Yesterday, a revolutionary new law went into effect that will alter the
landscape of the investment community. Eight decades after the Securities
Exchange Act, the Securities and Exchange Commission has fundamentally
changed the way private investment capital is raised. Under Title III
of the JOBS Act, the SEC has adopted final rules to provide an exemption
for equity crowdfunding of private companies.
On April 5, 2012, Congress signed into law the Jumpstart Our Business Startup
Act, or better known as the JOBS Act. The JOBS Act was passed to help
private companies jumpstart their business by allowing for certain exemptions
to the Securities Exchange Act of 1933. The new law consists of seven
Titles, with Title II and III being the most significant concerning the
raising of capital. Issued under Regulation CF - rules that have spent
nearly 2 ½ years under comment and revision - are now a reality.
The JOBS Act was meant to spur a sputtering economy by allowing small businesses
easier access to private capital. It is interesting to see that due to
the unusually long comment period, the law begins full implementation
at a time where many analysts feel we are at already at maximum employment.
Nevertheless, the new rules open up capital markets to an entirely new
investment medium – crowdfunding.
Reg. CF allows for small businesses seeking pre-IPO capital to tap into
a previously restricted capital market – the non-accredited investor
class. The Act’s initial goal was to make it easier for startups
to gain access to capital formation for their business, and not necessarily
targeted towards making it easier for retail investors to invest. The
new rules will almost definitely have an immediate impact on the amount
and type of investors entering the capital formation markets, and could
move capital from the sidelines and into the marketplace.
Accredited investors have traditionally set the tone for private capital
markets through their decision-making process. Savvy investors primarily
move money for three reasons: to make a profit, for liability tax shelter,
and to participate in humanitarian or philanthropic endeavors.
Under Title III, an entirely new investment class now enters the private
equity marketplace. Crowdfunding sites have been operating for years and
have funded everything from pet-projects to tech companies. Until now,
the only benefit crowdfunding investors received was early access to products,
a shirt with a company logo, or an honorable mention on the company’s
website. Under Reg. CF, those initial start-up crowdfunding investors
can now receive company equity in exchange for their investment, and stand
to earn significant financial gain if the company becomes successful.
The law, in turn, opens up a gateway for infusing the millions of dollars
in capital that is now sitting idle, into a variety of new and exciting projects.
Critics of the law have claimed that it opens up the market to the potential
for fraud, or at the very least, overly risky investments. These risks
are not new. Retail investors have always had to assume more risk and
lower returns than accredited or institutional investors. The new rule
attempts to “level the playing field” for the average retail
investor to participate in ventures that have a real opportunity for wealth creation.
The popularity of crowdfunding has opened the gateway for startups to raise
capital quickly and without much government scrutiny. The new Reg. CF
will now allow an opportunity for companies to raise even more money from
a variety of different sources. Accessing new asset classes and additional
capital could be a boon for startup enterprises. While concerns over risk
and fraud are valid, the Act will offer retail investors with an opportunity
to gain education and insight into how to create wealth through investments
and the risks associated with investing.
The Rules and Requirements
While Title III opens the door for a host of new investors, it also brings
the need for awareness of the rules surrounding investment. The JOBS Act
paved the way for companies to raise an unlimited amount of capital from
private markets and increased the IPO restriction from $5M to $50 Million.
The “funding portal” portion of the law under Title III went
into effect May 16, 2016, and as such not only carried some new regulations
on its implementation but, in some ways, eased the restrictions on how
offerings are handled.
Investor Limits – The final rules implemented restrictions on how much a retail
investor can contribute. For those making under $100K annually, they are
allowed to invest the greater of $2000 or 5% of their gross annual income.
For individuals who have a yearly gross income or net worth above $100,000,
they can invest the lesser of 10% of the net worth or income annually.
Suitability – Suitability standards are not required under Reg. CF as with broker-dealer
offerings. Funding portals have no responsibility to determine whether
an investment is consistent with an investor’s objectives. Alternatively,
broker-dealers are required only to consider those investments which are
in their client’s best interest.
Structure – Besides not having a requirement of principal or supervisory oversight
before initiating a transaction, funding portals are not obligated to
provide advice or have any certification in place for the establishment
of a recommendation for investment. Portals are allowed to rely on disclosures
from the issuers, with no liability unless obvious red flags are uncovered.
AML Issues – Portals have no requirement to perform AML evaluation of a company
or their investors. While there is no obligation, crowdfunding sites will
want to do their best to ensure they are complying with most AML guidelines,
and most portals are implying they will adhere to those same standards.
Funding Requirements – Funding portals use various funding mechanisms that they provide
to their customers. An investor from a crowdfunding site may use debit
cards, credit cards, or online payment services to fund their account.
As such, this may open the risk for reversal of commitment due to insufficient
funds or credit card reversals.
Escrow – The rules dictate that a third-party escrow company, such as broker-dealer,
bank, or credit union, must hold all funds and securities. While these
entities can hold the funds, they cannot act as an independent escrow company.
Size of Offerings – Funding portals are not permitted to allow Reg. D or other restricted
offerings. Crowdfunded offerings are limited to $1M in aggregate per year.
Transactional Changes –Under Reg. CF, funding portals are required to give notice and
wait five days before an investor can re-commit funds. No new subscription
documents are required.
Solicitation - A funding portal may not solicit sales of Reg. CF securities and the
issuers of the securities are not allowed to communicate with investors
outside of the crowdfunding site. The funding portal is allowed to provide
information on investments, though it must remain general in nature.
It is still left to be seen how well the crowdfunding option will work,
but so far the outlook from industry analysts has been mostly positive.
Allowing a network of investors that has produced hundreds of successful
startups to now share in the financial success of those companies with
which they invest, should provide a long-awaited boost in the amount of
private capital available for small businesses and startups.