes that by lifting and easing regulations and allowing smaller investors to participate, businesses will be able to more easily and efficiently raise capital. This will create more jobs. This direct link between businesses and investors also has the potential to cut into the business of venture capitalists, banks, and private equity firms who have traditionally provided capital for startups and small businesses.
The Bottom Line
The recent enactment of a regulation under the JOBS Act enables startups to approach small investors to fund their business. This so-called Regulation 'A plus' expands and enhances an existing Regulation 'A' under the Securities Act. The maximum amount that a business can raise under this crowdfunding approach is limited to $50 million over a 12-month period. The regulation identifies two tiers of offerings with Tier 2 offerings being subject to more reporting requirements. While previously investing in such a crowdfunding was restricted to wealthier, and presumably more savvy, accredited investors, it is now open to others as well, with some restrictions on the amount of their investment. If this sort of crowdfunding approach becomes successful, it could help build a direct bridge between businesses and investors.