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Democratizing Investment in Start-Ups

Where do new businesses go to raise money? Until recently, small businesses usually found themselves turning to standard credit cards if banks denied their loan requests or if they could not raise revenue from venture capital and private equity firms. In response to the perceived lack of funding sources for young businesses, a rule recently released by the U.S. Securities and Exchange Commission (SEC) promises to open a new funding avenue for small businesses.

ThinkstockPhotos-155235616The SEC’s rule allows the general public to invest in equity shares of emerging small businesses through a source of fundraising popularly known as crowdfunding. Under the new rule, certain business can offer and sell securities to a diverse swath of the population through online portals. Previously, only accredited investors—people whose net worth generally exceeds $1 million or who earned more than $200,000 a year for the preceding two years—were allowed to invest in small businesses through private equity offerings. The SEC’s new rule allows anyone to invest at least some amount of money in eligible small businesses seeking funding.

The new rule, which has been years in the making, amends SEC rules that have been in place since the SEC’s inception in early 1930s, including SEC Rule 147, which defines a registration exemption for certain small businesses. Once the new rule takes effect in May 2016, start-ups and small business will be able to raise funds from a larger swath of the public, exchanging ownership in the company for capital. Instead of placing a complete ban on non-accredited investors, the new rule imposes a cap on the aggregate amount each unaccredited investor can lend through crowdfunding. For people with an annual income or net worth less than $100,000, the cap will generally be $2,000 in a 12-month period. For those with an income and net worth equal to or greater than $100,000, the cap will be 10 percent of the lesser of their annual income or net worth.

The new rule is an outgrowth of the Jump-Start Our Business Start-Ups Act, which President Obama signed into law in 2012. The Act, which authorized the SEC to draft rules allowing online fundraising for small businesses, led to the SEC proposing an online crowdfunding rule in late 2013.

Part of the SEC’s mission is to protect investors from unregulated investments and to maintain fair and orderly markets. Yet, as Tom Rhue, an executive at the Kauffman Foundation reportedly said of the SEC’s new rules, it’s simply a matter of time before fraud occurs in this market space.

Purchasing equity in a new business is inherently risky because small businesses and start-ups have high failure rates and valuing their shares is difficult. Furthermore, under the new rule, investors purchasing equity generally will be required to hold on to the shares for at least a year, making their investment illiquid. Additionally, even those who advocate expanding public access to crowdfunding concede that fraud and failure are almost certain to occur once crowdfunded equity becomes available to the public.

To address some of the investor-protection concerns, the new rule imposes disclosure and compliance requirements for small business seeking capital through crowdfunding. The rule also disqualifies previously identified “bad actors” as well as companies that already report to the SEC from participating in crowdfunding. The rule also requires investors to conduct these transactions through an SEC-registered broker dealer or funding portal. It also limits the resale of equity purchased through online crowdfunding and requires the seller to file certain offering materials electronically.

In addition, the new rules impose more compliance requirements for larger offerings of up to $50 million. For example, companies engaging in larger offerings must provide audited financial statements to the SEC and file annual, semiannual, and current event reports. Also, the rule limits how much the company can accept from any individual non-accredited investor. Requirements such as these protect investors against fraud and failure as the disclosure enables potential investors to access information about the start-ups and small businesses that are their potential investments.

The finalized rule issued by the SEC proved to be less strict than the proposed rule. Many potential issuers criticized the proposed rule, arguing that compliance would be too costly and complex for fledgling businesses. As a result, the SEC did away with provisions that would have required audits for all first-time crowdfunding issuers and tax return filings for smaller offerings.

According to at least one industry participant, the market contains “a lot of pent-up demand from ordinary investors.” This rule is likely to make more capital available to small businesses seeking funds to grow. President Obama has suggested that this broadened access to capital could be a potential game-changer for small businesses.

Tom Rhue, a Kauffman Foundation executive, reportedly worries that there may be a regulatory overreaction when fraud is discovered and some investors lose money by investing in failing businesses. After all, investing in start-ups is different and riskier than investing in more traditional securities that have been available to ordinary investors for decades, such as mutual funds. However, ordinary investors may now have an opportunity to invest early and get equity in the next Uber. This financially tremendous potential upside keeps both regulators and investors determined to reach an optimal solution.



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