You Too Can Now Invest in Startups! What Could Go Wrong?
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, starting next year, 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 and San Francisco.
Now, entrepreneurs can turn to the crowd. And if you’re 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 and get equity. 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. And startups raising up to $1 million for the first time, or raising less than $500,000 any time, will not need to go through an independent audit, but can submit their own financial statements.
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 need to provide information to interested investors, take measures to minimize the risk of fraud, 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 with investors 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 decreases the costs that platforms have to charge and incentivizes them to do a better job,” says Richard Swart, a former crowdfunding and alternative finance researcher at the University of California, Berkeley (who is now joining NextGen Crowdfunding, an online community for startups and investors).
Risks, Rewards, Returns
All of which is pretty exciting. Startups like Pebble and Oculus have been able to succeed with the help of crowdfunding from sites like Kickstarter—imagine what it would be like to get equity instead of the promise of a product? For new startup investors, however, you might want to take it slow. Oculus and Pebble are the anomaly, not the norm.
“The odds are against you,” Swart says. “It’s the law of startups—mathematically the most likely exit event for a startup is failure.”
While individual angel investors and venture capitalists have been able to reap in 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 hope that one hits it big. They also have experience, industry expertise, extensive research, and lots of money—all things that a regular person might not have when looking into a new equity crowdfunding platform. Education about what investing in early stage startups really means and entails, Swart adds, is crucial.
“It’s like the new lottery,” says Southwestern law professor Michael Dorff of equity crowdfunding for nonaccredited investors. “There are very few Peter Thiels in the world, even in the VC world. It’s like asking, ‘Why can’t I be Warren Buffett?’ There are a lot of smart people trying to be Warren Buffett and Peter Thiel and very few people succeed.”
“So, your odds are slim even with the education and experience,” he adds. “Without it, you’re taking a knife to a gunfight, because you’re competing against people who have that stuff.”
And yet, VCs and angels, in particular, are often looking for startups that will reap enormous returns, meaning they may eschew potentially successful businesses if they don’t seem like, say, possible future unicorns. They’re also focused on startups predominantly in big coastal cities, but may not find those starting up in places like St. Louis or New Orleans. 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 small businesses too, like your local pizzeria that wants to launch a chain or a new real-estate group, may be ripe for the kinds of small investments that will come with this new kind of equity crowdfunding.
The platforms themselves may also serve interesting new opportunities. Early stage startups may be able to test out products, or consumer facing ideas, with potential future customers before going to, say, VCs for a bigger stake. There are certain types of companies too that might benefit from having consumers have an incentive for a company to succeed.
“When I first started looking at crowdfunding in 2007, I studied a small Dutch platform of artists and musicians,” says Christian Catalini, a professor at MIT’s Sloan School of Management. “Crowdfunding has 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.”
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