Crowdfunding 2.0: SEC Just Made It Easier To Buy Shares In Start-Ups

By James Rufus Koren
Los Angeles Times.

If you’ve ever backed a project or business on crowdfunding sites Kickstarter or Indiegogo, you probably came away with some swag, a movie ticket or a discount on a soon-to-be-released product.

Soon, you’ll be able to go to similar sites and come away with something potentially more valuable: shares of stock.

New rules approved by the Securities and Exchange Commission on Friday will make it easier for start-ups to sell shares directly to the masses.

The rules could be a boon for entrepreneurs looking to raise capital and a potential windfall — or loss — for investors hoping to be among the first to get a piece of the next Uber or Instagram.

They could also be big business for a handful of Los Angeles firms that want to act as the stock exchanges where these deals will take place.

The rules, which will take effect in about six months, allow private companies to raise up to $1 million a year from small-time investors without most of the reporting and auditing required of larger firms or companies raising more money.

They are a provision of the JOBS Act, a 2012 law championed by President Obama to boost start-up businesses.

Howard Marks, executive chairman of Start-Engine Crowdfunding, a Santa Monica firm that connects companies with private investors, said he expects thousands, even tens of thousands, of start-ups to try to raise money this way.

“It’s the democratization of capital,” he said. “That $1 million is great for a lot of start-ups. I could see where there’s a company who comes on our platform, raises $1 million, and the next thing you know Facebook buys them for $1 billion.”

That’s possible, but not the likeliest outcome. Many start-ups fail, and the new rules will allow inexperienced investors to put money into firms that have little oversight. Some critics warn that’s a recipe for trouble despite SEC vows to police the new marketplaces.

“You can embezzle someone’s money in the guise of making a securities offering,” said Mercer Bullard, a law professor at the University of Mississippi.

The offerings can be made only through brokerage firms or new Internet funding portals that must be registered with the SEC, a requirement aimed at protecting investors. Marks’ StartEngine Crowdfunding plans to register as a portal, as does Playa del Rey’s Crowdfunder, another platform that connects investors with start-ups.

SEC Chairwoman Mary Jo White said before the vote that agency staff members “will begin immediately to keep a watchful eye on how this market develops.”

They will assess what kinds of companies use the new crowdfunding offerings, how closely they follow the rules and whether the new practice promotes the raising of capital while also protecting investors.

Equity crowdfunding shouldn’t be confused with the kind of crowdfunding seen on Kickstarter and other crowdfunding sites. There, projects or businesses take either donations or advance orders from supporters.

Take the case of Irvine virtual reality start-up Oculus: It took to Kickstarter in 2012 and raised $2.4 million from nearly 10,000 backers. Not quite two years later, social media giant Facebook bought the VR-headset developer for $2 billion. But those online backers didn’t get a cent.

That’s because they were not investing in Oculus. Instead, donors who gave less than $15 got “a sincere ‘thank you’ from the Oculus team,” while donors willing to fork over $275 got an unassembled prototype of the company’s Rift headset.

Had the new rules been in place years ago, Oculus might have been able to sell equity — and those backers might have gotten a piece of the Facebook payout.

“That would have been the story of the year,” Marks said. “It didn’t happen because the regulations were not in place.”

The new rules under the JOBS Act are starting to peel back investment regulations that in some cases date back to the Great Depression.

Those regulations limited investments in most private companies to so-called accredited investors — people who, today, make $200,000 or more a year or are worth at least $1 million — and also blocked companies from seeking investors publicly.

JOBS Act rules already in effect have rolled back restrictions prohibiting companies from publicly soliciting funds from wealthy investors without the use of a broker.

The rules approved Friday allow people with annual incomes or a net worth less than $100,000 to invest a maximum of 5% of their yearly income or net worth, or up to $2,000 if that’s greater. Those with higher incomes can invest up to 10%. Investors generally would not be able to sell shares for at least a year.

They also exempt firms raising $1 million or less in a year from having to provide financial statements audited by an independent auditing firm, which can be an expensive proposition. The idea is to open equity crowdfunding to true start-ups, ones that might not have the cash to pay an auditor.

Larger companies trying to raise as much as $50 million have already been able to take investments from non-accredited investors since this summer. But to do so, companies have to file regular reports and audited financial statements with the SEC, much like big, publicly traded companies.

Because of those requirements, there’s been limited interest so far, and just a few dozen firms have attempted such offerings.
Chance Barnett, chief executive of Crowdfunder, called those offerings more like a “mini IPO.”

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