Startups and small businesses could sell ownership stakes in their companies by soliciting investors over the Internet under a proposal advanced by the Securities and Exchange Commission.
The plan would set rules for equity crowdfunding, which lawmakers said would spur growth by easing financing when they mandated it in the 2012 Jumpstart Our Business Startups Act. The rules, which the SEC voted 5-0 to release for public comment yesterday, may boost the nascent crowdfunding movement and help the agency through its backlog of regulations required by the JOBS Act and Dodd-Frank law.
Businesses and startups too small or risky to attract funding from banks or venture capitalists are expected to use equity crowdfunding. Regulators say they tried to address concerns that such fundraising will create a channel for fraud by allowing upstart companies to issue illiquid shares to retail investors.
“The proposal before us today appears to offer great promise for providing capital to small businesses so they can survive and hopefully thrive, but it may also provide great risks to investors,” Democratic SEC Commissioner Kara M. Stein said before the vote in Washington. “If we don’t get it right, I fear that the promise of crowdfunding will be lost.”
The SEC’s proposal, open for public comment for 90 days, becomes the second regulation from the JOBS Act advanced under Chairman Mary Jo White. In July the agency approved a rule lifting the ban on advertising for investors outside of a public offering, which eased the ability to market directly to investors considered sophisticated and wealthy enough to understand the risks of investing and withstand a loss.
Crowdfunding has drawn wide interest because it will be open to any investor regardless of their income or net worth. Under the proposal, crowdfunding must be done online through an entity that provides investors with forums to ask questions and communicate about a deal.
“All investors, not just the so-called accredited investors, will have the opportunity to invest in entrepreneurs and their ideas at an earlier stage than ever before,” Republican SEC Commissioner Michael Piwowar said.
Businesses using crowdfunding could raise no more than $5,000 a year from someone whose income or net worth is less than $100,000. Investors with income or net worth greater than $100,000 could contribute as much as 10 percent of their annual income or net worth, to a maximum of $100,000 in one year.
The proposal doesn’t require businesses or funding portals engaged in crowdfunding to verify compliance with those restrictions. Instead, a crowdfunding portal must ask investors to disclose their income or net worth as a means of determining compliance.
“It does make it easier for portals to operate with a large number of investors, which is within the spirit of the law,” said Rory Eakin, chief operating officer of CircleUp Network Inc.
The proposal creates a new regulatory regime for platforms such as CircleUp if they decide to engage in equity crowdfunding. The SEC estimates that 50 portals will initially participate in the market once the rules are adopted. Portals aren’t allowed to recommend deals or give investment advice.
Other portal operators that have shown interest in equity crowdfunding include Indiegogo Inc., EquityNet LLC, and RocketHub Inc. Kickstarter Inc., the most popular crowdfunding platform to date, has said it doesn’t intend to participate in equity crowdfunding.
A company using equity crowdfunding is limited to raising a maximum of $1 million per year. While companies raising smaller amounts would have to share financial statements and income-tax returns with investors, a business looking to raise more than $500,000 would have to provide audited financial statements. That requirement may deter some companies from participating in equity crowdfunding, Eakin said in a phone interview.
“It’s a very expensive process for early stage companies to spend $20,000 or $30,000 to have an audit,” Eakin said. “Venture firms historically don’t require those in Silicon Valley.”
Companies may intentionally limit their crowdfunding pitches to less than $500,000 to avoid having to hire an auditor, said Judd Hollas, chief executive of Fayetteville, Arkansas-based EquityNet.
“A formal audit is relatively rare and I’m a little bit surprised to see that is a requirement,” Hollas said.