Equity Crowdfunding Could Affect Private Business Values

Equity crowdfunding has been touted as a promising growth opportunity for private businesses under the 2012 Jumpstart Our Business Startups (JOBS) Act. In theory, it allows for a wider pool of investors with fewer restrictions. But many private companies are waiting for the SEC to issue its final regulations on crowdfunding before they can solicit investors from the general public.

The comment period for the SEC’s final regulations expired on February 3. So you might wonder: Why haven’t we seen an explosion of equity crowdfunding offers from start-ups and other private firms yet?

Crowdfunding Basics

You’ve probably heard a lot about crowdfunding in the news. It occurs when an entity uses the Web-based portals to solicit small amounts of money from the general public to achieve a pre-determined goal.

It’s already common outside the United States. Domestic not-for-profit organizations use it to drum up charitable contributions for disaster relief and other worthy causes. Students use it to study abroad and afford tuition at their “dream” universities. Director Rob Thomas even used crowdfunding to raise $5.7 million to finance the Veronica Mars movie, which comes out in March, after Warner Brothers turned down his pitch. The JOBS Act doesn’t affect donation- or reward-based crowdfunding sites, which have raised millions for causes and projects over the years.

Private Equity Crowdfunding: A New Breed of Online Solicitation

True private equity crowdfunding — in which an unregistered company solicits cash directly from the general public in exchange for equity interests in the business — is not yet legal under U.S. federal regulations.

Private businesses have limited funding opportunities. They can apply for a bank loan, ask friends and relatives for “angel” funds, or solicit investment from venture capital firms. Equity offers are trickier for private firms. The Securities Act of 1993restricts sales of securities to the general public unless the offering is registered with the SEC or there is an available exemption from registration.

The JOBS Act attempts to open new doors for growing businesses in need of cash by allowing an exemption for certain types of equity crowdfunding. Private firms are currently allowed to solicit only from “accredited” investors, which are wealthy people with net worth of at least $1 million (excluding the value of their primary residences) or annual income of more than $200,000 per individual (or $300,000 for married couples). Online solicitations to these wealthy individuals must come from SEC-registered intermediaries, however.

A Rough Start for Equity Crowdfunding

The JOBS Act charged the SEC with coming up with the rules for equity crowdfunding to the general public. After nearly two years of deliberations, the SEC finally issued a 585-page proposal last October that permits private companies to raise up to $1 million per year by tapping “unaccredited” investors.

But this proposal hasn’t been finalized — and the SEC received significant negative feedback during its 90-day comment period, which ended in February.

The proposed regulations contain numerous limitations to protect investors from losing money on high risk ventures. For example, consistent with the JOBS Act, the proposal limits how much money an unaccredited investor can contribute each year, based on certain income thresholds.

Investors with a net worth and income of less than $100,000 could contribute only $2,000 or 5 percent of their net worth or income (whichever is greater). Those with a net worth or income of more than $100,000 could contribute more. Investors would also be forbidden from selling or transferring their crowdfunding interests during the first year of purchase.

The SEC proposed that only SEC-registered broker-dealers or crowdfunding portals could offer private equity securities online. The non-broker dealer intermediaries must be Financial Industry Regulatory Authority (FINRA) members. They would also be prohibited from having an economic interest in the funded entity, offering advice, or excluding companies for subjective or qualitative issues.

The SEC proposal calls for extensive paperwork, including upfront and ongoing annual disclosures about:

Officers, directors, and owners of 20 percent or more of the business;
Description of the business;
Intended uses of funds, target amount and deadlines;
Share price;
Insider transactions;
Description of the company’s financial condition; and
Prior year tax returns and financial statements.

Many private firm owners and executives have told the SEC that these disclosures would be invasive and time-consuming. They would also add upfront costs to crowdfunding.

Firms that want to raise $100,000 or less would need two years of financial statements and its most recent tax return under the proposal. Those looking to raise more than $100,000 (but less than $500,000) would be required to submit reviewed financial statements. If the crowdfunding goal is higher than $500,000, the solicitor would be required to provide audited financial statements.

Some critics of the SEC proposal argue that it’s too limiting, complex and costly for private firms to realistically comply with. Others, including the New York State Society of CPAs and consumer advocate groups, argue it doesn’t do enough to protect unsophisticated investors from fraud. Stay tuned to see how the SEC responds to these criticisms.