As the holiday season approaches, it seems inevitable: Our social media feeds will begin to fill with appeals to support our friends – or friends of friends – in their latest projects on Kickstarter or GoFundMe.
Crowdsourcing has gone from something of a curiosity to a well-established tool for a variety of entrepreneurs and artists, from board game designers to online video creators to organizers of charitable causes. I recently contributed to a Kickstarter campaign, launched by a college professor at my alma mater, for the creation of a card game about social science experiments and human behavior. But while crowdfunding is common, it has still largely been framed in terms of gifts or donations; participants often receive “perks,” including insider information, swag or early copies of the product being funded, but no contribution to a Kickstarter campaign has ever been an investment in any traditional sense.
That is about to change.
The Securities and Exchange Commission recently adopted rules implementing a 2012 law that opened the door to startups selling stock directly to retail investors through crowdfunding-style portals. Starting next year, businesses will be able to offer investors a piece of their company by legally selling securities online.
In a press release, SEC Chairwoman Mary Jo White said, “There is a great deal of enthusiasm in the marketplace for crowdfunding, and I believe these rules and proposed amendments provide smaller companies with innovative ways to raise capital and give investors the protections they need.” (1)
The SEC’s rules place limits on these crowdfunded equity offerings. Potential investors whose annual income or net worth is less than $100,000 will be restricted to investing a maximum of 5 percent of their income or net worth, or $2,000 – whichever is greater – across all crowdfunding offerings. For investors above this threshold, investments are capped at 10 percent. Overall contributions are also limited to $100,000 total over the course of a 12-month period. The rules additionally restrict resale of crowdfunding securities for a year after purchase in most cases.
The rules impose limits on issuers too, including disclosure requirements for certain business information and a $1 million cap on the amount the issuer can raise through crowdfunding in a 12-month period. Firms that want to raise more than $1 million can do so, but will have to provide financial statements audited by independent accountants, something that may be out of reach for many new startups.
Further, the SEC has created a framework for broker-dealers and the funding portals that will fill this new crowdfunding niche. The rules are final, though they will not take effect until May 2016; portals will be allowed to register with the SEC beginning in January.
In general, I am not opposed to this new arrangement. Within reason, it could potentially offer investors opportunities to support businesses whose goals align with their own or whose proposed products appeal to them. But given the wide appeal of crowdfunding, I worry about those inexperienced investors who may invest the majority of their portfolios in one or two startups, imagining they will strike it rich by getting in on the ground floor of the next Uber or Facebook.
At my firm, we allocate a portion of certain clients’ portfolios to private companies, but we make sure our clients are in a position to make such investments responsibly. (Previous rules restricted investment in most private companies to “accredited investors,” meaning investing in private companies was off the table for many individual investors, regardless of their preferences.) An investor should first establish a well-diversified portfolio, invested in marketable securities across various asset classes and largely through mutual funds and exchange-traded funds to avoid company-specific risk. Even for investors with sizable, well-diversified portfolios, we usually recommend a maximum of no more than 10 percent be dedicated to private companies.
That is because, while startups and other private companies can be very rewarding, they are also very risky. According to The Associated Press, about half of all small businesses shut down within five years of launching. (2) Other estimates are much higher – some peg overall startup failure rates as high as 90 percent. Even well-capitalized companies that seem poised for success can be blindsided by a crucial flaw in a product, a poorly timed bout of bad publicity or legislative changes that undercut their business model. The more concentrated the position in any one company, the greater an investor’s risk.
Savvy investors know this and proceed cautiously. But I worry that inadequate education on the risks of startup investing, combined with the enthusiasm of crowds and the ease of using a Kickstarter-like website, may lure overly optimistic people toward investments that are much riskier than they seem on the surface. If everyone on your Facebook timeline is jumping on board, it may be easy to think “Why not?” in the same way it is much easier to donate to the Indiegogo campaign your friend just liked than it is to vet established charities on sites like Guidestar or Charity Navigator.
Investors with access to professional financial advisers, as well as institutional investors, also have advantages when performing due diligence on startup companies. They may have access to resources out of the average investor’s reach, or better context for understanding the information in front of them. A novice investor’s lack of know-how will doubtless be complicated by the fact information on private companies is sometimes limited, though the SEC’s disclosure rules are designed to combat this hurdle, at least in theory.
I also wonder how the SEC plans to ensure that investors comply with the restrictions on how much they are allowed to commit over the course of a year. The rules suggest the commission is placing the burden on the new funding portals, which must be SEC-registered from the outset. Portals must “have a reasonable basis for believing an investor complies with the investment limitations,” (1) but what safeguards will count as reasonable has yet to be determined.
Since there will almost certainly be a number of platforms established, what will prevent an investor from setting up accounts on multiple platforms to make investments significantly above the SEC’s limits?
White has said that SEC staff will “keep a watchful eye on how this market develops,” (2) but there is no immediate answer to the question of where the buck will stop regarding the limits the SEC expects platforms to enforce. The commission will issue a report on whether investor protections are robust enough within three years of the rules’ taking effect. In the meantime, investors will simply have to wait and see.
In the end, the new rules may help some startups get on their feet, and some smart investors may do well in helping them. But without education and sufficient enforceable protections, it is all too likely that some investors may get burned through too much optimism and fear of missing out on the next big thing.
1) www.sec.gov/news/pressrelease/2015-249.html, U.S. Securities and Exchange Commission, “SEC Adopts Rules to Permit Crowdfunding”
2) www.usnews.com/news/business/articles/2015/10/30/sec-opens-door-to-startup-investing-for-all, U.S. News & World Report, “SEC blesses public crowdfunding for startups, but will keep ‘watchful eye’ on potential risks”