A new door just opened for entrepreneurs to get access to capital.
The Securities and Exchange Commission voted 3-1 to adopt the next generation rules for equity crowdfunding this morning for entrepreneurs and small-business owners. Equity crowdfunding is the exchange of a piece of a company for cash. Before today’s ruling, entrepreneurs could only sell pieces of their companies to accredited investors, or those individuals who meet sufficient levels of assets and income. With the passing of this new set of rules, entrepreneurs can sell pieces of their companies to anyone who has the interest and cash to do so.
The rules for this new generation of online, equity crowdfunding got a “yes” vote from Chairman Mary Jo White, Commissioner Luis A. Aguilar and Commissioner Kara M. Stein. Commissioner Michael S. Piwowar was the lone dissenting vote.
The set of rules adopted today is the SEC’s second whack at writing rules for this new method of raising money for entrepreneurs to launch and grow new businesses. The JOBS Act, signed into law in April of 2012, made equity crowdfunding for unsophisticated investors legal, but it has taken the SEC more than three and a half years to wrangle a set of rules for how equity crowdfunding should be implemented.
It’s been a complicated slog for the agency to figure out how to both open up capital markets that have arguably been underutilized and also simultaneously protect unsophisticated investors from losing their savings in risky, unrealistic startup dreams or worse, fraudulent scams. The industry has very actively engaged with the SEC and participated in the development of this new set of regulations. “This rulemaking has generated tremendous interest from potential issuers, investors, and intermediaries. The more than 480 comment letters we received raised a number of important issues, focused on the best ways to protect investors while ensuring that securities-based crowdfunding is a workable path for raising capital by smaller companies,” said White in her opening testimony at today’s confirmation hearing.
The agency amended some of the most controversial pieces of the initial set of rules to get to today’s compromise legislation. Overwhelmingly, investors and entrepreneurs were pleased to see the SEC finally get a set of rules for equity crowdfunding over the threshold.
“This vote by the SEC to approve the final rules for Title III crowdfunding will prove to be the greatest advancement for entrepreneurship in a generation,” says Ron Miller, the CEO of StartEngine Crowdfunding, an online platform for investing in startups. “Access to capital is the greatest inhibitor to entrepreneurs in bringing innovative products and services to the market. Title III is the game changer which dramatically reduces this hurdle for companies that can prove themselves to the market.”
Not everyone was so celebratory, however. Commissioner Piwowar, the lone naysayer, says the complexity of the new fundraising tool will ultimately render it inefficient and useless. “The rules will spin a complex web of provisions and requirements for compliance. I fear that many traps for the unwary are hidden in the regulations, creating potential nightmares for small business owners that fail to place regulatory compliance at the top of their business plans,” Piwowar said. “Such burdens will spook many small businesses from pursuing crowdfunding as a viable path to raising capital.” (As an aside, who knew that securities commissioners have Halloween humor?)
Time will tell whether Piwowar was correct or an overly anxious outlier. In the meantime, the new rules authorize an inter-divisional staff working group to monitor for fraud in this new category of securities. Also, the agency is tasked with filing a comprehensive report 3 years from implementation reporting on how the new marketplace is functioning.
To be sure, nothing that involves government regulatory changes happen overnight. It will be another 180 days from when the rules make it to the official Federal Register until the rules are fully effective. Funding portals will be able to begin registering with the SEC on Jan. 29.
A deeper dive into key provision of the new rules
According to the rules which were just adopted, a startup is able to raise up to $1 million through online equity crowdfunding from unaccredited investors in a 12-month period.
The rules also put a limit on the amount that these unsophisticated investors can put into startups through these online portals. If a potential investor’s annual income or net worth is less than $100,000, then the investor can invest either 5 percent of his or her combined net worth or a maximum of $2,000 in a 12-month period, whichever is greater. Meanwhile, if an investor’s annual income and net worth are equal to or more than $100,000, then the individual can invest no more than 10 percent of the lesser of their annual income or net worth. No matter how wealthy an individual is, the maximum amount an investor can put into startups through online equity crowdfunding in any given year is $100,000.
“For instance, even if you are Warren Buffett or Bill Gates, you are limited to investing no more than $100,000 during any 12-month period in all crowdfunding investments,” said Commissioner Piwowar, the dissenting voter.
The limits on amounts that entrepreneurs can raise and that individuals can invest also disappointed Howard Orloff, the chief marketing officer of ZacksInvest, an online funding portal for startups. “I feel like a starving man who waited 3 ½ years for a feast and who was just given a handful of rice,” said Orloff. “I’m excited and appreciate the SEC efforts but they clearly fall short of expectations.” Orloff had hoped to see $1 million cap that entrepreneurs can raise in a 12-month period raised to between $3 million and $5 million in the same time period. Also, he had hoped to see investor limits set at $2,500 per deal.
Another controversial component of the first generation rules that industry stakeholders were anticipating highly was the requirement that companies looking to take advantage of equity crowdfunding receive a financial audit before they raise money. The fear was that requiring an audit was so expensive that it would end up being a fundamental non-starter for entrepreneurs. The SEC’s new rules attempt to strike a balance that both removes that barrier to entry for startups and prevents investors from sinking their money into unsavory investments.
The new rules include an exemption from the audit requirement for first-time crowdfunding issuers. Entrepreneurs raising less than $500,000 are permitted to provide specific information from their tax returns that have been “reviewed” by an independent tax accountant. Companies raising between $500,000 and $1 million for the first time are also permitted to submit “reviewed” financial documents, as opposed to the formal, and more expensive, process of getting a financial audit.
The more lenient financial disclosures are a definite win for entrepreneurs and small-business owners, says Swati Chaturvedi, the co-Founder and CEO of Propel(x), an online platform for investing in startups. “One key aspect of the final rules that I think will be beneficial to startups is that there are no required audited financial statements for first time crowdfunding issuers,” says Chaturvedi. “Providing audited financial statements is an expensive and time intensive process – one that many startups cannot afford at their current stage of growth. Allowing reviewed financial statements instead of audited ones lowers the cost for startups who are seeking to raise funding.”
Today marks an historic milestone in the regulation of how entrepreneurs raise money to launch and grow their businesses, but it’s also undoubtedly the first step in what will be a years-long process of this new class of securities being born, wrangled and used effectively.
Related: What the U.S. Can Learn From the Netherlands About Equity Crowdfunding