March 20, 2014

BARELY LEGAL: Entrepreneurs and Investors Get Stoked: Title III is Coming

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By BYRON CROWE II

Last month, the Securities and Exchange Commission closed the comment period on its proposed crowdfunding regulations. If you’re an entrepreneur, this news should get you stoked. The closing of the comment period means the startup community is one step closer to gaining a valuable tool for financing early-stage companies.

Unlike most crowdfunding arrangements in the United States, where individuals give money as a donation or in exchange for the opportunity to receive a T-shirt or future product, the new rules will allow startups to sell shares in the company. Under the SEC’s proposed rules, which will effectuate Title III of the Jumpstart Our Business Startups Act, startup companies will be able to raise up to $1 million per year by selling securities to the general public through online funding portals without the need to go through the formal initial public offering process.

Equity crowdfunding is an exciting new frontier for entrepreneurs who, up until now, were generally limited to traditional funding sources, like angel investment, venture capital, loans and incubator arrangements. While all of these sources will undoubtedly continue to be important for many startup companies, equity crowdfunding will give entrepreneurs a valuable alternative. Startups will be able to receive smaller dollar contributions from thousands of non-accredited investors.

Title III will also broaden the investment opportunities available to the general public. Because of the SEC’s current private placement framework, investment opportunities in startup companies are often presented only to accredited investors. In order to be an accredited investor, an individual needs to have a net worth of over $1 million or an annual income of over $200,000 (or $300,000 in joint income with a spouse). This means most ordinary people are excluded from investing at the early stage in some of the most exciting new companies. Under the proposed rules, non-accredited investors will have a whole new range of potential investments available to them, subject only to a few limitations. Individuals whose annual income and net worth are both less than $100,000 will be able to invest the greater of $2,000 or five percent of their annual income or net worth (whichever is greatest). Individuals whose annual income or net worth exceed $100,000 will be allowed to invest 10 percent of either their annual income or net worth (whichever is greater) — up to $100,000 per year.

Of course, crowdfunding is not without its drawbacks. For example, as many commentators have noted, the cost of the initial and ongoing disclosures required by the new rules may be prohibitively high. Companies raising more than $500,000 will be required to provide audited financial statements, which according to the SEC could cost around $30,000 or more per year. Moreover, startups that crowdfund may subsequently find it difficult to raise money from traditional venture capital firms that don’t want to deal with a large base of unsophisticated shareholders. While some in the startup community have proposed ways of getting around these potential problems (Google “After Online Equity” for an article on some of the proposed ways crowdfunded companies can do so), these drawbacks mean that crowdfunding may not be appropriate for every startup.

Moreover, there is still some uncertainty as to what some of the crucial rules will look like. For example, under the proposed rules, investors will be allowed to self-certify that their net worth and income meet the requirements of the JOBS Act. However, if the SEC changes its position, the potentially onerous process of having a third party certify investors could undermine the entire crowdfunding scheme. Thus, which way the SEC comes out in its final rules could impact the viability of crowdfunding as a financing tool for startups.

But despite these drawbacks and uncertainties, the final crowdfunding rules will be a dramatic improvement over the current framework, which does not allow for equity crowdfunding with non-accredited investors. With the finalization of the rules — hopefully by the end of the year — the SEC’s crowdfunding framework will provide entrepreneurs with an alternative financing option and give ordinary people more opportunities to invest in early-stage companies.

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