Equity crowdfunding: The SEC's new plan to help small startups and investors

This week, the SEC proposed a new set of rules for allowing entrepreneurs and small business to sell bits of their companies online — essentially, it's a way to "equity crowdfund" their venture.

Different from Kickstarter's model, which takes investments in return for some kind of reward — like a sample of the product, or a "thank you" on an album cover — equity crowdfunding lets individuals buy a stake in small companies, thereby cracking open the investment landscape, which right now is dominated by a small coterie of financial insiders.

The plan is part of the Jumpstart Our Business Startups (JOBS) Act, a set of measures signed into law by President Obama in 2012, aimed at lighting a fire under small businesses, making it easier for them raise money, grow, and hire more workers. The idea is that equity crowdfunding would allow small businesses to jumpstart new ventures, while at the same time allowing small-time investors to take part in the potential rewards.

Subscribe to The Week

Escape your echo chamber. Get the facts behind the news, plus analysis from multiple perspectives.

SUBSCRIBE & SAVE

Sign up for The Week's Free Newsletters

From our morning news briefing to a weekly Good News Newsletter, get the best of The Week delivered directly to your inbox.

From our morning news briefing to a weekly Good News Newsletter, get the best of The Week delivered directly to your inbox.

Sign up

But the SEC has struggled to find a balance between the needs of cash-strapped start-ups and the vulnerabilities of unsophisticated investors. And because of this balancing act, the proposal is stocked with limitations. For example:

• Funds have to be raised through a "regulated portal," meaning a registered broker-dealer or funding portal, which is prevented from offering investment advice or compensating employees based on sales.
• Companies are only allowed to raise up to $1 million a year.
• Individuals can only invest between $2,000 and $100,000 each year — depending on their own net worth and income. Individuals with incomes of $100,000 or more, may not invest any more than 10 percent of their incomes, and those who make less than $100,000, may not invest any more than 5 percent.
• Start-ups looking to raise more than $500,000 must pay to be checked out by a third-party auditor first.

These proposed rules have attracted two types of critics: Those who say the restrictions are too tight, and those who say they're still too loose.

Critics in the first category argue that the rules would make it too expensive for a company that isn't yet generating profits to take part. At Forbes, Deborah Jacobs says:

The critics in the second category say mom-and-pop investors will still be open to many types of fraud and losses. Investor advocates complain that the rules don't require start-ups to verify the investor's net worth, instead just taking them at their word. They also point out that small businesses fail a large percentage of the time — 44 percent by year three, according to StatisticBrain.

But those who support the plan, see a potential virtuous cycle of prevention. One of the chief reasons that many start-ups fail is lack of funding. Sherwood Neiss of Crowdfund Capital Advisors told The Washington Post, "While I don't know if this [crowdfunding plan] is the silver bullet, I am optimistic that if we can address that problem, we can reduce failure rates.”

The good news: Both sides will have their voices heard. The SEC has opened the proposal to public feedback, which it will take into account before finalizing the plan in 2014.