Beginning May 16, 2016 Regulation Crowdfunding is the law of the land in the US. For the first time, US startups have a legal framework for seeking investment from the general public. This article, and the next in the series, lay out the new equity crowdfunding rules and their implications.
An Historical Pivot
For nearly 80 years, the basic rules on an issuer selling stock to the public in the US have required either (i) a registration statement with mandated disclosures (e.g. the long Form S-1 associated with most IPOs), or (ii) a special exemption from the registration statement requirement.
The most popular exemption for the last 30+ years has been Rule 506 under Regulation D. Rule 506 allows certain private companies to raise unlimited capital without a registration statement PROVIDED: (i) they only sold to "Accredited Investors" (with a narrow exception) and (ii) they did not use "General Solicitation" in connection with the offering. (Accredited Investors are investors the SEC deems sophisticated and able to bear losses because they have sufficient financial means. General Solicitation was never precisely defined by the SEC, but, based in part on Rule 502(c) and various "no action letters" over the years, it is generally agreed to be any form of public discussion or public advertising of the terms of the offering.) For many years, the rules were simple: as long as it was a private sale to accredited investors, filing of a registration statement was unnecessary.
On September 23, 2013, the SEC implemented the first part of their reaction to Congress' JOBS Act of 2012 and published a rule lifting the ban on general solicitation. This rule confused most people because it did not lift the requirement that offerings be limited to accredited investors; startups could speak more broadly about their financing rounds, but couldn't actually make them more broad. If there was a general solicitation, startups needed to take extra steps to confirm the investors were accredited.
Fast Forward to May 2016
The well-meaning new rules are revolutionary in terms of the activities they allow: companies can take direct equity investment from the general public without the requirement that the investor be accredited. And they can give notice directly to the public about the existence of an offering (though nothing more than a notice and pointer--most entrepreneurs don't realize that any discussion of the offering details in must occur on special portals--see the next article in this series for more detail on that).
However, despite this new approach, in keeping with the SEC's obligation to maintain order and protect investors, the applicable restrictions on the new rules are very tight. Unfortunately, this reality may curtail any true revolution.
The restrictions in the new 2016 crowdfunding rules include three main categories:
- Limitations placed on the amount of money investors can invest;
- Requirements placed on the form and mechanism for the transactions; and
- Offering limitations and disclosure obligations placed on companies.
The reasons for these restrictions are valid and logical. Keep in mind what a serious pivot this is: historically, the SEC has limited these deals to accredited investors they believed did not need protection due to their sophistication and financial resources. Now the SEC is opening these deals to an entirely new breed of investor viewed as not ready to "fend for themselves"--they are not required to be as sophisticated, nor to have the same level of financial resources. Given this, no one can blame the SEC for putting these restrictions in place, since their primary responsibility is to protect the public and maintain order in the markets.
The problem is, you cannot have it both ways.
It is impossible to throw the doors open to unregulated mass-scale crowd-based capital formation and still have adequate protections against fraud and unanticipated consequences. To achieve the latter, you have to constrain the former. The problem is that to ensure even the most basic protections, the rules end up needing to be pretty stiff.
I go through those restrictions in detail in the next article in this series, but let me preview the bottom line: this is going to be tightly-restricted, burdensome, expensive capital for companies. The amount of effort and hassle per dollar raised is going to be high, and the non-financial value from the deals low, relative to traditional alternatives.
Experience teaches that nature follows the path of least resistance. In the fullness of time I believe that, at least for the best management teams with the best ideas, this kind of offering is not going to be economically competitive with exempt private deals from accredited investors such as angels or VCs. The effect of this could be stark. Will these crowdfunded equity offerings become the last refuge of hungry companies who cannot get access to, or traction with, the most sophisticated and experienced investors? My bet is yes. Played out over time, such a reality would inevitably lead to adverse selection issues and a stigma for the companies attempting to raise money this way.
For more detail on how the restrictions work and why I see it playing out this way, stay tuned to this series for the next installment.