The SEC's new crowdfunding rules mean small businesses will be able to sell shares in their businesses.
Credit: Crowdfunding image via Shutterstock
Small businesses in search of funding may soon be able to turn to the Internet to find investors.
This week, the Securities and Exchange Commission unveiled a proposal under the JOBS Act that would allow companies to use crowdfunding as a way to raise money by offering a stake in their business. While businesses have previously been able to raise money through crowdfunding, they haven't had the ability to sell shares of the company in exchange for a donation.
The new Title III of the JOBS Act creates an exemption under the securities laws so that this type of funding method can be easily used to offer and sell stakes in a company. With the proposal on the table, the SEC is now asking for public opinion.
SEC chairwoman Mary Jo White said the intent of the JOBS Act is to make it easier for startups and small businesses to raise capital from a wide range of potential investors and provide additional investment opportunities for investors.
"There is a great deal of excitement in the marketplace about the crowdfunding exemption, and I'm pleased that we're in a position to seek public comment on a proposal to permit crowdfunding," White said. "We want this market to thrive in a safe manner for investors."
Bill Clark, president and founder of MicroVentures, an online equity crowdfunding platform for startups and investors, said the proposal offers a lot of benefits to small businesses in need of capital.
"I think it is definitely a positive," Clark told BusinessNewsDaily. "The benefits are that you have this access to capital that wasn't previously available."
Alejandro Cremadas, co-founder and CEO of the crowdfunding site Rock The Post, said the new rules will add millions of new investors into the mix for small businesses.
"When Title III of the JOBS Act is implemented, all Americans, regardless of income or net worth, will be able to invest in private companies," Cremadas said. "Currently, only the 8.7 million households that qualify as accredited investors are able to invest in private offerings, but that will increase at least tenfold with the new guidelines, providing a whole new asset class for nonaccredited investors."
Under the proposal, many small businesses will have the opportunity to raise as much as $1 million via crowdfunding each year.
Rather than startups, Clark envisions established businesses, with a loyal following, as those that will be most able to take advantage of the new crowdfunding rules.
"I think initially it is going to be the mom-and-pop pizza place and coffee shops that want to expand," Clark said, of the types of businesses he thinks will have the greatest success initially.
The SEC proposal does eliminate some businesses from raising capital through crowdfunding, including non-U.S. companies, companies that already are SEC reporting companies, certain investment companies, companies that have failed to comply with the annual reporting requirements in the proposed rules, and companies that have no specific business plan or have indicated their business plan is to engage in a merger or acquisition with an unidentified company or companies.
Under the SEC proposal, there are a number of guidelines for how much investors can invest in small businesses. Specifically, over a 12-month period they would be able to invest up to:
- $2,000, or 5 percent of their annual income or net worth, whichever is greater, if both their annual income and net worth are less than $100,000.
- 10 percent of their annual income or net worth, whichever is greater, if either their annual income or net worth is equal to or more than $100,000. Over the course of one year, these investors would not be able to invest more than $100,000 through crowdfunding.
Clark said it will be up to each company to put a value on their shares and then determine how investors will be paid back. He said options could include paying out dividends when certain financial goals are met or when or if the company is ever bought out or given a new influx of capital through someone such as an angel investor. Investors will also be able to sell back their shares, but not for at least a year.
Regardless of which route companies choose to take, Clark said investors would be wise to go in not expecting a big day in return and especially not a quick payday.
"Pretend like the money is gone," Clark advised, adding it could be several years before investors see any financial gain from the investment. "Only invest a small (amount of money) and don't have unrealistic expectations on a return."
Richard Swart, director of research for the Innovation in Entrepreneurial and Social Finance Program at the Coleman Fung Institute for Engineering Leadership at UC Berkeley and a leading authority on crowdfunding data, said the new crowdfunding rules could be most beneficial to those who have the toughest time accessing capital through more traditional means, such as women, minorities and those living in rural areas.
"Women and minority founders should be evaluating this (option) very carefully," Swart said.
Both Clark and Swart, however, see some downsides to the proposal. One is the $1 million cap on how much businesses can raise in a year. Swart said Congress' original plan called for a $5 million limit.
"I think you will see some pressure to raise the cap," Swart said.
Another problem for some businesses in the proposal is the need to have audited financial statements if they plan on raising more than $500,000. Clark said because of that he envisions many companies will try to raise just under the half-million dollar threshold.
"That is a huge burden on companies," Clark said. "(Audits) take a lot of time and money and that's capital that could be spent in other places."
While there are already hundreds of crowdfunding sites, Swart expects many more will be coming online as a result of these new rules. He thinks niche sites that focus on specific industries or types of businesses will pop up rather quickly, as well as some established sites that have already seen success in this arena overseas.
"There are going to be European sites moving to the U.S.," Swart said. "They see big a market opportunity."
Clark said it will be critical that crowdfunding platforms do both screening of the businesses they promote on their site and intense investor education to make sure they aren't dumping money into poorly run or badly structured companies that don't have a chance of succeeding.
"There are going to be a lot of businesses that are funded that shouldn't be funded," Clark said.
Cremades said it will also be up to the investors to do their own research into the company to make sure they are making a sound financial decision when buying shares through crowdfunding.
"Investors will likely experience a marked increase of private offerings in the marketplace and would be well advised to carry out their own due diligence on each private offering they are considering for investment," he said.
Swart said business owners wanting to take advantage of these new crowdfunding regulations must now start promoting their business. He said companies should use social media and other marketing means to build up new clients and a network of possible investors well before the proposal goes into effect as way to increase interest in their venture.
"They need to think about it as if it is a product launch," Swart said.
While the SEC proposal is a big step forward for the new crowdfunding regulations, business owners shouldn't think they will be able to start raising funds right away. Currently, the SEC is seeking public comment on the proposed rules for 90 days. The commission will then review the comments and determine whether to adopt the rules, which Swart said could take several months.
In addition, once a proposal is adopted, it would be at least 60 days before businesses could start taking action on it. Swart believes a best-case scenario is that companies will be able to start raising money from crowdfunding no earlier than the third quarter of 2014.
A full version of proposed rules are available on the SEC website.
Originally published on BusinessNewsDaily.