Last Wednesday, the Securities and Exchange Commission released new rules for crowdfunding under the 2012 Jumpstart Our Business Startups (JOBS) Act. Crowdfunding gives startups a way to raise capital through the Internet and thereby reach a large, diverse set of investors.
Under the new proposed rules, startups would be allowed to raise funding from people with lower net worth and lower gross income as well as from wealthy accredited investors. According to the proposed rules, startup companies would be able to raise up to US$1,000,000, a year through crowd funding. However, the amount invested by each individual investor will be limited according to such investors’ income and wealth. For example, a person with an annual income or net worth less than US$100,000 a year would only be able to invest 5% of her income and up to US$2,000. The new proposed rules also contemplate changing the manner in which crowdfunding transactions will be conducted. According to the new proposed rules, crowdfunding transactions must be conducted through an intermediary—either a registered broker or a new type of entity called a “funding portal” designed to regulate and track the crowdfunding process.
On one hand, the new proposed rules are supposed to affect the viability of crowdfunding as a capital-raising method for startups and small businesses. The new rules, if adopted, will create a new and relatively convenient funding process for startups and small businesses that previously did not exist. Traditionally, startups raised their first investment rounds from friends and family, angel investors, micro-funds or established venture capital firms. Crowdfunding can provide a new source of funding from an army of small investors that could also help create a “buzz” and market the startups or their products. However, critics of crowdfunding claim that crowdfunding money is “dumb money”—less valuable than venture capitalists’ (VC’s) or other sophisticated investors’ money. Even if the critics are right, crowdfunding may still encourage more individuals to invest in startup companies, investments that may lead to the formation of new companies, more job creation and growth of the struggling economy.
On the other hand, these new rules may also increase the risk for individual crowdfunding investors. Startups and small companies are considered risky. According to the statistics of the National Venture Capital Association, around 40 percent of venture backed companies fail. Since most of the crowdfunding investors do not have the knowledge, experience, or time to assess the chances of a startup’s success, we can only assume that the unsuccessful investments among crowdfunding investors will be even higher than 40%. Another difficulty that is associated with crowdfunding is the individuals’ lack of investment diversification. Unlike VC’s funds that are derived mostly from stable institutional investors like pension funds, individuals usually lack the experience and the funds to diversify their investments in an efficient way that will justify the risk they will assume in investing in risky businesses, like startups.
The newly proposed rules try to deal with those difficulties. For example, under the proposed rules, companies that raise more than US$500,000 through crowdfunding will have to provide audited financial statements. This measure is designed to provide investors with more information, in order to provide them with the relevant information that is required to reach an informed decision. However, some critics claim that this proposed rule may be feasible for startup companies to comply with, as audited financial statements are too expensive, especially for companies without any stable earnings.
Despite all the “flaws” in the proposed rules and the risks of crowd funding, many entrepreneurs and equity crowdfunding supporters seem to be pleased with the SEC’s progress. “This is a huge day, because nobody can say this is never going to happen,” says Jason Best, co-founder of Crowdfund Capital Advisors. “We now have the finish line in sight,” says Best.
The proposed rules attempt to provide protections to crowdfunding investors from the risks that are associated with crowdfunding investments. The vetting process is not entirely over; first the rules will be published in the Federal Register, then the SEC will review public comments, and more changes will likely be made. For those who see crowdfunding as the future of startup investments, this is a victory.