The Securities and Exchange Commission recently announced long-awaited new rules affecting equity and debt crowdfunding. Entrepreneurs have every right to be excited, since these new rules will open up new avenues for raising money starting in the spring of 2016. But they also need to understand that with every new opportunity comes a cost, and this one is no different.
What are these new rules and how do they affect your ability to raise money for your business?
First, in case you missed the memo, crowdfunding means raising money from “the crowd,” (anyone who is willing to pony up) and there are a number of different types of crowdfunding platforms. Currently, the most popular type is “reward-based” crowdfunding. That’s where someone pitches a project or product and offers a reward for those who contribute. (A musician might offer a CD for a small contribution, for example, or a live concert for a very large contribution.) That type of crowdfunding is not affected by these new rules.
Donation-based crowdfunding is also currently popular. That’s where people gather donations for someone’s medical bills, college costs or disaster relief, for example. That’s not what we are talking about here either.
These new rules open up opportunities for equity and debt-based crowdfunding, both of which involve three key players. You’ll have the entrepreneurs who are initiating the effort. You’ll have the crowd that is being asked to put up funds, and you’ll have the internet “funding portal,” which acts as the middleman. Debt-based crowdfunding allows individuals to loan money to these companies, while equity-based crowdfunding allows individuals become investors. (I’ll stick to focusing on investors in this article, since that’s currently where the most interest is targeted, though debt-based crowdfunding will allow individuals to essentially become small business lenders and many of these same rules apply.)
The JOBS Act passed in 2012 made these opportunities possible, but they have been on hold pending new rules by the SEC. The SEC’s job is primarily to protect investors. It knows that most businesses fail, and that it can be all too easy for a company to exaggerate its prospects, and therefore is trying to, in effect, protect investors from themselves!
A Whole New World of Investors
By far, the most significant change here is that it gives smaller investors the opportunity to invest in companies that are not publicly traded. Before, these kinds of opportunities were limited primarily to “accredited investors,” or those with $200,000 a year incomes or a $1,000,000 net worth.
Now, individuals with an annual income or net worth of less than $100,000 will be allowed to invest the greater of $2000 a year, or 5% the lesser of their income or net worth per year. Those with higher incomes and net worth can invest up to 10% of the lesser of income or net worth. (So if your annual income is $150,000 and your net worth is $500,000 you can only invest $15,000). At the upper end, investors can only place a total of $100,000 in all crowdfunding offerings each year. Overall, these changes open up a whole new pool of potential investors, especially in the context of the other rules.
Here’s another significant change: Prior to the JOBS Act, a private company trying to raise money couldn’t use any form of public solicitation to advertise their offering. That meant they had to operate within networks of people they knew. In other words, you had to have connections to accredited investors or go through a broker-dealer, which can be very expensive (Is it any surprise doctors get pitched business opportunities all the time?)
Now, if you’re trying to raise less than $1 million, you may reach out to your network (even if they aren’t wealthy) as well as tap the power of the crowd through the internet. This is a monumental change for both the companies trying to raise money, as well as for individual investors hoping to get in on the next Facebook or Google.
Companies and investors must connect through registered funding portals, which currently include companies such as Crowdfunder, Seedinvest, AngelList or EarlyShares. (No doubt others are being formed right now.) These portals are designed to help facilitate compliance with the SEC rules, and they are allowed to take equity in your business at the same rate as everyone else in exchange for the services they render.
Disclosure Is Key
While you’ll want to make your offering compelling, there will be strict requirements around disclosure, so you have to be careful and accurate. You’ll have to give your prospective investors complete and honest information so they can make an informed decision about whether to invest. It’s required by law and it’s the right thing to do. For more information on preparing an investment document, see my book, Finance Your Own Business.
The SEC is making it easier for companies to raise money this way by no longer requiring an often cost-prohibitive full financial audit for new issuers. Financial disclosures are required, but only if you are raising $100,000 or more will you have to spring for a CPA to review your financial documents. Still, the SEC will require certain disclosures to them, and it’ a good idea to work with a knowledgeable securities attorney when venturing into raising money from strangers. If things don’t work out, the last thing you want to do is find yourself embroiled in costly or lengthy investigations or even lawsuits triggered by disgruntled investors.
You must raise the full amount of your offering in order to receive funding. In other words, if you ask for $500,000 and only raise $200,000, you don’t get to keep any of it. There will be expenses that have to be paid (legal, accounting, platform fees, promotion etc.) regardless of whether you are successful. On the one hand, you want to make sure you raise enough to successfully launch or expand your business. If you aim too low, you may not have the runway you need to succeed before running out of funds. But if you aim too high the effort could fail. So it will be important to be think hard about how much you really need and what you need it for.
Also keep in mind that a deal can fall apart at the last minute. Investors may change their mind up to 48 hours prior to closing and that means the whole deal can blow up at the last minute. Try to exceed your target rate (which is allowed) so there will be wiggle room in case investors back out.
How soon can I cash out?
If your plan is to raise money for a hot offering then quickly get out, think again. Like regular private placement offerings, the investor must hold shares for at least a year. And even after a year, it’s not likely shares will be very liquid. Most investors will get to cash out when the company is acquired or when it goes public.
Is this a great way to raise money or what?
Maybe—and maybe not. First, it is not necessarily easy or cheap. The SEC estimates it will cost roughly $7000—$12,000 to raise up to $100,000, $33,500—$53,500 to raise up to $500,000 and in the range of $75,000—$118,000 to raise up to $1 million.
Plus, if you are successful, you’ll have a whole new group of people to please. Unlike reward crowdfunding, they won’t be satisfied by simply getting the reward you promised; instead they are left waiting for a much bigger financial reward, and that will take time—perhaps a long time. While these investors may have been starry eyed when they invested, they can become disgruntled quickly if the company isn’t achieving expected milestones. As any CEO of a public company knows, trying to balance the demands of shareholders and customers, while trying to build the best business you can, is often trying at best.
In addition, just because you used crowdfunding, that doesn’t mean you can just do whatever you want with the money you’ve raised. “You have a fiduciary duty to your investors,” says Dave Archer, a co-founder of the Reno Angels and the president and CEO of NCET, Nevada’s technology organization. “You must act in their best interest at all times.” You’ll have to continue to disclose material changes to the business to the SEC as well as to your investors. The SEC can take a hard stance on companies that deceive investors. Working with a knowledgeable securities attorney can be very valuable.
Yes, jobs will be created as a result of these new options, but no doubt there will be questionable practices that arise via these platforms as well. So caution is in order.
Garrett Sutton is an attorney and the bestselling author of eight business books, including Start Your Own Corporation and Loopholes of Real Estate. His latest book, co-authored with Nav’s Head of Market Education Gerri Detweiler, is Finance Your Own Business. Garrett can be reached at CorporateDirect.com. http://www.corporatedirect.com/.
This article was originally written on November 23, 2015 and updated on November 3, 2016.