Avoiding The Equity Crowd Funding
The new JOBS Act allows small private startup companies and entrepreneurs to raise capital by offering equity to unsophisticated investors. The question is: is this a good thing or a bad thing? The answer depends largely on who you ask. The approach, called equity crowd funding, is an offshoot of an earlier method, in which individuals donated money to projects in return for gifts and tokens. The JOBS Act allows individuals to invest money in these private companies in exchange for equity. Unlike older forms of private placements, a company need not provide extensive documentation to raise up to $1M a year ($2M if it provides audited financial statements). Also new is the ability for the company to market the equity openly on the Internet. Individuals can invest up to $2,000 (five percent) if they earn or own less than $100,000; otherwise the limit rises to $100,000 (ten percent).
The JOBS Act also increases the maximum number of investors in a private company from 500 to 2,000 before triggering security regulations. Triggering security regulations means that the company will have to register shares with the SEC before offering them to the public. Remember, investors need no longer be “sophisticated” or “accredited” (basically, wealthy) to join in the fun – the doors are open to everyone. What could go wrong?
Well, for one thing, there are few consumer protections built into the Act. Remember, these startup companies are private — they don’t have to disclose a lot of information to potential investors. Public companies can only offer shares if they’ve prepared a prospectus, which contains a lot of revealing information. Non-public companies who offered private placements have had to prepare a special memorandum – very similar to a prospectus in a number of ways. Now, under equity crowd funding, a few financial statements will do. Don’t expect a lot of recourse if you hook up with some shady operators.
But the biggest losers will be angel investors and the companies they invest in. Angels fund small startups in their early stages in return for some ownership of the company. In return, the company gets needed funding plus (and this is very important) valuable advice from experienced investors. In the new scheme, angels may be crowded out of a new company, depriving that company of the kind of guidance only sophisticated investors – like angels – can provide. The fear is that, for lack of this guidance, companies will make more mistakes and ultimately face a higher risk of failure. We shall see in the fullness of time how this little experiment in finance will play out.