For all the recent talk of Wall Street’s disdain for Main Street, the public investing market is actually designed to be a pretty democratic space — a crowded restaurant without a guest list. Anyone with a hankering and some dollars to spare can get in the door and order off the menu.
But there’s a far quieter operation just down the block. And if you can get past the velvet rope, a vast smorgasbord awaits. It’s the market for private offerings. And it’s essentially an exclusive club, reserved for individuals and institutions — known as accredited investors — that possess certain financial means. This private market is huge and growing. In 2014, according to an SEC report, com-panies raised more than $1.3 trillion in capital this way. For the accredited investors who get in early, these offerings can lead to mind-boggling wealth.
But in mid-May, the velvet ropes come down. When Title III of the Jumpstart Our Business Startups (JOBS) Act goes into effect, anyone, no matter their income or net worth, will be able to get a piece of the unregistered securities market. Welcome to the bold new world of equity crowdfunding, where non-accredited investors can buy a piece of early-stage companies.
NEW AVENUES FOR INVESTORS
“We are very excited about it. It’s great for investors,” says Matthew Milner ’94, co-founder and co-CEO of Crowdability, a financial publishing company that focuses on alternative investments. As part of its service, Crowdability curates the most credible offerings from a variety of private securities investing portals (currently open only to accredited investors) like AngelList and CircleUp and also offers data services and investor education. Protecting and educating investors is key, Milner says, because “these are very risky, illiquid companies.”
But if you know what you’re doing, the risk can pay off. As an illustration, Milner tells a bit of tech-world lore about that most vaunted of startups, Uber. The car-sharing company initially raised capital through AngelList. “If you put in $10,000 in the first round, guess how much it would be worth today?” Milner asks. “Sixty million dollars.” That’s an extreme example, Milner says, but you get the point.
Yet until Title III, the only people allowed to invest in Uber were accredited investors — individuals who make more than $200,000 a year or have a net worth of more than $1 million. “The JOBS Act said, ‘Why is it that only the rich are allowed to invest in startups?’” says Gil Penchina ’97, a veteran Silicon Valley investor and head of a top investor group on AngelList.
ACCREDITED VS. NON-ACCREDITED
The SEC’s answers to that question can be found in the creation story of the agency itself, established in 1934, when the U.S. economy lay bleeding and broken at the bottom of a tall, stock market-shaped cliff. From the beginning, the SEC was saddled with a difficult mission: protect the little guy, but also foster access to capital.
The agency was trying to do both when it created the market for private securities three decades ago.
The idea was to help small businesses. Registering securities for sale in the public market required a mountain of paperwork and a host of disclosure and oversight, and smaller companies just couldn’t keep up. They needed an easier way to raise money.
Enter Regulation D, a list of exemptions added in 1982 to existing securities law. Under Regulation D, businesses could sell equity without all the painful SEC requirements, but, since these were very risky assets, there were some rules. Among them, rules about advertising — you couldn’t — and rules about who could buy these securities.
“As a democracy, you do want to have broad participation in the economy,” says Mitchell Petersen, the Glen Vasel Professor of Fi-nance at Kellogg, “but you also want to protect individuals from making stupid decisions.” The SEC decided the best way to do this was to make sure that only the wealthy could invest in these very risky securities and establish the accredited investor rules.
Yet under Title III, some of those rules go out the window. Which means the buyers market for private equity could get a lot more crowded.
NEW RULES FOR A NEW MARKET
Under the new paradigm, people whose income or net worth is less than $100,000 can invest, at most, $2,000 each year in unregistered securities. If your income or net worth is $100,000 or higher, you can spend more — 10 percent of income or net worth, but never more than $100,000 annually.
“The SEC doesn’t want somebody to take half their income and invest in some super-risky stock,” says Michael Fishman, Kellogg’s Norman Strunk Professor of Financial Institutions.
In addition, the SEC has capped the amount that startups can raise through equity crowdfunding at $1 million in a 12-month period. (Companies can also seek capital from other sources.)
All transactions must be conducted through registered portals or brokers; in other words, non-accredited investors will likely buy private equities in much the same way that some accredited investors do now — through websites like AngelList that can’t make recommendations, but can show a user what other, very successful people are buying and offer buy-in on portfolios assembled by more experienced investors.
Finally, startups must adhere to a laundry list of disclosure requirements if they wish to raise capital this way.
“The rules all have the flavor of protecting investors,” Fishman says. Yet some fear the rules are too exacting.
areas of expertise:
Corporate finance, insider trading, regulation of financial markets
- Research focuses on financial market regulation and contracting.
- Won the 1989 Smith Breeden Prize for Distinguished Paper, awarded by the American Finance Association.
- AServes as associate editor for a number of finance journals and co-edited A Primer on Securitization (MIT Press, 1996).
CUT OFF AT THE KNEES?
“There is a fair amount of paperwork burden on the issuer,” says Karin Dommermuth O’Connor ’89, a longtime angel investor and president of Perimeter Advisors in Chicago. “The Twitters of the world don’t need that kind of hassle to raise a million dollars. So then you have to ask, what kinds of companies are willing to jump through these extra hoops?”
Also, a million dollars is not a lot for tech companies to work with, says Nikki Pope ’86, an attorney at Cooley LLP in Palo Alto, California, who has been steeped in the details of Title III for years. “That’s going to limit who’s interested.”
Pope also objects to the limits placed on non-accredited investors. “If you make less than $100,000 a year, the SEC is saying you can’t spend more than $2,000 on private equities. I don’t understand why we’re being babysat for investments, but not babysat for spending $5,000 on a concave TV,” she says. The limits also don’t leave much room to diversify, and investors may not have the running room to ever hit it big.
So is equity crowdfunding doomed from the start? Pope, Dommermuth O’Connor and others predict that the new crowdfunding rules could be a boon for small businesses — say, a dry cleaner or a chain of pizza shops.
And, says Eric Young ’80, co-founder and partner at Canaan Partners, a venture capital firm, crowdfunding could offer a lifeline for startups that fall through the cracks under the current investing structure. “The companies we invest in strive for market caps in the hundreds of millions. Or billions,” he says. “And there are many startups that are just not of that nature. So we would say, ‘No, thanks.’ But that doesn’t mean it’s a bad idea.”
And if the big names in contribution crowdfunding jump into the private equity business — Indiegogo has stated interest, Kickstarter has not — that will be a game-changer, says Milner. Those brands are already familiar. “People are going to say, ‘Should I spend money and get a t-shirt? Or should I spend money and actually own a piece of the company?’”
Yet Milner, like Pope and others, agrees that the SEC may need to loosen the rules for startups and investors alike, if equity crowd-funding is truly going to pay off for both. But, he says, Title III is a step in the right direction. “It’s not perfect,” he says. “But I think it’s a good start.”