As of Monday, a belated provision of the 2012 JOBS Act goes into effect, allowing anyone and everyone to participate in fundraising for private companies and receive stakes in potentially high-growth startups in return. At the same time, companies that have essentially no hope of raising money from venture capitalists can now raise up to $1 million per year from anyone and everyone. Or at least, that’s the idea.
The principle behind Title III of the JOBS Act is similar to the one behind Kickstarter. Someone in need of money pitches their idea to the masses, and a large number of people pitch in small amounts of money to meet the funding goal. Rather than just receiving a T-shirt, however, those chipping in under the “Crowdfund Act,” as Title III is also known, receive equity.
Ron Miller, co-founder of StartEngine, describes the new rule as an “opportunity for the other 92% of the population to invest in the next great company.” The vast majority of investors were locked out of Google, Facebook, Dropbox and Tesla’s rapid early growth, but “starting Monday, everyone has a chance.”
Accredited vs. Non-Accredited
In general, securities law in the U.S. maintains a strict separation between relatively scarce (8% of the population according to Miller) “accredited” investors, who are rich, supposedly sophisticated and therefore allowed to fend for themselves; and the “other 92%,” the non-accredited. In general, accredited investors are the only ones who are allowed to invest in non-public companies, while the rest must wait for the IPO.
|Earned income over $200,000 (or $300,000 for a married couple) in each of the prior two years, with a reasonable expectation of earning the same in the current year, OR|
|Net worth of over $1 million, either individually or including a spouse, excluding the value of a primary residence.|
An early exception to that rule was Regulation A, a 1936 tweak to the 1933 Securities Act, which gave smaller issuers a way to raise up to $5 million without undergoing a full IPO. According to Thaya Knight, Associate Director of Financial Regulation Studies at the Cato Institute, the problem was that the exception did not supersede state laws, meaning that companies had to comply with up to 51 different sets of regulations (including D.C.). There were usually cheaper ways to raise the money, and few used Regulation A—only one company in 2011, according to Knight, compared to 125 IPOs.
That regulation was updated by Title IV of the JOBS Act, dubbed Regulation A+, which went into effect in June and allows businesses to raise up to $20 million per year without contending with state laws (or $50 million, subject to state laws). “General solicitation” is also allowed, meaning issuers can advertise their securities freely through whatever medium they see fit.
The Crowdfund Act
Title III/the Crowdfund Act enjoys federal preemption, meaning that business’s attempts to raise funding are not subject to 51 sets of rules apiece. Unlike Title IV/Regulation A+, it does not alter an existing exemption to the accredited investor requirement, but creates a new one.
Under the Crowdfund Act, companies can raise up to $1 million per year. For critics, the cap is too low, since issuers are required to file potentially costly annual reports. One company planning to use the provision to raise money, Cleveland Whiskey LLC, told Bloomberg that it will likely spend $40,000 to $50,000 to raise $1 million, meaning 4–5% goes towards paperwork. If a company does not reach its funding goal, it must return the funds it’s raised.
There are also limits on what investors can put towards crowdfunded offerings: the greater of $2,000 or 5% of their annual income or net worth, for investors with either a net worth or annual income of less than $100,000. The limit is 10% of net worth or income for wealthier investors, but no one—”not even Warren Buffett,” as Knight puts it—can invest more than $100,000 per year in a crowdfunded offering.
Another quirk of the new rule is the “portal,” a new entity that serves as a mandatory intermediary for crowdfunded offerings. These online middlemen are subject to strict regulations, 650 pages of them according to Miller. They are also responsible for all of the advertising around a Title III issue. The companies themselves are only allowed to present a “tombstone,” says Miller: the name of the company, the terms of the offering and a brief description.
Will It Work?
Given the $1 million cap on fundraising and the reporting requirements, the Crowdfund Act could prove to be an expensive way to raise money. Combined with the advertising restrictions and the need to go through a portal—only five of which have currently been approved—it’s worth asking whether Title III will end up unused and forgotten like the original Regulation A.
Miller doesn’t think so. He estimates the costs of preparing annual reports at $5,000 a year, which isn’t terribly onerous. He also stresses the number of entrepreneurs who miss out on funding opportunities under the existing system, saying that venture capital funding is statistically more difficult to get than an acceptance letter from Harvard Law.
He sees crowdfunding appealing most to consumer-facing companies with access to a reasonably large community of fans and customers. Absent an attention-grabbing celebrity endorsement, he thinks it could be difficult for early-stage companies to attract enough attention from potential investors. StartEngine lists two Title III issuers as of Monday morning: Santa Monica-based Gigmor, a network for connecting performers and music venues; and Charles Town, West Virginia-based Bloomery Investment Holdings, LLC, a craft distillery.
He expects 15 to 20 companies to join the portal in the next 30 days, indicating that there is some early interest in crowdfunding on the part of entrepreneurs. It’s too early to say how much investor interest there is, but Elio Motors’ Regulation A+ offering on StartEngine raised $17 million, and other offerings have attracted attention.
Miller thinks the “democratization of the access to capital” allowed for by crowdfunding will particularly benefit groups that have traditionally been marginalized in the business world. To take one example, he says that women receive less than 5% of venture capital funding despite demonstrating equal or greater entrepreneurial abilities based on a number of measures.
Miller is especially excited about crowdfunding’s potential to combine the roles of customer and investor to create “an army of brand ambassadors.” As social media overtakes traditional media, he reasons, the value of having committed stakeholders could eclipse traditional advertising.
Title III of the JOBS Act brings crowdfunding to the world of startups, allowing retail investors to buy stakes in private companies. For boosters, the new rule is a democratizing force, helping to fund companies that lack access to venture capital and giving regular investors exposure to potentially high-growth startups. For critics, bad design threatens to relegate the Crowdfund Act to the historical dustbin of securities reform. What comes of this specific regulation remains to be seen, but the push to bring crowdfunding opportunities into the world of investing isn’t likely to go away.