The Crowdfunding Landscape Is Evolving: Should Entrepreneurs Be Worried?
The rules have only been in place for a matter of months, but already Congress is moving to fine-tune the regulatory framework around the emerging field of equity crowdfunding that unaccredited investors are jumping into at a rapid pace.
In recent weeks, the House Financial Services Committee passed a pair of bills that will make it easier for companies to raise money via crowdfunding campaigns. One will remove some of the more onerous public reporting requirements for startups; the other will allow unaccredited investors to pool their investments in what are called Special Purposes Vehicles, creating de facto crowdfunding “funds.” Both bills enjoy wide bipartisan support and are expected to pass the full House by the end of the year.
But, what else is coming? Will the rules around equity crowdfunding change more in the next few months or years? At this point, with comment still to come from various regulators, no one can say for certain.
The real question, then, for entrepreneurs isn’t if changes are coming, but whether or not they should be waiting for them to become law before launching their own crowdfunding campaigns.
In response to the changes currently working through Congress, the general feeling is that this sector is still very new and somewhat unsure. Should entrepreneurs hold off until this is all sorted out?
Yes, and no.
A limited market
The truth is that, as the regulations stand today, it is very simple to decide whether or not to launch an equity crowdfunding campaign: Companies that want to raise $1 million or more should hold off, while those that need less than that amount might as well go ahead.
The Securities Exchange Commission (SEC) and the existing regulatory structure have taken a “go slow” approach, and have effectively put a cap on the marketplace for crowdfunding investments in the United States. Today, an individual can invest no more than $2,000 per year in crowdfunded equity investments. That’s a per-person total, across however many companies that investor would like to fund.
So, if an investor wants to crowdfund two different companies, he or she could commit just $1,000 per year to each. A diversified portfolio of 40 different crowdfunded investments would then mean earmarking just $50 per company. And that simply isn’t realistic.
What’s more, each company that raises funds under the existing rules may accept investments from no more than 500 investors in total. When you do the math, it’s clear that in order to raise $1 million under the existing framework, each of those 500 investors would need to commit his or her personal maximum of $2,000 to the company.
That’s a tall order for any entrepreneur and it doesn’t make sense for individual investors, either.
Startups should not be a large allocation for most individuals. Investments in crowdfunded startups -- pre-IPO shares in a company developing the next killer iPhone app, or in a disruptive tech firm seeking $250,000 or perhaps $500,000 to get its idea off the ground -- should compose only a small portion of anyone's portfolio.
However, everything could soon get easier for entrepreneurs looking to tap crowdfunding and for individuals hoping to snag the next WhatsApp.
The Special Purpose Vehicles (SPV) concept currently being considered in Congress will effectively remove the 500-investor cap on equity crowdfunding campaigns, allowing more unaccredited investors to participate up to and beyond the current limit, by effectively counting each SPV pool as "one" investor.
This could open up new opportunities for investors by allowing them to more effectively diversify their investments, while also making the fund-raising process simpler for founders.
Investing in an SPV instead of directly in a startup is a great idea for individual investors because about three-quarters of venture-capital backed firms in the United States never return investors' capital, according to a study by Shikhar Ghosh of Harvard Business School. Among 30 percent to 40 percent of U.S. start-ups, the study said, investors lose all their money; and 95 percent of startups fail to hit their projected rate of return.
That’s why big-venture capital firms spread their money around and why individual investors should, too. For any individual entrepreneur, having an SPV as a buffer between your company and all those individual investors makes sense, too.
The power of one
What’s more, such pools would make it easier to raise those larger rounds, as the entrepreneur would only have to convince one deal committee or SPV board to invest in his or her company. That’s a lot less of a lift than would be required to convince 500 or 1,000 more individuals to invest, provided the business idea were compelling enough.
It is always easier to get money from one source than from many different ones.
Still, the sweet spot for equity crowdfunding campaigns is in the under-$1 million range and will likely remain there for some time to come. Even under the proposed changes that we know are coming, non-accredited investor participation doesn’t always fit with the needs of all companies, and that isn’t changing.
We knew equity crowdfunding would be slow taking off. That’s because the initial red tape put into place by the Securities and Exchange Commission (SEC) meant that for the next couple of years, crowdfunding would effectively be in a trial phase, as regulators seek to limit the risk to individual investors. Some experts complained that not allowing SPVs to facilitate deals made equity crowdfunding riskier than it ought to be.
So, the good news is that allowing SPVs to invest could yet make this form of financing an important capital-raising mechanism.
Meanwhile, what entrepreneurs need to keep in mind right now is that, as with anything, there isn’t any perfect solution for everyone. There are other options available for raising larger amounts of funds, and crowdfunding isn’t always the best or most direct path for every startup.