In the spring of 2012, President Obama passed an act that will drastically alter the landscape of crowdfunding platforms. Until April 5, 2012, a small pool of existing crowdfunding sites were only permitted to operate on a reward or donation basis, essentially offering a product, discount, or enticement in exchange for monetary funding. With the launch of the JOBS Act, short for Jumpstart Our BusinessStartups, the ability for the general public to receive company equity in exchange and explore the opportunity not only for funding but also to invest in startups is now a possibility.
As of today, the Securities Act of 1933 states that entities can not offer or sell securities to the public unless (a) the offering is registered with the SEC, or (b) there is an available exemption from registration. Unfortunately, the crowdfunding exemption introduced under the tittle III of the JOBS Act under Section 4(a)(6) of the Securities Act won’t be available until the SEC issues its regulations.
The issue is entrepreneurs find it very difficult to access financing. Not only because their business plans are rejected 98% of the time by Venture Capitals when they can manage to get an introduction, but also because U.S. banks according to the Small Business Administration, held $607 billion in outstanding business loans of $1 million or less during 2011, which surprisingly enough, represents $100 billion less than in 2008.With the current state of the recession and the rising numbers of unemployment, crowdfunding could be a great asset to our country’s economy. These portals could serve as a great vehicle for investing in small businesses, which are accountable for creating 65% of the net new jobs over the past 17 years. As the Co-Founder of RockThePost, the leading equity crowdfunding platform for entrepreneurs and small businesses, I have seen just how effective the power of the crowd is.
Crowdfunding is essentially a tool that gives entrepreneurs the opportunity to attract a pool of people via social media or shared interests in order to contribute to a funding target that has been previously established by the entrepreneur.
Data from massolution research indicates that total funds via the reward and donation based crowdfunding are growing at a rate of 524 percent, where platforms raised almost $1.5 billion, funding over one million projects in 2011.
With the addition of equity as a potential option within the crowdfunding space, the spotlight on crowdfunding has increased substantially. Business savvy individuals can now dream of being one of the first seed investors in the next Facebook , Airbnb, or Dropbox.
Crowdfunding Capital Advisors, a crowdfund industry consultancy firm will be releasing a report in September 2013 that shows the debt and equity crowdfunding space to be at least $4.3 billion in its first year of operation.
As it always happens in life, there are people who are contrary to its implementation as they think that equity based crowdfunding is very risky for the average American. On this note, I would like to mention the fact that Americans purchase $45 billion dollars worth of lottery tickets every year, with the average household spending $150 annually. The odds of winning the lottery are one in 175 million according to Aaron Abrams, a mathematician atEmory University. The stock market odds might be a bit brighter. However, total assets invested in stocks, bonds, mutual funds, pension funds and insurance funds equal $30 trillion according to the economist Michael Shuman. For both, lottery and stock markets have no limits, any individual could spend all the money they want and of course lose it.
On the other hand, equity crowdfunding or startup investing comes with limits, as the law permits investments to 5 percent for individuals with annual income of less than $100,000 and 10 percent for those who make over $100,000.
So the big question is, why do most crowdfunding sites still not offer equity as an option yet? Now that the JOBS Act has passed, the US Securities Exchange Commission (SEC) has been instructed by Congress to step in and monitor the new changes before the Act can take effect for equity crowdfunding (regulations are expected on or before January 2013). The SEC exists to regulate financial Federal laws, and protect the public from potential fiscal misuse regarding these laws.
In order for the general public to feel protected while investing in small businesses, the SEC is working on creating a structure to safeguard these new allowances. While deliberating the numerous issues involved, the SEC created an online forum to receive comments from the public and aid in their decision. Until they finesse these changes, crowdfunding platforms will not legally be able to exist as equity based models without operating under the license of a broker-dealer.
Even though the SEC has a deadline established on January 2013, there are fears concerning delays on the delivery of the regulations. A good example of the type of delays funding portals could be facing, could perfectly be the Dodd-Frank Act, which became the law in July 21, 2010. It was schedule to be enforce no later than April 15, 2011. However, after a year of its deadline the enforcement is nowhere to be seen. Note, that the SEC staff have said publicly in a number of forums that JOBS Act rules are taking precedence over Dodd-Frank rules.
For equity crowdfunding to operate properly, funding portals will not only need regulations in place, but also the appointment of a self-regulatory organization or SRO. This SRO is most likely to be FINRA as the last time an SRO was introduced in the market was back in the 1930’s. This organization will be accountable for overseeing the regulation of the equity crowdfunding industry. Unfortunately, FINRA is privately run where they receive annual dues from brokers and firms in the financial industry. This fact could extend the delays even further.
A good step forward was SEC’s proposal on August 2012 to end the prohibition against general solicitation and advertisement on startups and investment funds under Rules 506 and 144A offerings. With this proposal, essentially sellers would not be restricted when advertising an offering. Without a doubt, social media is a key element behind the success of crowdfunding and if project creators are not able to tell the world about it via these networks their fundraising efforts will most likely suffer to some degree.
An interesting fact stated on the proposed SEC Rules eliminating ban on general solicitation of 506 offerings, is that in 2011 the estimated amount of capital (including both equity and debt) raised in Rule 506 offerings and Rule 144A offerings was $895 billion and $168 billion compared to $984 billion raised in registered offerings. In 2010, the amount of capital (including both equity and debt) raised in Rule 506 offerings and Rule 144A offerings was $902 billion and $233 billion, compared to $1.07 trillion raised in registered offerings.
On another note, it is surprising how the U.S. startups find it so difficult to raise money during the initial stage of their business where only accredited investors and other institutional investors, representing 1% of the US population, are the only crowd allowed to participate. In the UK for example, not only equity crowdfunding is legal, but also under the EnterpriseInvestment Scheme anyone investing between £500 and £1m in a qualifying business could be eligible for income tax relief, worth 30 percent of the amount invested.
To conclude, I have to say that I am a big fan of investor protection. However, I do fear that too many requirements may kill the attractiveness of startup investing. As the title 3 (concerning crowdfunding) of the JOBS Act states, companies seeking equity crowdfunding should already think prior to their fundraising efforts through a funding portal about filing with the SEC and all potential investor documentation that will include:
-Registration and incorporation documents.
-Name of directors, officer and stockholders.
-Description of the business.
-Prior year tax returns.
-Intended use of proceeds, target amount and deadline.
-Description of the ownership.
-Outstanding securities of the company.
In addition to this, in the event the company is raising over $500,000 it will need their financial statements to be audited, which could be a costly process.
Funding portals will also be “invited” to pass certain requirements. Some of these might be registration fees or for the portal management team to hold whatever exam FINRA or other SRO may require. Word on the street is that there might be either a special exam for portal operators or for them to pass the existing Series 7, 63, 64, 66 or 79. Holders of these exams may also need to be supervised by at least one holder of a Series 24 and another with Series 28.
While the future of equity-based crowdfunding is still undetermined, enthusiastic entrepreneurs and investors wait with baited breath for the SEC’s final verdict. Either way, the face of small business investing will be drastically altered as the JOBS Act begins to take effect.