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Advisors, Private Equity

Should Middle Market Investors Worry About New Rules for Crowdfunding?

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When someone mentions “crowdfunding,” we often think of it as a way to support a charitable cause, or help an emerging artist launch an art show or music recording. Indeed, websites like Indiegogo and GoFundMe fill this role. Crowdfunding has also developed into a way for small (especially start-up) businesses to source capital for a product launch or other need (Kickstarter is one popular example).

Earlier this month, the SEC adopted new rules broadening the types of investors who can participate in internet-based equity crowdfunding to support companies’ growth. Still, the future of crowdfunding remains unclear.

By adopting these most-recent rules, the SEC expands implementation of the 2012 JOBS Act (Jumpstart Our Business Startups Act). Previously, participation in an equity crowdfunding program was generally limited to “accredited investors.” These are individuals with income of more than $200,000 per year, or a joint income of $300,000 in each of the last two years. Among other restrictions, the prospective investor must have a net worth exceeding $1 million excluding the value of one’s primary residence.

For the first time, the new rules allow individuals with annual income or net worth of less than $100,000 to invest in small company equity offerings up to a maximum of 5% of their yearly income or net worth (or $2,000 if that is greater). Those with higher incomes can invest up to 10%, but an individual is restricted from investing any more than $100,000 in all offerings during a 12-month period. Various restrictions also apply on the companies making the equity offering.

The inclusion of individual non-accredited investors has driven the expectation that it will expand access to equity funding for companies, taking business from other market participants. That’s not necessarily true.  Under the former rules, according to xconomy.com, equity crowdfunding collected only $300 million in 2014. By comparison, angel investing was estimated by Jeff Sohl at the University of New Hampshire to be $24 billion in 2014. Pitchbook reports that total venture capital funding accounted for $66 billion in the same year. A more relevant comparison, however, would be first-time venture capital fundings for early-stage companies. Pitchbook estimates that these fundings totaled $7 billion in 2014, significantly less than equity crowdfunding and a better apples-to-apples comparison. Reliable estimates for 2015 and beyond aren’t available yet.

The numbers clearly show that equity crowdfunding has a long way to go to catch up to other funding sources. It is safe to say, however, that crowdfunding will play an increasing role in funding early-stage companies. But, despite the new SEC rules, the evolution of regulatory oversight remains unclear. Given the the JOBS act originally emerged in 2012, and the new SEC rules emerged just earlier this month, regulators have been slow to react. Industry players attribute the delay as indicative of latent concern among regulators for the individual equity crowdfunding investor. Brian Dunn, CEO of Growth Capital Services Inc., says that “It’s a matter of ‘when’ – not ‘if’ – individual investors will be harmed by losses associated with unsuccessful crowdfunding. How regulators will respond to the resulting outcry remains to be seen.”

While these new rules have the potential of creating an alternative way to finance small, start-up, or community-driven businesses, it’s likely they will increase the total market amount of funding rather than replacing or reducing more established ways to raise capital. Although this may be the objective of legislators, the prospective success of individual investors and the resulting reaction of regulators is yet to come.

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