On October 30th, the SEC approved Title III (equity crowdfunding) of the JOBS Act, opening the floodgates for everyday investors to put money into small startups - and for businesses to crowdfund their capital. The law overturns restrictions on who could invest in early-stage companies in return for equity: previously, only SEC-designated "accredited investors" (basically, high net work individuals) could put money into startups, equity-based crowdfunding projects, and other private investments. Now, pretty much anyone can invest in private companies in exchange for equity. We'll break down how Title III will be implemented, and what it means for companies looking to raise funds.
What's changed with Title III?
Before we talk about Title III, here's a bit of historical background. The Securities and Exchange Commission (SEC) was founded in the wake of the Great Depression to protect the public from fraud and prevent unwary or uninformed investors from losing their shirts. According to SEC guidelines, only accredited investors who met income and net-worth tests could invest in private companies, which aren't subject to the strict disclosure rules that publicly traded ones are. Most recently, an individual could be an accredited investor only if her income exceeded $200,000 annually (or $300,00o combined with a spouse), or had a net worth over $1 million excluding her primary residence (either individually or with a spouse).
This pretty much restricted private investing to corporations (like private equity funds, venture capital firms, banks, partnerships and nonprofits) and to high net worth individuals. As a result, businesses wanting to raise capital concentrated their efforts on the wealthy or on professional investors. Sure, crowdfunding platforms like Kickstarter and Indiegogo existed, but crucially, they relied on rewards like newly created water bottles, DVDs or meetings with entrepreneurs, rather than straight-up equity.
Title III of the Jumpstart Our Business Startups (JOBS) Act blows open the gates that kept everyday people (91% of Americans, according to the SEC) from funding private companies in exchange for equity. This means that a small startup looking to raise a $500,000 seed round can skip the PowerPoint pitch to join Sequoia Capital's portfolio, and instead turn to a crowdfunding platform where a large number of investors can chip in for a stake of the company.
The new regulations
Of course, Title III doesn't mean that startups can solicit money completely without oversight. Here are some of the restrictions a business looking to crowdfund faces:
- Anyone can invest up to $2,000, but after that, income and net worth designations still apply.
- Crowdfunding must take place through an SEC-registered funding portal, or through a broker or dealer; however, businesses can use Facebook, Twitter, email and the like to raise awareness of their offering.
- These rules impact only companies that raise up to $1 million.
- Auditing and disclosure rules are still in effect: though a previous provision requiring costly audits has been waived for first-time crowdfunders, crowdfunded businesses must disclose pertinent financial information in an SEC-specified manner.
The big takeaway, though, is this: startups can now make their pitch directly to everyday consumers, rather than only focusing on corporate entities or the wealthy.
So what does this mean for businesses raising money?
If you're a startup looking to raise less than $1 million, this might well be a game-changer. Research has shown that venture capitalists' decisions are biased by everything from gender to geographic location to whether the founder and VC went to the same school; the ability to bypass traditional channels may help more diverse or less traditional startups get off the ground.
According to a DataFox analysis of 1,642 companies founded in the last three years that have raised funding,* startups show remarkably similar traits:
- 20% had an executive who attended Stanford, Harvard or MIT for undergraduate, graduate or business school
- A whopping 37% were located in the Bay Area
- A further 15% were located in New York City
- 11% received investments from Y Combinator, Andreessen Horowitz, Google Ventures or Kleiner Perkins Caufield & Byers
*Our analysis excluded companies where executive school, location and investor information was unavailable; of 6,142 funded U.S.-based companies founded after November 2, 2015, we analyzed the 1,642 with complete information.
The data can be interpreted in different ways. You could argue that certain schools may attract the most entrepreneurial talent, the best and the brightest move New York and Silicon Valley, and a few top-tier venture capitalists are best equipped to allocate capital. On the other hand, you could say that VC's unfairly favor those in the same alumni networks and those who already have enough money to pay sky-high rents, and that a small number of of people have an outsize influence in determining what products make it to market. If you fall on the side of interpreting funding homogeneity as bias, you may see Title III as an avenue to overlooked startups getting the capital they need and deserve.
It's too early to tell, of course, whether such homogeneity reflects bias or solid assessment, or even whether smaller investors will fund different types of companies. Still, a new avenue for fundraising has been opened. Look for more and more startups to pursue crowdfunding, especially those left out by the traditional funding system.