The Jumpstart Our Business Startups (JOBS) Act, signed into law by President Obama in April of 2012, was designed to ease securities regulation and make it simpler for small businesses to obtain funding from outside investors — both accredited (with net worth greater than $1,000,000 or an income of over $200,000 per year) and non-accredited.
However, the reality is that there are still significant limits and huge hoops to jump through, making crowdfunding a difficult fundraising strategy for most early-stage companies, and a risky type of investment for investors interested in private companies.
Equity Crowdfunding is Still Illegal
While new “crowdfunding” sites are popping up almost daily, selling securities to unaccredited investors is still illegal in the United States. True, the JOBS Act has opened the door to unaccredited investors, but until the SEC finalizes their rules – currently anticipated for Q1 2015 –stock in private companies can only be offered through a registered broker-dealer and only offered to accredited investors. Any platform that currently calls itself crowdfunding is most likely a forum for companies to publicly solicit their own securities, and even then they still have to verify accreditation.
Diligence Flip: Companies Have to Do More to Verify Investor Accreditation
The only portion of the JOBS Act that has been implemented to date is the portion repealing the prohibition of general solicitation, which was originally instituted to protect unsavvy investors from swindlers. Companies are no longer limited regarding where they can advertise their capital raise. That means websites, social media, e-mail – they’re all fair game.
The hitch, however, is that if companies do publicly solicit, then they need to take “reasonable steps” to verify investor accreditation. That means companies have to look at tax documents (which many potential investors may be reluctant to share) or receive an affirmation from an investor’s attorney or accountant stating that the potential investor is, in fact, accredited. Not only does this add cost to investors, but it also creates a layer of bureaucracy that may slow down both deal flow and execution.
Alternatively, companies can rely on a registered broker-dealer’s confirmation that the investor is accredited. That means an investor can pre-certify his/her accreditation with a broker-dealer before he/she is shown investment opportunities. The broker then represents the investor’s status to the issuing company, relieving the company of the burden.
Investors Get Greater Access to Deal Flow
The requirement used to be that companies were limited to 35 non-accredited investors, all of whom were shown to be “sophisticated.” But under the JOBS Act, the number and level of sophistication will be unlimited… to a point.
Once the crowdfunding law goes into effect, non-accredited investors and companies will have to rely on third-party intermediaries to conduct the transactions. These intermediaries can be classified as a new “funding portal” entity or a registered broker-dealer. Funding portals are severely limited in their ability to help close an investment transaction and act more as passive listing sites like the ones that currently exist without the crowdfunding law. Broker-dealers, however, can conduct diligence for investors and serve both parties to get the deal done.
But, even where investors take advantages of a broker-dealer’s services, non-accredited investors are limited in how much they can invest. Non-accredited investors can only invest $2,000 or 5% of their net worth (whichever is greater) if they earn less than $100,000 per year. Those that earn more than $100,000 are capped at $100,000 or 10% of their net worth (whichever is less). While intermediaries will verify this information for companies, the onus is still with the company to make sure that investors don’t exceed their annual limits.
Crowdfunding Comes at a Cost to Companies
Opening the doors to crowdfunding also limits the upside for companies. Companies are only allowed to issue $1,000,000 in crowdfunded securities each year — a lot of money for some companies, but not enough for many others.
But all of this compliance — verifying accredited investors, tracking non-accredited investors and their previous investments across crowdfunding platforms — will cost companies time and money, both of which are in short supply for most startups. And the reward for this added work ends up limited to the $1 million maximum that can be raised per year. Capital limitations aside, with heightened regulatory burdens comes greater investment risk.
Put simply, if investors are looking to invest in emerging companies, but don’t want the limitations and risks associated with crowdfunding, then their best option may be to partner with a registered broker-dealer that will stand behind its diligence and verify accreditation.