Our Thoughts on the Proposed Crowdfunding Rules
Last week the SEC released proposed rules for non-accredited investor crowdfunding, which would let unaccredited investors (anyone) participate in securities offerings. What this means in plain English: when and if these proposed rules are enacted, companies will be able to raise up to one million dollars by selling stock to anyone willing to buy it, and for the first time they won’t have to do an IPO to be able to reach these investors.
Currently, to sell stock, companies have to:
- File a registration statement and go through an IPO process that is generally prohibitively costly for all but the most successful companies; or
- Conduct a private placement offering that only accredited investors (individuals with $200k in annual income or over $1mm in net worth) can participate in.
Why crowdfunding (in theory) is an exciting development
The idea of crowdfunding is exciting. It’s the same idea as Kickstarter or IndieGoGo, but instead of receiving swag, like a t-shirt, investors will receive stock. One of the best aspects of crowdfunding is that it empowers the market (the “crowd”) to determine what products or services it wants by enabling the crowd to choose which products or services to fund. Currently, startups looking for capital have to persuade friends, family, bankers, angel investors, or venture capitalists to invest in their company, otherwise their startup may never get off the ground. These select individuals currently wield great power in our economy because to a large extent they choose which companies will receive the capital necessary to achieve success. In theory, crowdfunding could democratize the capital markets for startups, and at the same time it could provide validation to entrepreneurs, confirming that people are interested in the products or services being developed.
Why crowdfunding (as proposed by Congress and the SEC) is not exciting
While the idea of crowdfunding is exciting, the law enabling crowdfunding is not. The SEC’s 585 page release details layers (and layers) of regulation that in our estimation will prevent this type of securities offering from being widely used. One of the main problems is that the process of complying with the proposed rules will be too burdensome (and expensive) for most of the companies that these rules are aimed at helping. Because there is no requirement that investors meet wealth thresholds, regulators are requiring that companies make more disclosures–which will protect investors by giving them more information to consider before investing in a company.
The following are requirements that are proposed for crowdfunding offerings, that are not required for private placement offerings (offerings to accredited investors):
- The company has to offer its shares through a funding portal or registered broker dealer, in other words you can’t offer securities on your own website
- File the following with the SEC:
- resumes of business principals
- minimum and maximum amounts sought to be raised
- date the securities offering will close
- the company’s business plan
- the income tax return for most recent year (if any)
- GAAP financial statements, including audited financials if the company is raising more than $500,000
- CEO discussion on the company’s financial position
- detailed description of how the capital being raised will be utilized by the company
- extensive disclosure of risks
- funding progress reports every 5 days
- The company will also have annual reporting obligations, including financial statements
- The company cannot publicly solicit investment (as it could under a 506(c) offering), instead it can only direct potential directors to its funding portal
- All investors must pass bad actor checks
- The company can only raise $1 million per year under this exemption
An additional detriment to these types of offering is an increased number of shareholders–there’s a cost that comes with each shareholder–tax forms, meeting notices, etc.
Crowdfunding (as proposed) is not a great opportunity for change
A company that has access to conventional forms of capital will have major incentives to stick with private placement offerings. I’ve heard people say that crowdfunding will enable investors to buy stock in the next Facebook or Google–but the odds are that these companies won’t be trying to raise less than a million dollars from hundreds of investors and creating initial and ongoing filing obligations when, if they have a compelling company, they can get one or two checks from angel investors without jumping through so many hoops or creating ongoing SEC reporting obligations. What this means is that private placement offerings will filter out most of the best startups, and the retail investors will have a wider pool of less attractive opportunities. As compared to other opportunities, crowdfunding (under the proposed rules) is not an attractive option for companies or for investors.
Statistics for infographic from SEC release (starting on page 63)