Are we about to start a new era of American capitalism? With the Jumpstart Our Business Startup (JOBS) Act just days away from being passed into law, start-ups will soon have new avenues to raise money. Currently, only accredited investors can buy equity in private companies. If the JOBS Act passes, private companies will be able to present securities offerings to the masses through the Internet. This is known as equity-based crowdfunding.
Crowdfunding itself isn’t new. Donation-based crowdfunding (such as kickstarter.com) and debt-based crowdfunding (such as LendingClub.com) are both legal forms of this. In the former, “investors” receive either a gift in return or no return at all. In the latter, investors are actually creditors, lending companies up to $50,000 a year.
Under the JOBS Act, equity-based crowdfunding will allow anyone to purchase equity in a company and receive a portion of its profits. It’s like selling shares on a public stock market without actually going public in the traditional sense.
Start-ups will be able to raise up to $1 million a year online from a large number of small investors in exchange for equity. Start-ups will also be able to raise up to $2 million a year if they provide audited financial statements. When the JOBS Act is passed into law, private companies will be able to take on as many as 2,000 investors before triggering securities regulations. Right now, private companies are limited to 500 investors before the SEC requires action.
What are the pitfalls?
There’s a lot of debate and concern about crowdfunding and the potential for fraud. When mom-and-pop investors buy shares in a public company, they do so with the assurance that that company’s books are open and have been audited. This isn’t always the case with crowdfunding, so it’s even more important for investors to do their due diligence. To limit exposure to fraud, the act stipulates that an investor with an income or net worth below $100,000 is limited to investing 5% of their annual income up to a maximum of $2,000. For wealthier investors, it’s 10% of their income or net worth, up to a maximum of $100,000.
Where to from here?
The core purpose of crowdfunding and the JOBS Act is to increase American job creation and economic growth by improving access to the public capital markets for emerging growth companies. In theory this makes a lot of sense and I am always a proponent of helping entrepreneurs. However, I’ve personally heard from a few start-ups in the Bay area that they wouldn’t be interested. One of their main concerns is related to follow-on funding. Imagine you have been successful at raising $100K from 200 separate investors. This has the potential to scare off angel investors or venture capital investors down the road. I also hear that the biggest hurdle to new start-ups is not always the money. Rather, it’s the network of professionals and advisors they need to be successful.
While jury is out on equity-based crowdfunding, it’ll be interesting to see if this really is the dawn of a new era of American capitalism.
Let us know what you think.