On May 16, Americans will get a new way to both raise and invest capital. The long-awaited investment crowdfunding law will be live, more than four years after Congress and the White House gave it the green light. Although the subject of much enthusiasm in some corners of the Internet, the final product may be too clunky to be an effective engine of small business growth. The idea behind the new law – that the Internet can and should be leveraged to facilitate capital formation – however, remains a good one and other recent changes in U.S. law may provide better avenues for attracting investment.
Crowdfunding as it is commonly understood dates from the mid 2000s, when sites such as ArtistShare followed by Sellaband, Indiegogo and Kickstarter emerged. These sites enable the general public to provide funding to projects that interest them via web-based platforms. The underlying concept – raising funds from the public through a large number of small donations – is, however, much older than the Internet. In the 19th century, it was known as “taking subscriptions” and was done door-to-door. The Statue of Liberty stands in New York Harbor thanks to just such a subscription campaign. What is new is the Internet’s ability to minimize transaction costs and extend the reach of a campaign to thousands or even millions of people.
Although online crowdfunding is now entering its second decade, its usefulness has been limited by the fact that using crowdfunding as a way of selling securities has not been legal in the U.S. Specifically, while a company has been able to use crowdfunding to raise capital, it has not been able to offer a return on investment. Instead, companies have offered rewards such as hand-written thank-you notes from the CEO, t-shirts, or priority on a wait-list for a coveted product. Glamorous ventures, such as music or film productions, have been able to offer perks such as the donors’ names written in a CD’s liner notes, or included in a film’s credits. Obviously not every venture will have the ability to offer such attractive incentives. Additionally, while many donors may enjoy seeing their names in lights, others may simply prefer the chance to make money.
Unfortunately, until now, the structure of American securities laws has made such investment nearly impossible to offer legally. With only a few exceptions, investment by the general public (the so-called retail investors) has been limited to public companies. There was no option suitable for very small companies to access the public capital markets to obtain seed money to start a business, or a small amount of capital for a modest expansion. The guiding assumption under U.S. federal securities law is that a transparent and fair market requires certain mandated disclosures from the issuer. These requirements can be waived when it is clear that the investors can “fend for themselves” without the assistance of government. Private placements, for example, may be done without mandated disclosure because the pool of investors is limited to those believed to be either financial sophisticated or able to withstand a financial loss (or both). A registered public offering, however, carries too heavy a regulatory burden to be feasible for raising a very small amount of money; certainly it would not be feasible for a company looking to raise only $1 million or even less.
The new law allows investment crowdfunding, and allows retail investors to participate, but strictly constrains both issuers and investors alike. Starting May 16, most privately-held U.S. companies will be allowed to raise up to $1 million per year in capital using special online platforms or traditional brokers. There are no wealth-based restrictions on who may invest, as there are with private placements, although there is a cap on how much an individual may invest, based on net worth and income: Investors with income or net worth less than $100,000 may invest the greater of $2,000 or 5 percent of whichever is lesser, annual income or net worth, in any given year, and investors with income or net worth greater than $100,000 may invest 10 percent of whichever is greater, net worth or income, up to a cap of $100,000 annually.
There are additional restrictions and requirements, the full weight (and cost) of which may make investment crowdfunding ultimately unworkable. For example, issuers, although permitted to sell to the general public, are severely limited in their ability to advertise the offering. For the most part, they may only direct investors to the online platform listing the offering. The reason for the limitation is most likely to ensure that potential investors have the full complement of information required to be included on the platform. But not only does the restriction make it difficult for issuers to promote the offering, it may unwittingly expose them to liability. A company looking to raise less than $1 million in capital is a small company with limited funds for legal advice. The more complicated the rules for crowdfunding, and the more nuanced their application, the more likely that companies will get into trouble. It is not unreasonable to expect that a start-up, especially one that has not been able to afford a lawyer, might run afoul of this rule while using social media or other sources to advertise the offering.
Other parts of the new law make investment crowdfunding equally unattractive. Issuers must use accrual-based instead of cash-based accounting even though few small businesses use accrual-based accounting. Issuers must also make a number of disclosures to the SEC at the time of the offering, and must continue to make annual disclosures. And missing even one follow-on disclosure puts the company at substantial risk: If a company fails to make its disclosures, it loses an important regulatory exemption and could be forced either to go public – an expensive and unfeasible option for very small companies – or be found in violation of the securities laws.
While this particular law may not prove workable, there are other new laws that have been phased in in the U.S. in the last few years that offer companies the ability to raise capital online. While not part of the legal provision titled “crowdfunding,” they operate in a similar way and may ultimately be more useful for small companies looking to raise cash.
Until recently, private placements in the U.S. were subject to strict rules regarding how they could be advertised. Whether the offerings were promoted to a narrow audience was a key factor in determining whether they were truly “private” and therefore exempt from several regulatory requirements. In 2013, the law changed. Now issuers may advertise as widely as they wish, so long as they sell only to certain investors, called “accredited investors,” who are, generally speaking, institutions and wealthy individuals. While this type of offering is not “crowdfunding” in the sense that it is not an offering to the general public, since retail investors are excluded, it does share with crowdfunding its use of the Internet as a means to reach a wide audience. Additionally, several online platforms have sprung up that allow accredited investors to browse offerings and select companies for investment. As with most private placements in the U.S., there is no cap on the amount an issuer can raise using this type of offering.
Another change in the law, which became effective in 2015, allows issuers to raise up to $50 million in capital through sales to the general public. This type of offering has been dubbed the “mini-IPO” because, like an IPO, it allows the company to sell securities to the general public, and allows the securities sold through the offering to be freely traded in the secondary market. Securities sold through private placements are typically “restricted” and secondary trading is limited. This type of offering has existed almost as long as the U.S. securities laws have, but until the recent changes it was hamstrung both by a low cap on the amount that could be raised – $5 milllion – and by the requirement that the offerings comply with state laws. Because the U.S. has a federal system, and each state has its own laws, all securities offerings must comply with local state laws unless the federal government has claimed exclusive jurisdiction. The federal Securities and Exchange Commission has long had exclusive jurisdiction over public offerings and most private placements. But until last year, the mini-IPO, also known as a Regulation A offering, was still subject to state registration. This made Regulation A offerings so cumbersome that in recent years there was sometimes only a single offering of this type in an entire year. The new law exempts some offerings under Regulation A from state registration if the issuer provides certain ongoing disclosures to the SEC, and increases the amount that can be raised from $5 million to $50 million. Both the reduced regulatory burden and the increased cap will likely make this type of offering more attractive to issuers. The fact that Regulation A offerings can include retail investors makes the Internet a viable option for soliciting investment.
Crowdfunding and closely related concepts will likely play an increasingly important role in capital formation both in the U.S. and abroad. By one estimate, crowdfunding platforms raised more than $16 billion worldwide in 2014. Although the basic premise is an old one, the methods, including the ease of reaching millions of people almost instantly via the Internet, are still very new. Regulators have wrestled with how to maintain existing frameworks while welcoming innovation. They have not always gotten it right. But the diversity of capital access now available to smaller businesses may help to smooth over some of the roughest edges in existing regulation, while also pointing the way toward improvements down the road.