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

It's like Kickstarter — except you get a stake in the company instead of a free T-shirt and gushingly grateful email

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(Image credit: (Andrew Holbrooke/Corbis))

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.

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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 proposed rules are extremely impractical because of the restrictions and procedural hurdles a crowdfunding issuer, investor, and funding portal will have to endure to raise capital. Compared to other forms of crowdfunding and capital raising, equity crowdfunding to the public has the worst "bang for your buck" in all of corporate finance...

Let's not forget costs, too. To produce an offering disclosure document, enlist a funding portal, run background checks, and file an annual report with the SEC year after year might well cost upwards of $100,000. The high expenses compared to the low maximum amounts that can be raised by a company and invested by an individual make public equity crowdfunding one of the costliest forms of (legal) capital raising. [Forbes]

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.

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