Four years after Congress passed the Jumpstart Our Business Startups Act —also known as the JOBS Act—equity crowdfunding for non-accredited investors finally arrived on May 16. But the regulations are so complex that Congress is already working to simplify them.
In the meantime, given that the regulations are here and no one knows for sure if and when they will change, advisors should be aware of the regulations so they can decide whether crowdfunding is a viable investment for their clients.
Equity crowdfunding allows relatively small investments online to fund new ventures. While traditional crowdfunding provides prizes ranging from film credits to free CDs in exchange for contributions, equity crowdfunding provides equity to investors.
By freeing up this new potential source of capital, businesses are theoretically more likely to grow and hire more workers. While crowdfunding is having significant success in countries such as the United Kingdom and Australia, like the companies it’s designed to fund, crowdfunding is still in the start-up stage in the U.S. The top 50 crowdfunding deals from 18 leading portals are listed on the CNBC Crowdfinance 50 Index and range from $82,500 to $8,506,897.
Alternative investments have doubled in size since 2005, “with global AUM growing at an annualized pace of 10.7%, twice the growth rate of traditional investments,” McKinsey reported. As investors seek non-correlative selections to hedge against traditional volatility, that growth may continue and, as a new alternative investment, equity crowdfunding may enjoy significant growth.
Crowdfunding Regulations
JOBS includes three “titles” pertaining to crowdfunding, according to “The Crowdfunding Curriculum,” which was developed by Equity Institutional, which provides alternative asset custodial services. Title II permits general solicitation of accredited investors under Rule 506(c) of Regulation D. Title III allows funds to be raised from non-accredited investors, but the amount raised cannot exceed $1,000,000 in a 12-month period. Regulation A+, which replaced the underutilized Regulation A in Title IV, enables entrepreneurs to raise larger amounts from either accredited or non-accredited investors, but the regulations are far stricter and more costly to comply with than Title III or Reg D.
Title III
According to The National Law Review, other important facts about Title III include:
• Non-public U.S. companies may raise funds on the Internet from both accredited and non-accredited investors.
• Crowdfunding must be conducted through Securities and Exchange Commission-approved portals managed by registered broker-dealers.
• Investors with annual income under $100,000 are limited to investing the greater of $2,000 or 5% of their net worth. Investors with annual income of at least $100,000 are limited to investing 10% of their annual income or net worth, whichever is lower, up to a total limit of $100,000.
• Prior to fundraising, the company must file Form C, which requires a detailed disclosure of corporate and financial information, with the SEC.
• The public filing must include financial statements certified by a company officer if less than $100,000 is being raised, reviewed by public accountants if $100,000 to $500,000 is being raised and audited if more than $500,000 is being raised.
Regulation A+
Reg A+ allows non-accredited investors to participate in two types of offerings:
• Tier 1 offerings may raise up to $20 million in a 12-month period, including up to $6 million of securities sold on behalf of security holders. The issuer is required to provide only reviewed, unaudited financials. A state-level qualification is also required.
• Tier 2 offerings may raise up to $50 million, including up to $15 million of securities sold on behalf of security holders. The issuer is required to provide two years of audited financial statements. State-level qualification is not needed.
Through a Regulation A+ investment, a “testing-the-waters” provision permits communications to prospects prior to SEC approval for information purposes only, as long as communications include no implied or direct obligations. This allows companies to determine the level of interest for their business before finalizing legal and accounting commitments. “Testing the waters” is allowed without prefiling, but solicitation materials must be filed with the first solicitation statement and an offering circular must be filed 48 hours before the first sale.
The North American Securities Administrators Association (NASAA) has opposed Regs A and A+ due to concerns about investment fraud. NASAA is especially critical of allowing companies to bypass state review, considering the high risk of crowdfunding.
The Wall Street Daily’s Louis Baseness also noted that, by issuing Reg A+, “the SEC is hoping to revive the use of Regulation A offerings by putting a new spin on them. The SEC is significantly increasing the maximum amount of money that a company can raise—from $5 million to $50 million. That’s enough for such offerings to be considered mini IPOs. Additionally, the SEC is letting companies use Regulation A+ offerings to solicit investments from ‘the crowd.’ In other words, for the first time ever, non-accredited investors can invest up to 10% of their annual income or net worth in each deal.”
Finally, the costs of implementing Reg A+ may prove prohibitive. “It was estimated that a Regulation A+ offering will cost companies upwards of $100,000 or more to prepare the necessary documents,” Baseness wrote. “Then there’s the added expense of accountants’ fees, in order to comply with reporting obligations, as well as state regulatory fees, depending on the size of the offering.”
Regulation D
Given potential drawbacks of Reg A+, Regulation D (Reg D) offerings for accredited investors may dominate crowdfunding, barring regulatory changes. Under Reg D, accredited investors can gain immediate access to private equity and debt offerings, as well as crowdfunding opportunities, coming onto the market continuously.
Reg D’s Rule 506 allows accredited investors to commit unlimited amounts of money to an offering without an SEC filing or financial disclosures, so it may be faster and less expensive than Reg A+. Reg D issuers are obligated to determine that self-designated non-accredited investors understand their liability for vetting their investment choices.
Regardless of the regulation used, before accepting any crowdfunded investment, the investment sponsor must complete offering documents that include a description of the company's property and business, the security being offered, company management and financial statements certified by independent accountants.
Weighing Potential Pros And Cons
Supporters see equity crowdfunding as a potential game changer. Opponents believe the new regulations may lead to a record number of broken nest eggs. Equity Institutional’s “Crowdfunding Curriculum” cites the following potential pros and cons.
Potential “Pros”:
• Discovering the next Facebook: For investors who dream big, investment crowdfunding offers the excitement of playing the long odds on winning big.
• Diversifying: Having a strong diversification strategy is as necessary for alternative investments as it is for traditional investments.
• Building a network: As investors form crowdfunding groups, they may be open to other ideas from the same entrepreneur or investment sponsor.
• Simplifying: Crowdfunding may be easier to implement than traditional forms of capital investing.
Potential “Cons”:
• It resembles gambling. Barbara Roper, a director at the Consumer Federation, was quoted as saying the following in the Washington Post in 2012: “No one has to commit fraud, no one has to do anything wrong for this to be one stage removed from gambling. So now we’re going to connect unsophisticated investors with unsophisticated issuers to harness the power of the Internet to buy these stocks? What can possibly go wrong?”
• Start-ups are risky: Three quarters of start-ups backed by venture capital don’t return the original investment, according to a study by Shikhar Ghosh of Harvard Business School. Companies that rely on crowdfunding will likely be in their seed stage, and may be even riskier than venture-backed companies.
• Start-up stock is hard to value: Private company stock is difficult to value, as much of the company’s financial information is not made public.
• Limited liquidity: Investors may profit if the start-up is acquired or if it goes public, but otherwise there are limited options for selling an equity share.
When choosing specific investments, potential investors with industry experience may be aware of growth opportunities and may be able to apply their insights to vet crowdfunding opportunities.
“The Crowdfunding Curriculum” suggests monitoring companies closely for a given period and conducting research. You may want to research answers to questions such as: What experience does the leadership team have running a business? Does the startup have an established track record? What are the startups’ barriers to growth? Are any VC or angel investors invested who might add value beyond their capital infusion?
As with any investment, it’s important to consider how returns will be taxed. A crowdfunding IRA is one option to consider, as investments can be tax advantaged.
Where IRAs and equity crowdfunding are concerned, investors will want assurance that their custodian can handle such alternative assets. According to Jeffrey Kelley, Senior Vice President for Equity Institutional in Westlake, Ohio, “We’ve been helping financial professionals and their clients maintain the tax-qualified status of alternative investments for 40 years. While we do not offer investment advice, evaluate investments, perform due diligence, or sponsor products, we can facilitate the investment of equity crowdfunding alternatives in IRAs.”
It is also important that investors have reasonable expectations. “The Crowdfunding Curriculum” suggests that advisors may:
• Encourage investors to limit their initial investment: Investors should never commit assets they cannot afford to lose.
• Diversify, diversify, diversify: Its likely most investments will not be profitable, so select carefully. Investors may be better served by spreading $100,000 across 10 different investments, than by investing $100,000 in one crowdfund.
• Avoid opportunities that make false promises: Advise clients to avoid investments that promise excessive rates of return, lack adequate documentation or claim that the assets are safe.
According to a Legg Mason survey of millionaires , when they were asked to tell future generations the decisions they made that had the most positive impact on investing success, the top three responses were: developed a financial plan, engaged with a financial advisor and invested in products other than stocks and bonds.
For advisor and investors, equity crowdfunding offers another option that may have a positive impact on investing success.
John Drachman is the founder of AlphaSegment, a financial marketing firm. He can be reached at [email protected].
1. The National Law Review, “Equity Crowdfunding Rules: What You Need to Know.”
2. Wall Street Daily, “Crowdfunding Regulation A+”
3. Investment News, “How Millionaires Invest.”