After a 4+ year wait, the SEC has finally opened up the world of startup investing to the general public for the first time in over 80 years. To help walk you through this seismic shift in the world of finance, I will be sharing a series of posts that will walk you through the what, why, and how of this new breed of crowdfund investing.
Unless you have been living off the grid for the last ten years, you likely already know the origin story of Facebook. Here’s a six-sentence refresher anyways.
After getting into a bit of hot water for hacking into Harvard’s “freshman facebook” photo database to create a hot-or-not style web app, Mark Zuckerberg shifted gears and began working on a social network to connect students in late 2003.
When he opened up TheFacebook.com to Harvard students on February 4th 2004, the site went hyper viral well before “going viral” was even a thing.
But as Facebook’s traffic grew, so did its need for server space, which back in the days before cloud computing could get real expensive, real fast.
To fund those server costs, Zuckerberg convinced his wealthy Brazilian classmate Eduardo Saverin to invest $15,000 in TheFacebook in exchange for a 30% ownership stake in the fledgling business and a position as CFO.
It wasn’t long though before Zuckerberg and Saverin began disagreeing on some key strategy decisions for Facebook’s future.
While the resulting fall-out between the two made for some Oscar-winning drama, the whole mess could have been easily avoided.
Instead of pulling Saverin into the fold, why instead had Zuckerberg not just asked some of Facebook’s earliest users to invest in the business they were stark raving mad about?
On a campus where annual tuition tops $50,000, surely Zuckerberg could have convinced 150 students to invest $100 each for a piece of TheFacebook. If each those hypothetical investors had been able to hold on to their 0.3% ownership stake without being diluted in the fashion Saverin eventually was, their $100 investment would have been worth over $2 million when Facebook (now without the “The”) held their initial public offering in 2012.
Around the same time Facebook was deciding what to do with their $16 billion in IPO cash, another startup was looking to raise just a fraction of that amount to grow their own business.
The designers of the Oculus Rift, a virtual reality headset designed specifically for video games, needed $250,000 to build some prototypes of their headset that they could get in the hands of developers. That way, when they launched their VR headset to the masses, there would be some great games and other apps already available for download.
Instead of finding a wealthy investor was willing to risk the $250,000 for a sizable stake in their risky startup, the team at Oculus decided to take a different approach. Since they knew there were VR-enthusiasts in the world that would be more than willing to purchase their prototype at a discounted price, they decided to raise the money by pre-selling their VR headsets on the popular crowdfunding site Kickstarter.
Spoiler alert: it worked out pretty well for them.
Four hours after Oculus’s Kickstarter went live they hit their $250,000 goal. Within 36 hours they had raised $1 million. And when their Kickstarter wrapped up 30 days later, 9,522 people had filled the Oculus coffers with $2,437,430 in cold hard cash to launch their product.
After showing that type of market demand, Oculus was then able to easily raise a couple rounds of venture capital (at much better terms than they would have gotten pre-Kickstarter) to really put the “virtual” pedal to the metal.
Less than two years after Oculus’s Kickstarter success however, Facebook used a big chunk of their remaining IPO cash to swoop in and buy Oculus for $2 billion (yes, that’s billion with a “b”).
The purchase left many Oculus Kickstarter backers upset.
Some hated seeing a company they loved getting gobbled up by a large corporation. But most backers were upset because they believed that as Oculus’s earliest financial supporters, they too should have been entitled to some of that Zuckerberg cash.
One backer summed up the frustration perfectly: “I think I would have rather bought a few shares of Oculus rather than my now worthless $300 obsolete VR headset. What’s two billion dollars amongst 9,522 friends?”
So why did Oculus turn to venture capitalists and not their original Kickstarter supporters when they needed more money to continue growing their business?
And why did it take Mark Zuckerberg, who wants to “make the world more open and connected ,” eight years to finally offer the users who helped build his business into the giant it had become a chance to invest in Facebook’s future?
The answer? A bunch of antiquated securities laws that were nearly a century old.
The 80 Year Old Laws That Prohibited Equity Crowdfunding
“Happiness is not in the mere possession of money; it lies in the joy of achievement, in the thrill of creative effort” – Franklin D. Roosevelt
Things weren’t looking so good for the United States in the 1930s. The roaring 20’s had just concluded with quite the bang, now commonly referred to as Black Tuesday.
After that stock market crash in 1929 and the soon to follow Great Depression, Congress passed sweeping financial reforms in 1933 as part of the New Deal.
Their first order was to restore confidence in a banking system that had seen thousands of bank failures and panic-fueled “runs” on deposits. So Congress passed the Bank Act of 1933 to prevent banks from speculating in the financial markets and insure customer deposits (via the newly established FDIC).
But while the Bank Act helped protect the public’s money while it was in their checking accounts, it did little to protect their investments in the stock and bond markets, which had largely been regulated by state laws up to that point. To prevent another crisis in those securities markets, Congress doubled up and passed the Securities Act of 1933 that same summer.
The Securities Act of 1933 
The Securities Act’s purpose was to make sure “issuers” (companies offering securities such as stocks or corporate bonds for purchase) did not misrepresent themselves to the investing public. It did this by requiring issuers to (1) register with the newly formed Securities and Exchange Commission and (2) disclose a significant amount of accurate information to investors so they could make informed investing decisions. If the information presented was inaccurate, the issuer, underwriter, and other parties that signed the SEC registration statement could be liable for criminal and civil prosecution.
But that process of registering with the SEC, hiring an investment bank to underwrite their IPO, and providing quarterly disclosures to the public is extremely expensive, both in terms of time and money. For startups that have limited amounts of each, tapping the public markets for their financing needs just doesn’t make economic sense.
Seeing as how small businesses create the majority of American jobs though, Congress didn’t want to completely shut off their access to much needed growth capital. They therefore included certain exemptions in the act that would allow some companies to bypass the SEC registration process and still raise capital via private placements.
Private placements can refer to the sale of various types of securities, but in this particular instance I am referring to selling ownership shares (equity) of a company that is not listed on a public exchange. One of the exemptions that companies have traditionally used to raise capital via private placement is Regulation D, which is the foundation for the private equity and venture capital industry.
“Reg D” contains three rules that provide exemption from SEC registration, but the most widely used is Rule 506. The two main requirements for offering a private placement under Rule 506 are (1) those securities must be sold mainly to “accredited investors” and (2) those selling shares are prohibited from general solicitation of their investment opportunity. In layman’s terms, what this means is that if you wish to raise capital outside of the public markets, the majority of your shares must be sold to millionaires. Furthermore, while those “accredited” millionaires can take out a front-page ad telling the world they have money burning a hole in their pocket, you are prohibited from publicly promoting your investment opportunity!
Those two requirements are precisely why Mark Zuckerberg put on his pajamas and pitched Facebook in private to venture capitalists (who pool funds from accredited investors into one investment fund) instead of sitting in his pajamas at home and asking Facebook users to invest a few hundred dollars each.
In a nation that was built on taking calculated risks, those securities laws have separated America into a country of haves and have-nots. For 80+ years, the haves (meaning the 3% of Americans who qualify as accredited) have been able to invest in high growth businesses in their earliest stages, realizing vast returns if they end up being successful. The have-nots, who were supposed to be protected from substantial risks by those very laws, were left to toil in a stock market that was becoming increasingly volatile.
After the financial crisis of 2008 however, the other 97% of Americans began to ask why they could gamble away $1,000 at a roulette table in Vegas but couldn’t invest that same $1,000 in a small business they believed in and supported. After all, weren’t those the very types of businesses that help create millions of American jobs every year? Well, Congress began to wonder the same thing, and despite increasing levels of partisanship, they came together to help democratize the finance industry.
The Four Types of Equity Crowdfunding
“For the first time, ordinary Americans will be able to go online and invest in entrepreneurs that they believe in” – Barack Obama
In April of 2012, after passing through the House of Representatives and Senate with overwhelming support from both Republicans and Democrats, President Barack Obama signed the Jumpstart Our Business Startups (JOBS) Act into law. In addition to provisions that would make it easier for a company to either go public earlier or stay private longer, the JOBS Act finally reversed the rules on both general solicitation and non-accredited investing. With those being some of the largest changes to financial regulations in nearly a century, the SEC racked their brains for over three years before they finalized the rules, but now that they have, a brand new asset class has been born: equity crowdfunding.
Despite its name, the JOBS Act was not specifically designed to create jobs, but as the founder of AngelList (which is a trailblazer in the equity crowdfunding industry) Naval Ravikant stated, “what congressperson can vote against something called the JOBS Act?
Instead, the JOBS Act was a conglomeration of securities related bills that had already been presented in the House of Representatives. Each bill was given its own “Title” within the act and while Titles I, V, and VI have big implications for companies thinking about going public, Titles II, III, and IV are the ones we can thank for opening up this new world of crowdfund investing to the masses.
Each of those three titles, which I describe in more detail below, has created a new avenue for raising capital. In each, Congress’s goal was to make it easier for companies to raise capital while simultaneously ensuring investors were adequately protected.
Title II: Accredited Investor Equity Crowdfunding
Before any entrepreneur could hop on the internet to announce that they were selling shares in their business, the JOBS Act needed to get rid of that pesky “general solicitation” rule (you know, the one that said the first rule about raising capital is you don’t talk about raising capital). Title II did exactly that, removing the prohibition of general solicitation but with one major caveat: “issuers” (i.e. the entrepreneurs looking to raise said capital) could still only sell those securities to accredited investors.
So even though Title II still left the general public on the investing sidelines when it went live in September 2013, it was an incredibly important first step as it brought venture investing out of the shadows. Title II opened up the internet as a place where the entire fundraising process for entrepreneurs, starting with pitch decks and ending with cashed checks, could take place.
Despite this style of investment crowdfunding only being available to the 3% of investors who met the criteria to be labeled as accredited, America’s first foray into the world of equity crowdfunding showed immediate signs of success: less than seven months after Title II went live, more than 900 companies raised more than $10 billion using the new rules.
Title II accredited crowdfunding still uses the tried and true Regulation D as its structural backbone, but each crowdfunding platform that sprung up to facilitate this new style of crowdfund investing added their own unique spin. Some focused on specific industries such as real estate, consumer products, or early stage technology. Others such as Angellist created “syndicates” that allowed newcomers to the world of private equity investing put their money into deals that experienced angel investors had already vetted and invested in themselves. Many of those platforms may not choose to open their doors to non-accredited investors when that day finally arrives, but the ideas and formats they have shown to work will surely be copied by those that will cater to the masses.
Title IV: Reg A+/Mini-IPO Equity Crowdfunding
When Congress drafted up the JOBS Act, they gave the SEC a 270 day deadline to finalize the rules for Title III. Even though the SEC was given no such timeline for Title IV, they surprised us all by adopting final rules for Title IV in March of 2015 (when Title III was more than 800 days overdue). Part of the reason they jumped ahead is Title IV crowdfunding is an evolution of an existing SEC exemption known as Regulation A.
The original Regulation A is a rarely used rule that allows issuers to raise a mini-IPO of sorts. Those using Regulation A can raise up to $5 million from the general public (meaning both accredited and non-accredited investors) without going through the full SEC registration process needed for a full IPO. Being able to sell to securities to the public while bypassing that cumbersome registration process seems like a great deal, but the reason Reg A was rarely used is it still required review and approval by state securities agencies before a single share could be sold to the public.
That state-by-state process can be both slow and expensive, so considering the fact that issuers considering Reg A were limited to raising just $5 million, most companies chose to use the much less onerous Reg D, even if it meant it cutting non-accredited individuals from the pool of possible investors.
What Title IV did to address that issue is create a new “+” version of Reg A that increases the amount a company could raise from $5 million all the way up to $50 million while also providing a pre-emption from review by state securities agencies.
But the state regulators (who were a little miffed that the feds cut them out of the process) did act as another line of defense for investors. In order to ensure those investors remain adequately protected, the SEC created two tiers of offerings with different requirements for each:
- Tier 1 increased the maximum capital raise from $5 million to $20 million but otherwise resembled the original Regulation A. It still allowed for an abbreviated registration process and continued to require state review of offerings, but that state approval process would now be through a more streamlined “coordinated review.”
- Tier 2 looks really rocked the boat though. With Tier 2, issuers get to completely bypass the state approval process, instead dealing only with the SEC. And instead of being limited to $20 million in total funding, Tier 2 issuers can raise up to $50 million! So why would anybody opt for Tier 1? Well to balance the equation, the SEC requires Tier 2 issuers to provide initial and ongoing audited annual financial statements, with additional semi-annual reports as well. Title IV also caps the amount non-accredited investors can put into each Tier 2 offering at the greater of 10% of their annual income or net worth.
To avoid that state review process, most companies using Reg A+ will likely opt to go the Tier 2 route. The financial audit requirement might cost tens of thousands of dollars, but when compared to the exponentially higher cost of conducting a traditional IPO in the public markets, Tier 2 still makes economic sense considering the potential for a $50 million raise from a vastly increased pool of possible investors.
It has now been six months since those rules were approved and while many companies have announced they will be raising a round of capital using Reg A+, not a single share has been sold to the public yet. Many, if not most, of those companies will eventually make it to that point, but getting the SEC to sign off on their offering is still a process.
Knowing this, the SEC has allowed Reg A+ issuers to “test the waters” before they get the green light to sell shares. During this time, companies can get soft verbal commitments from those who are interested in investing. So far, many companies have received indications of interest far beyond the amounts they were hoping to raise, but it has yet to be seen how often those commitments will translate to actual investments.
Reg A+ will therefore be great for companies that want to sell their shares to the general public but aren’t quite ready for a full blown IPO. However, the costs involved will still make it unfeasible for earlier stage entrepreneurs that need less than a million dollars to launch or grow their business. Enter Title III.
Title III: Retail Equity Crowdfunding
When the JOBS Act was approved in 2012, no section received more praise, hype, and scrutiny than Title III. And it wasn’t just because Congress absolutely nailed the acronym. I imagine some legislative aid spent quite a few coffee-fueled evenings coming up with CROWDFUND, which is short for “Capital Raising Online While Deterring Fraud and Unethical Non-Disclosure (Act of 2012).
No, the reason Title III was such a big deal was it truly opened up the world of early stage private equity investing to the public for the first time in over 80 years. Title III stated that companies could now raise up to $1 million from the general public through online “funding portals” with no SEC review or clearance of the offering statement and minimal financial disclosures.
The quality of financials required will be based on the amount raised, with raises of less than $100,000 requiring nothing more than company prepared financial statements, raises of $100,000 to $500,000 requiring CPA “reviewed” financials, and those over $500,000 requiring CPA audited financials. However, given the high price tag of having financial statements audited, the audit requirement is removed for first time issuers.
What this all means is that entrepreneurs in the earliest stages of their journey will finally be able to offer equity in their startup to anybody that believes in them. No more putting up their house as collateral for a bank loan. No more maxing out their credit cards. No more borrowing money from friends and family. Instead, they can sell a stake in their business, sharing some of the risk and much of the reward with their shareholders.
But those risks for shareholders are much higher than if they put their money in a bluechip publicly traded stock, particularly now that many of the upfront and ongoing SEC reporting requirements had been stripped away. To make sure everyday investors didn’t lose their shirts, Congress included the following guidelines in Title III:
- Companies using Title III must conduct their offerings via SEC-registered “funding portals” or broker-dealers
- Those funding portals will be required to run background checks on those raising capital on their platforms, which will be a first line of defense against fraudulent actors.
- The next line of defense will be the “wisdom of the crowd,” i.e. the crowdsourced diligence process that potential investors will undergo. As they do so, they will share questions and concerns amongst each other and with issuers. That dialogue will take place inside communication channels that are housed on the funding portals, another stipulation that Congress requires for funding portals.
- Each investor is limited in how much they can put into each offering. For those making less than $100,000, that limit is the greater of $2,000 or 5% of annual income or net worth. For those with net worth or annual incomes exceeding $100,000, that limit increases to 10%.
So what types of businesses will turn to Title II, III, and IV to raise capital? What should you look for when considering investing in these types of securities? And how might these investments fit in to your overall investing strategy? Those are just a few of the topics I will be covering in the coming weeks.
The Five Major Risks of Equity Crowdfunding Investments
Equity Crowdfunding & Your Portfolio
Equity Crowdfunding Diligence: How To Analyze An Investment
Equity Crowdfunding Deal Flow: Where To Find Investment Opportunities
How To Manage Your Portfolio Of Equity Crowdfunding Investments
Finale: The Future Of Equity Crowdfunding