This past Friday, just a day shy of Halloween, the SEC finally voted on Title III of the JOBs Act, the “Crowdfunding” provision enabling individuals who do not meet the definition of “accredited investor” to participate as investors in online portals investing in the start-up space. This “democratization” of capital formation will be done through funding portals that will need to register with the SEC and become a member of a national securities association.
Under the rules:
- A company would be limited to raising a maximum of $1 million in any 12-month period through crowdfunding platforms and would also be required to provide certain financial and business information to the SEC.
- Individual investors would have annual investment caps based upon their income/net worth.
- Funding portals would provide the communications channel regarding the company and the investment opportunity as well as handle the transfer of funds.
Although these new rules will not go into effect until sometime in 2016, it is interesting to speculate as to how this will impact the funding landscape of early stage companies. Seed stage investing involves a high degree of risk coupled with a lack of liquidity and oftentimes a very long investment horizon until exit. Here are a few of my thoughts:
All money is not the same shade of green.
I am a fan of ABC’s reality show – Shark Tank . Part of the discussion that you always hear while the various sharks are considering any potential investment in an entrepreneur is how that particular shark can be helpful because of their expertise in the space, ability to make introductions to potential customers, assistance with manufacturing or sourcing…. The value that an investor can bring to a entrepreneur is so much more than the check that is written. As I wrote about in a prior blog post, once funded – the real work begins. Having a strategic investor involved in the very early stages of the company can be a real asset.
Monitoring the amount that an individual may invest will be interesting…
Under the rules, a individual, who does not meet the accredited investor test has aggregate investment limitations over a 12 month period as follows:
- For individuals with either annual income/net worth less than $100,000 – the greater of $2,000 or 5% of the lesser of annual income/net worth
- For individuals with both annual income/net worth equal to or greater than $100,000 – 10% of the lesser of annual income/net worth subject to a cap of $100,000.
What is to prevent an individual from participating via more than one crowdfunding portal? For those investors with an annual aggregate limit of $2,000, how will they be able to build a diversified portfolio of early stage investments? Will be interesting to see how this provision of the rules will be monitored and enforced.
What will capitalization tables look like for companies deciding to use this new source of crowdfunding?
When I am considering an investment, it is important to me to understand the funding of the company to date and to make sure that there will be alignment among the investors. If a company has raised a round with a large number of investors having invested let’s say $500 or less, it will be a more cumbersome cap table and more difficult to ascertain the expectations of the underlying investors. I am assuming that one of the roles that these funding portals will play is to consolidate these smaller investments into some form of aggregate investment vehicle to make administration and voting more efficient. How these services are priced will be important.
Technology has clearly changed and expanded the access that early stage companies have to startup capital, which is great. I would encourage all potential early stage investors whether they are “accredited” or not to become educated investors before they begin to write checks so that they have a better understanding of the risks and rewards in this asset class. A few great reads on this topic are:
What Every Angel Investor Wants you to Know by Brian S. Cohen – the Chairman of NY Angels
Startup Wealth by Josh Maher – the President of Seattle Angel