In prior blog posts, we noted a couple of regulatory changes that eased some restrictions on (relatively small) securities-based fundraising from a wide base of investors.
- Regulation A+, which became effective in June 2015, increased the annual offering cap from $5 million to $50 million for (smaller) companies that are not subject to the full SEC reporting requirements.
- Beginning May 2016 companies may use crowdfunding to raise up to $1 million a year.
This blog post provides an update on the second development (crowdfunding). The SEC published an investor bulletin recently that discusses a number of related rules and features:
- Investment restrictions. The crowdfunding rules permit any non-accredited investor to participate in the raise subject to certain limits based on annual income or net worth. An individual with an annual income or net worth below $100,000 can invest (during a year) up to 5% of such income or net worth, or $2,000, whichever is greater. Individuals with annual incomes or net worth greater than $100,000 are limited to annual investments of 10% of their income or net worth (with a cap at $100,000).
- Financial disclosures. Crowdfunding companies are required to provide certain information regarding the company, the offering, and the planned use for the funds raised. Companies raising less than $100,000 (in a 12 month period) are required to disclose financial statements and certain items from their tax returns. Financial statements are required to be reviewed by an independent public accountant if a company raises between $100,000 and $500,000 a year. Larger raises (of up to $1 million) require audited financial statements (for first-time users of crowdfunding, reviewed financial statements would suffice).
- Intermediaries. Companies offering crowdfunded securities are required to use a broker-dealer or funding portal that is registered with the SEC and is a member of the Financial Industry Regulatory Authority (FINRA). The broker-dealers and funding portals are required to provide educational materials that help investors understand the risks around crowdfunding investments. In addition, the broker-dealers and funding portals are also required to provide for a venue where investors can communicate with each other regarding the investment opportunity.
In addition to noting that these investments are inherently speculative and susceptible to fraud, the SEC investor bulletin mentions two risk items with valuation implications:
- Illiquidity. Except under limited circumstances, investors are generally prohibited from reselling their investments for a year. Even after the one-year restriction lapses, a ready market for the securities may not exist. Imposed or inherent illiquidity would (should?) likely impair the valuation of these securities relative to more easily tradable alternatives.
- Valuation and capitalization. Valuations of private companies, especially startups, are difficult. Additionally, the rights and preferences of the offered shares may be inferior compared to other securities that comprise issuing company’s capital stack.
Crowdfunding and issuances under Regulation A+ are unlikely to displace traditional venture capital investments as the dominant, preferred mechanism to raise funds that fuel growth for pre-public companies. However, these fundraising channels are potentially interesting for two reasons:
- Offering events have the potential to yield timelier valuation-useful information on the underlying companies.
- Offerings will also create a class of (at least theoretically) tradable securities, which may provide employees and early-stage investors with an avenue for liquidity, even in the absence of exit events or more organized secondary transactions.
Assuming a suitable transaction-crossing platform for the new securities will be available, more frequent capital events and trading will yield some pricing data, whatever the degree of information asymmetry between the transaction participants. This leads to the ultimate valuation question – will the relative democratization of (early-stage) investing deliver adequate market efficiency to provide reliable pricing indications for (all classes of) hard-to-value securities issued by pre-public companies?
- Crowdfunding to Provide Alternative Capital Source to Early-Stage Companies
- Regulation A+: Raising the Capital Cap for Small Companies
- Startup Stock Secondaries: Cash In Early, Cash In Often?