Crowdfunding (#242)
/In this podcast episode, we discuss new ways to sell shares through crowdfunding. Key points made are noted below.
Crowdfunding Regulations
First, the bad news. Regulations. The Securities and Exchange Commission issued Regulation Crowdfunding in 2016, which places a few restrictions on the process. A business can only raise a million dollars a year, which includes all other fund raising within the same period. This amount is inflation adjusted, so the fund raising figure for 2017 is $1,070,000, and that number will presumably keep going up. Nonetheless, that is not a lot of money, so crowdfunding is probably going to be restricted to small startup companies. Any organizations larger than that will need more money.
Funding Levels
The second bad item is that individual investors can only invest a relatively small amount of money. I won’t get into all the restrictions, but it’s basically ten percent of their annual income or net worth, which is reduced to five percent if the person’s income or net worth is less than $107,000. And again, this figure is inflation adjusted. This rule was put in place so that investors wouldn’t lose too much money if the investee goes bankrupt. From the company’s perspective, it means that they’re going to need a lot of investors to meet the maximum annual investment cap – probably around 200 of them.
Reporting Requirements
And then there’s the third bad item, which is reporting. Any business that wants to sell stock through crowdfunding has to file a Form C with the Securities and Exchange Commission, which is estimated to take 50 hours to complete. In addition, the firm has to provide its tax returns if it’s raising a small amount of money, and reviewed financial statements if it’s raising a mid-range amount, and audited financials for amounts near the top of the allowed range.
Auditing Requirements
Audits are expensive and time-consuming, but if you want to raise at least $535,000 per year on an ongoing basis, then the audit must be completed – in advance. There’s also some reporting to be done while the fund raising is being conducted, as well as the annual Form C-AR, which has to be filed in each of the next three years, depending on the circumstances. Figure on spending a total of 200 hours on the Form C and then the three Form C-ARs.
Stock Registration
And for a final bad item, the shares that are sold will still have to be registered with the SEC if the company’s assets ever exceed $25 million. I talked about registering shares back in episode 93. The brief version of that episode is that stock registration is expensive, time consuming, and frustrating.
Investor Issues
So far, I’ve only mentioned the bad side of crowdfunding from the perspective of the company. There’s also a bad side for the investor, which is that the level of disclosure made by a company is relatively light, compared to a full initial public offering. Also, the investors who invest through a crowdfunding deal are less likely to be sophisticated investors. Put those two issues together, and you get people investing in stock offerings that may not be overly likely to pay off.
Crowdfunding Benefits
So, how do I balance all of this grim news with the benefits of crowdfunding? The main benefit is that a small startup company may have very few possible sources of funding, or at least, that aren’t rapacious – so crowdfunding gives them another option. In addition, if a business plan is really risky, a crowdfunding campaign might still raise money, whereas a more traditional investor wouldn’t consider investing. And finally – and not a small item – a business no longer has to be physically located near one of the main fundraising centers, like Silicon Valley or New York. Instead, since the fundraising is conducted on-line, the company could be located pretty much anywhere.
Crowdfunding Summary
So in summary, I haven’t really painted a favorable picture. Selling shares through crowdfunding could be useful for some smaller companies, but not all that many.
Regulation D
But don’t give up hope, there is an alternative, which is Rule 506-c of the SEC’s Regulation D. The quick summary is that Rule 506-c is pretty awesome, because you can raise an unlimited amount of money.
The downside is that stock sales can only be to accredited investors, and the company has to confirm that they’re actually accredited investors. An accredited investor is someone who has a net worth of at least $1 million dollars or annual income of at least $200,000 individually or $300,000 of joint income with a spouse. That’s the short definition – there are some other options.
This accreditation rule means that the pool of possible investors is reduced – a lot. People who qualify as being accredited constitute only about 3% of the population. On the other hand, there’s no cap on the amount you can raise from each one, so this restriction may not be much of an issue.
The way to use Rule 506-c is to go to a fundraising portal, which is a registered website that handles crowdfunding stock sales. The portal may have already investigated a pool of investors to see if they’re accredited, so that takes care of the legal requirement for reviewing investors. The fundraising portal posts the sale opportunity on its website, and investors can review the materials to see if they’re interested. Examples of these websites are crowdfunder.com, fundable.com, and microventures.com. And there’re many others.
The only real downside of this rule applies to investors, which is that the shares issued are not registered with the SEC – and that means the shares can’t be resold to someone else. So if you buy shares under Rule 506-c, you might have a hard time liquidating the investment later on. This usually means that you either hope that the company will be sold, or you pressure the company to register the shares with the SEC – which, as I already noted, is not easy. And even if the shares are registered, there may not be much of a market for them, so it could still be difficult to sell the shares.
So in summary, Regulation Crowdfunding is only good for small amounts of money and requires a fair amount of reporting. Rule 506-c is better all around, because you can raise much more money.