You, your mom, or that random guy down your block will all soon be able to join the ranks of startup investors.
The Securities and Exchange Commission voted this past week to approve so-called equity crowdfunding rules for investors, an effort spawned by the passage of the JOBS Act way back in 2012. What that means is that startups or small businesses looking for investors can go through brokers or online platforms to find them—and those investors can now be, well, anyone.
This is a pretty big deal. It marks a shift in the kinds of capital that startups and small businesses can raise. Startups today often turn to venture capitalists, angel investors, bankers, and other accredited investors, but access can require the right connections, which are often hard to come by outside major financial hubs like New York, San Francisco, and Boston.
Now, entrepreneurs can turn to the crowd. And if you've part of the crowd that's always wanted to invest in a startup, you may soon be able to in ways that you couldn't before. But there are some things you need to know. Since the passage of the JOBS Act, experts have worried about putting safeguards in place to protect unsophisticated investors, as well as protections for startups to minimize fraud. The SEC is hoping that its new rules will address those concerns. Here's what you need to know.
So, You Want to Invest
In the past, only so-called accredited investors have been able to invest in startups. Here's what that meant in a nutshell: If you made less than $200,000 a year, and you didn't have a million bucks in assets, you couldn't invest. Now, starting sometime next year, even if you aren't that well off, you'll be able to buy into companies you like.
However, in order to protect you from, say, putting all your retirement savings in what you think is the next Facebook but turns out to be the next Myspace, the SEC approved very specific rules to limit how much a nonaccredited investor can invest. People with an annual income or net worth below $100,000 can invest no more than $2,000, or up to 5 percent of the lesser of their annual income or net worth. For those who make at least $100,000, the SEC says they can invest 10 percent of either their annual income or net worth (whichever is less).
Looking to the Crowd
For startup founders or small business owners, the new rules approved this morning will allow them to raise up to $1 million per year through crowdfunding.
The SEC is also requiring that all startups disclose basic financial details, but only some will need to submit to a full audit. Some experts have argued that it would be too costly for every early stage startup to pay for an independent audit, especially if the maximum funds they could raise were $1 million. So the SEC has created different tiers requiring startups to submit different degrees of information depending on how much money they're hoping to raise. Startups raising less than $100,000, for example, won't need to have an audited review at all but will submit financial documents put together by their in-house financial officer.
Where's the Money
With the new rules in place, investors looking for startups and startups looking for investors will be able to go to brokers that already exist, or they can turn to new online "funding portals." These platforms—think Kickstarter, but for equity—will be able to collect financial information and provide disclosures based on the SEC's rules. (These already exist for accredited investors.)
The platforms themselves will play a crucial role not only in establishing fair marketplaces, but also in helping potential investors figure out where to invest. The SEC says that platforms will be able to curate their startups to help investors determine what might be the best picks; they'll also be able to take a stake in startups so that their incentives will be aligned. The SEC seems to believe that if the platforms want the startups to succeed, then it's more likely they will.
"It incentives platforms to do a better job," says Richard Swart, a former longtime crowdfunding and alternative finance researcher at the University of California, Berkeley who is taking an executive role at NextGen Crowdfunding, an online community for new investors.
Risks, Rewards, Returns
All of which is pretty exciting. Startups like Pebble and Oculus Rift have been able to succeed with the help of crowdfunding from sites like Kickstarter. But imagine what it would be like to get equity instead of just the promise of a product. For new startup investors, however, the best plan is to take it slow. Oculus and Pebble are the anomaly, not the norm.
"Even if you're truly invested in investing in a startup, the odds are against you," Swart says. "It's the law of startups—mathematically the most likely exit for a startup is failure."
While individual angel investors and venture capitalists have been able to reap millions of dollars from smart investments, they don't only invest in one or two startups—they invest in many, knowing most will fail and hoping that one hits it big. They also have experience, industry expertise, research, and money—all things that a regular person might not have when looking at a new equity crowdfunding platform. Education about what investing in early stage startups really means is crucial.
"It's like the new lottery," says Southwestern Law School professor Michael Dorff. "There are very few Peter Thiels in the world. It's like asking, 'Why can't I be Warren Buffett?' There are a lot of smart people trying to be Warren Buffet or Peter Thiel. Your odds are slim even with the experience, expertise, and education. Without it, you are taking a knife to your gut."
Where Angels Fear to Tread
And yet VCs and angels are often only looking for startups that will reap enormous returns, meaning they may eschew potentially successful businesses if they don't seem like potential unicorns. They're also focused on startups predominantly in big coastal cities like San Francisco, New York, and Boston. By allowing anyone to invest in a startup, the SEC is giving investors more freedom with their money and supporting small businesses that might not otherwise get funding.
Swart says that the new rules around investing won't just benefit potential tech startups. Any small businesses, like your local pizza restaurant or a new real-estate group, may be ripe for the kinds of small investments made possible by this new kind of equity crowdfunding.
The platforms themselves may also offer interesting new opportunities. Early stage startups may be able to test out products or ideas on potential future customers before going to, say, VCs for a bigger stake.
"When we started looking at crowdfunding, it was a small Dutch platform of artists raising $50,000," says Christian Catalini, a professor at MIT's Sloan School of Management. "It's gone a long way and it would be very hard to imagine at that time the kinds of things you could do with it now. We want entrepreneurs to experiment with new models."
