Until a few years ago, federal securities laws made it difficult for most people to invest in startups and growing small businesses. Issuers were not allowed to advertise their offerings to the general public, so most people – even accredited investors – were not even aware of such investment opportunities. Non-accredited investors were essentially barred from the private securities markets, with some exceptions. The “crowd” was not welcome.
The Jumpstart Our Business Startups (JOBS) Act of 2012 unlocked the door to (and shined a spotlight on) certain securities offerings made by startups and growing small businesses.
The JOBS Act includes three new exemptions from those restrictive, Depression-era securities laws, letting issuers raise capital via crowdfunding portals and broker-dealer platforms (intermediaries) registered with the SEC. One of the three new exemptions (Title II of the JOBS Act) permits general advertising to accredited investors, and the other two exemptions (Titles III and IV) allow an unlimited number of non-accredited investors to participate in equity crowdfunding deals. In other words, the crowd is welcome. (Title I of the act makes it easier for larger private companies to raise capital for a longer time or even indefinitely, without going public.)
Equity crowdfunding, as we use the term, refers to:
Investments in equity (common or preferred stock, LLC shares, convertible debt, SAFE, etc.) of startups and growth-stage companies. These are made by accredited investors through online offering platforms (under Title II of the JOBS Act). Regulation D, Rule 506(c) further authorized this exemption in 2013. Reg D does not limit the amount of capital an issuer could raise per offering; nor does it limit the amount that an accredited investor can commit to an offering.
Investments in equity of mostly seed-stage startups. Any investor can make these investments through crowdfunding portals and platforms (under Title III of the JOBS Act). Regulation Crowdfunding, or Reg CF, further authorizes this exemption (which went into effect in 2016). Reg CF limits the amount of capital that an issuer can raise to $1 million per year. The amount that investors can commit each year is limited based on their net worth and income.
Investments in equity of mostly growth- and later-stage private companies (not quite ready for an IPO). Any investor can make these investments through crowdfunding portals and platforms (under Title IV of the JOBS Act). The revised Regulation A (or Reg A+, as it is known colloquially) further authorizes this exemption (which became effective in 2015). Issuers are limited to $50 million per offering, and investors are limited based on net worth and income. Because issuers must file a scaled-down registration with the SEC (which is much shorter and less expensive than full registration), the Reg A+ offering is also called a “mini-IPO.”
* "Accredited investors” include natural persons who possess a net worth (alone or with spouse) exceeds $1 million, excluding the value of their primary residence and not counting home mortgage as a liability; or persons whose annual income exceeds $200,000 (or joint income with spouse over $300,000) in the two most recent years and who has reasonable expectations for similar or higher income in the current year.
Each of these exemptions allow investors to select and invest directly in a single issuer of securities – as opposed to investing in a venture capital fund, where the fund manager (not investors) select portfolio companies. That is one of the main difference between angel investing and venture capital investing.
Another difference? Venture capital portfolio companies tend to be more established in terms of revenue, market penetration, and/or growth stage, than crowdfunding issuers.
As crowdfunding is still a relatively young investment concept, the rules governing crowdfunding issuers, investors and intermediaries continue to evolve.
Equity-based crowdfunding followed the success of less-regulated kinds of crowdfunding, namely rewards-based, donation-based and debt-based.
Crowdfunding allows companies to collect many small contributions to finance or capitalize a popular enterprise. Modern crowdfunding takes place online.
Today’s crowdfunding concept began with Brian Camelio, a Boston musician and computer programmer, who launched ArtistShare in 2003. It started as a website where musicians could seek donations from their fans to produce digital recordings, often in return for the promise of rewards such as discounts on – and/or early access to – new music downloads months later.
ArtistShare evolved into a fundraising platform for film, video, music and photography projects. Thanks to ArtistShare, more rewards-based crowdfunding platforms launched. Notable examples: Indiegogo in 2008 and Kickstarter in 2009.
Debt-based crowdfunding emerged as an investment vehicle in 2006 in the United States. Debt crowdfunding allows individual borrowers to apply for unsecured loans — not backed by collateral. If accepted by the platform, they may borrow money from “the crowd” and pay it back with interest.
Also known as peer-to-peer lending (P2P), debt-based platforms generate revenue by taking a percentage of the loan amounts (a one-time charge) from the borrower and a loan servicing fee (either a fixed annual fee or a one-time percentage of the loan amount) from investors. The application process is free for borrowers. Investors earn the interest on each loan (or package of similar loans), assuming borrowers make timely payments.
As more institutional investors poured capital into P2P and overwhelmed the true peers, this asset class became better known as marketplace lending.
Angel Investing OnlineDonation- and reward-based crowdfunding took off between 2000-2010. Naturally, the angel capital market exploited the efficiencies of crowdfunding platforms to match startups with angel investors, disclose information and deal terms, allow investors to collaborate on due diligence (and exploit the wisdom of the crowd), and facilitate the investment transactions. All of it takes place online.
The old version of offline angel investing typically took eight to 12 months for an entrepreneur to find interested angels and negotiate a deal. Today, especially on Reg D offering platforms, it may take as little as a few weeks from the day an issuer lists its offer to closing a deal with investors.
Further, equity crowdfunding platforms attract investors (especially strategic investors) to deals from across the country. Before, issuers typically had to promote a deal through a network of personal relationships—often limiting their options to a metropolitan area or narrow region of the country.
If you are an accredited investor, you have one additional choice for buying early equity online: traditional Reg D offering platforms. These have been around since before the JOBS Act in the USA, so they’re more mature and often involve more experienced investor communities around them. But this is where it gets a bit complicated.
Traditional Regulation D equity offerings, under Rule 506, appeared on internet-based offering platforms as early as 2011 in the USA. They still operate today under Rule 506(b), but they are not considered crowdfunding. This is because issuers may not advertise their offerings to the general public, i.e., general solicitation is banned. Access to information about equity offerings is strictly limited, which essentially bars “the crowd.”
Recall that Title II of the JOBS Act of 2012 allows general solicitation under Rule 506(c), so that the crowd, although limited to accredited investors, has access to full information about offerings.
So now you’ll see two different Regulation D securities exemptions being used for internet offerings: traditional Rule 506(b) and “new” Rule 506(c). Only the latter is considered crowdfunding because, as I pointed out, Rule 506(c) allows general solicitation under Title II. There is one other important difference between the two from an investor’s point of view:
Under Rule 506(b), an investor may “self-certify” his or her accredited status when registering on the platform. This typically involves simply checking a box, so it is known as one-click certification.
Under Rule 506(c), an investor may be required to verify his or her accredited status by submitting tax returns or bank statements, for example, or a confirmation letter from a lawyer, banker, or financial advisor.
Many equity offering platforms tend to focus on one or the other kind of exemption, or one particular industry. For example, MicroVentures, one of the earliest platforms, specializes in high-tech startups and mainly uses Rule 506(b). CircleUp, another pioneer in online investing, focuses on retail and consumer products and mainly uses Rule 506(c) so it can cast a wider net for prospective investors by advertising.
|Securities Exemptions for Online Offerings|
|Exemption [Nickname]||Launched||Crowdfunding||Investors||Raise Limit||Investment Limit||Typical Stage|
|Reg D, Rule 506(b)[Traditional Reg D]||2011||No||Accredited* (self-certify)||None||None||Startup, growth|
|Reg D, Rule 506(c)[Accredited crowdfunding]||2013||Yes||Accredited (verify)||None||None||Startup, growth|
|Reg CF (Title III)[True equity crowdfunding]||2016||Yes||All||$1 mil||Based on income/worth||Seed|
|Reg A+ (Title IV)[Mini-IPO]||2015||Yes||All||$50 mil||Based on income/worth||Later|
* On internet offering platforms, investors must be accredited. But offline, Rule 506(b) allows up to 35 non-accredited investors per offering.
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David M. Freedman has worked as a financial and legal journalist since 1978. He has served on the editorial staffs of business, trade and professional journals, most recently as senior editor of The Value Examiner (National Association of Certified Valuators and Analysts). He is coauthor of Equity Crowdfunding for Investors, published in June 2015 by…
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