What You Should Know About The New Rules On Startup Crowdfunding

The SEC recently voted to approve Title III of the JOBS act, opening up equity crowdfunding to non-accredited investors. What this means for startups and other early-stage companies looking to boost their funding through the sale of equity is that they will, as of mid-2016, be able to sell investments in their businesses to the general public – with the ability to raise up to one million dollars per year without registering with the SEC. Currently, only accredited individual investors who meet specific wealth thresholds are allowed to fund startups, and of course institutional investors such as venture capital firms may as well. For new businesses seeking capital for growth, this will almost certainly be a game-changer.

For individual investors looking to get an early stake in The Next Big Thing, these new rules open the door to opportunities that have historically been out of reach for over 80 years. What it also means is that it will be easier than ever to put your money, and your financial future, in jeopardy. The level of risk inherent in this type of investment is huge, and the SEC’s decision to open up this market to the general public, despite the mechanisms they intend to enforce for the security of investors, may ultimately lead to increased incidents of fraud and embezzlement. Even completely legitimate operations may, however unintentionally, mislead casual investors into making significant financial mistakes.

The key points of these new regulations include basic provisions for both investors and businesses seeking funding. Businesses are capped at $1M per year in equity crowdfunding before being obligated to register with the SEC, and will be required to make significant disclosures when offering securities to the general public. Investors will be somewhat limited as to their participation in this market; those with net worth or annual incomes below $100k will be able to invest the greater of $2k or 5% of the lesser of their annual income or net worth, and those with net worth and annual earnings above $100k will be able to invest up to 10% of the lesser of their net worth or their annual income. In any twelve-month period, an individual investor may not purchase an aggregate amount of crowdfunded equity in excess of $100k. All of these rules apply to amounts in aggregate, and do not limit the number of companies one can invest in, so one could invest in as many companies as they wish, or put all of their crowdfunded equity investment allocation into a single business.

Such offerings must be made either through a registered broker-dealer or through a portal intermediary – online services that allow individual trading and which must be registered with the SEC. Both brokers and portals will be obligated to vet both the companies seeking funding and the individuals who wish to invest in them, and individual investors generally will be required to hold their crowdfunding securities for one year. Individual retail investors will be limited to putting a total of $100k per year into crowdfunding offerings.

This is exciting news for many people on both sides of these potential transactions, but before you start trying to figure out what hot Silicon Valley disrupter to put ten percent of your paycheck into, it is important to consider both the volatile nature of startup companies and the reasons why small businesses might prefer crowdfunding to soliciting traditional VC or angel investment. Just one example is that companies seeking less than $100k through crowdfunding won’t even have to have the financial statements their executives draw up independently audited.

First of all, investors should be aware of the level of risk involved in funding startup companies – and it is substantial. Most startup companies fail, dissolving entirely and leaving their financial backers with nothing but an expensive lesson in modern business. The term “most” doesn’t mean the likelihood that any given startup will fold is just better than 50/50, either; the real figure is closer to nine out of ten new businesses, or just better than a ten percent chance that any given startup will survive at all, let alone thrive and yield significant returns for its investors. Under the new crowdfunding regulations, investors generally may not sell their equity within a year of purchase (if they can sell it at all), so given the typically brief life cycle of startup companies, the likelihood of the company folding before investors can try to unload their equity is very high. Although a traditional stock might lose half of its value in a day of trading, stockholders can sell at the end of that day and at the very least walk away with what remains of their initial investment.

Traditional stocks give investors the ability to monitor the value of their shares and liquidate them if their value declines precipitously, but the cold comfort of knowing you can walk at any time with even a fraction of your initial investment is absent from equity crowdfunding. Even if the startup you invest in does very well, you will have purchased equity in the company, typically a convertible note – not a share of stock. Unless the company goes public, what you will own is a stake in the business, and your ability to profit from it depends entirely on the willingness of others to purchase your stake. Even in the best-case scenarios possible through crowdfunding, the equity that investors purchase in these early stages will almost certainly be highly diluted by the time it is even theoretically possible to liquidate.

On the corporate side, there are many reasons why startup companies choose to delay or avoid seeking investment from venture capital firms or angels, and one of the biggest is desire to retain full control of the business. VCs and angels typically invest in a company only if they get a say in the operation of the company, allowing them to use their business experience to influence the direction of the corporations they invest in. Startup founders are typically hesitant to accept input from even the most seasoned investors if that direction goes against something the founders intend to do, regardless of the merit of the activity the investors are counseling against.

While budding entrepreneurs frequently claim that institutional investment thus stifles creativity and innovation, investors are right to insist on the ability to influence the practices of businesses they back with six, seven, or even ten figures of their own capital. Crowdfunding equity solves this dilemma for startup owners, relinquishing some of their share in their businesses but giving up zero control. Naturally, many in the startup world are pitching the coming revolution in crowdfunding as a democratization of investment that will grow the economy and boost innovation in all sectors.  What they seem to be keeping silent on is the inability for investors in crowdfunded equity to exercise measures of corrective action should the companies they invest in begin making questionable decisions. The prevalent narrative here is that these new rules will give average folks the same access to opportunities that were once reserved for institutional investors. What is conveniently omitted is that crowdfunded equity gives investors less control over the companies they now own a part of than even the limited voting rights typically associated with ownership of common stock. Coupled with the inability to resell crowdfunded equity for a year, this means many investors will watch companies they backed spiral downward with no recourse at all, not even the option to sell their equity at a loss.

To put it bluntly, the level of risk inherent in purchasing crowdfunded equity in a startup is beyond what any reasonable person would refer to as a relatively safe investment. It would be more prudent to think about buying equity in startup companies in terms of how much you are willing to lose, not how much you might earn if all goes well. Still thinking about investing some amount of money in startup equity crowdfunding? If you wouldn’t be comfortable taking the amount you are considering to the nearest casino and gambling it all, you should feel no more secure placing that money in the crowdfunding market.

All investing involves some level of risk, but investing wisely means taking your personal risk tolerance into account while diversifying your holdings to insulate you from volatility in any one investment vehicle. Although higher-risk investments may in some cases offer higher potential returns, your financial future and the stability of your comprehensive financial plan depend upon minimizing your exposure to risk above a certain level. Unless you know both your own risk tolerance and the potential impact of any financial loss, you may not realize the true consequences of a bad investment – or the potential gains you could make if everything works perfectly.

That’s why BFA Wealth Management offers complementary introductory financial planning complete with a detailed interactive risk tolerance assessment. We want everyone to know where they stand, regardless of whether they ultimately become our clients, because we know that informed decisions are better decisions. Your investments should reflect your goals and your needs – if you would like an objective review of your portfolio, an assessment of your current financial plan, or just a straightforward answer to a simple question or two, give BFA Wealth Management a call. Let’s talk.