Originally published in The Street
By Douglas Fink
In 2016, crowd financing will become big business for small- and medium-sized companies. But tech-start-up unicorns? Not so much.
Thanks to new SEC rules finalized at the end of October, this year non-accredited investors will be able to invest up to $1 million in startups and middle market companies, opening up a way of raising capital that will appeal to businesses ranging from those without revenues to companies with annual sales of up to $5 million. The rules, part of Title III of the Jumpstart Our Business Startups (JOBS) Act of 2012, go into effect in May.
Most people are familiar with crowd funding — long a popular way of raising small amounts of money in return for rewards and perks. More serious crowd-backed corporate financing should be called crowd-finance — offering equity ownership or debt in return for an investment. In other words, crowd finance, also sometimes called equity crowdfunding, is a security offering that offers an expectation of return. In 2016, crowd finance will no longer be only for smaller startups and ideas, but also for bigger, more traditional businesses.
A local dry cleaning chain could fund its expansion or finance switching to organic cleaning. A developer could fund a construction project.
It’s a large potential pool of investors: Non-accredited investors comprise most of the population. Accredited investors have a net worth of at least $1 million, excluding your home, or an income of at least $200,000 or, if married, $300,000 for each of the last two years.
It’s a market that should be in full swing by mid 2016 so the SEC’s timing, intentional or not, is good.
One thing you probably won’t see, however, are many technology “unicorns” being crowd financed under Title III. That’s because if a company has more than $25 million in assets or takes on more than 500 individual investors, it must disclose financials — something many companies with billion dollar valuation ambitions would find onerous.
There are ways around the rule. For instance using a single broker-dealer for a raise could allow the securities to be held in street name, so there’s only one “shareholder.” Using a broker-dealer could also allow for some flexibility to crowd finance funds under different regulations, such as Title II or Reg A+. Title II allows access to accredited investors only. Reg A+ allows participation by unaccredited investors.
Crowd finance will find a sweet spot with less glamorous middle market businesses.
Globally, crowdfunding is already a $34.4 billion industry that grew 167% between 2013 and 2014. Only recently have the evolving regulations allowed U.S. investors to participate.
In fact, projections are for crowdfunding to overtake venture capital in 2016 in the total amount of money raised.
On Sept. 23, Title II of the JOBS Act, which only allows accredited investors to fund private companies, turned two. Data compiled by Crowdnetic about Title II investment reveals a great deal about what we might expect as crowd finance widens under Title III.
In the second year of Title II, there were 6,063 capital offerings, raising about $870 million, up from 4,712 offerings for commitments worth $386 million during the first year of Title II. That was a 125.5% increase in capital commitments – an indication that this new way of raising capital is becoming accepted. The majority of offerings (4,171) raised equity while 1,202 were for convertible debt and 548 of the offerings raised debt.
Over the last year, financial companies raised the most capital ($277 million), followed by services firms ($198 million) and technology companies ($134 million). Other sectors that raised significant capital last year included energy ($72 million), consumer goods ($71 million) and healthcare ($59 million).
When should a small company consider crowd financing rather than venture capital or private equity?
Crowd finance will particularly appeal to those wanting to retain control of their firm. In the United Kingdom, Australia and Israel, such funding has been used to sell an average of between 10%-20% of a firm’s equity. By contrast, venture capital firms typically take the vast majority of a company’s equity. Private equity typically demands less but still takes a majority in return for its investment. Most VC and PE investors typically don’t finance less than $15 million.
Crowd finance also carries the least risk to the business in that capital will not have to be repaid if the enterprise fails. For many companies, it will be the first opportunity for serious financing after getting a basic line of credit or loan from the local bank.
Companies will be able to use portals or broker-dealers to raise up to $1 million. Companies needing to raise more money can work with broker-dealers. Larger companies particularly will benefit from using broker-dealers rather than raising cash directly through web sites because the additional preparation and paperwork should help them attract a higher-caliber of investor.
Still, the changes come at a great time for America. The driver of the American Dream has always been its can-do entrepreneurial spirit and yet there have been major criticisms in recent years about regulations throughout the country that hamper start-ups and early stage companies.
Title III should certainly make business creation easier because it does not require a firm to have audited financial statements. It will be the cheapest way of raising capital known to man, allowing young companies to keep more of their scarce dollars to hire staff rather than paying legal fees — something that’s good for everyone.