A Kickstart for Business Financing? SEC Issues New, Long-Awaited Investment Crowdfunding Rules

RedmanIn big news for businesses and investors, national investment crowdfunding has arrived at last. On October 31, 2015, the U.S. Securities and Exchange Commission (SEC) approved rules for investment crowdfunding under the 2012 federal JOBS Act. Simply put, for the first time in recent memory, businesses can raise money through investment crowdfunding at a national scale. This is a big change in securities law. But what does it mean? Let’s start with the basics.

Why do local investors and businesses care about securities law? A “security” is almost any note, loan, or investment made in someone else’s business made with the expectation of repayment. A business can face severe penalties under state and federal law if it offers or sells a security unless the security is (a) registered with the government or (b) exempt from registration. Traditionally, securities law has made it difficult for small businesses to offer or sell investments directly, particularly publicly or to the average person.

In other words, it is technically unlawful to ask a neighbor to invest even $10,000 in your business unless the security is registered or meets exemptions under state and federal law, especially if you wanted to publicly ask for money, such as through social media.

But what do the new rules change? I thought crowdfunding was already legal. There are two types of crowdfunding to keep in mind: the first, “donation” or “rewards” crowdfunding has been “legal” for a long time because it isn’t an investment; it is a gift made without the expectation or repayment or profit (think Kickstarter or Indiegogo).

The new rules address investment crowdfunding, which is subject to securities regulation because the money is given with expectation of repayment. Michigan adopted the “Michigan Invests Locally Exemption” (MILE) Act allowing investment crowdfunding in Michigan in 2012, but it wasn’t previously allowed at the national level.

What will a crowdfunding raise look like under the new JOBS Act rules?
JOBS Act crowdfunding must be done online, through a web portal registered with the federal government. Prior to raising money, businesses register with the SEC, including numerous disclosures, and set a deadline by which to raise a target amount. A business can raise up to $1 million in a 12-month period (reviewed financial statements are required to raise over $100,000, and audited financials to raise over $500,000). The SEC predicts the registration process could cost up to: $11,667 for a business raising $100,000; $29,333 for a business raising $500,000; and $238,583 for a business raising $1 million. There are ongoing investor reporting requirements.

Is all investment crowdfunding “equity crowdfunding?”
No. Investment crowdfunding can be lending or equity based, and globally lending-based crowdfunding is much more prevalent than equity-based crowdfunding (approximately $11.08 billion in 2014 for lending, compared to $1.11 billion for equity).

Will crowdfunding mean regular people fritter away savings in fraudulent or bad investments?
No one can predict the future, but the rules do provide some investor protection. Businesses must disclose significant information about their business and are subject to strict penalties for fraud. To harness the “wisdom of the crowd,” investors can ask questions and discuss the investment opportunity publicly online. In addition, investors with annual income or net worth of less than $100,000 are limited to the greater of: up to 5% of the lesser of their annual income or net worth; OR $2000; whichever is greater, in aggregate annual federal crowdfunding investments.

How is the new JOBS Act crowdfunding different from MILE crowdfunding?
Because the Michigan MILE complies with the federal “intrastate” securities law exemption, it can only be used by a Michigan business seeking money from Michigan residents to spend primarily in Michigan. However, in other ways the MILE is more flexible: the securities registration process is simpler and cheaper; investors can invest up to $10,000 per business per year, with no annual aggregate limit; and businesses do not have to use the internet to advertise the investment.

What does this mean for local businesses and our community?
Instead of looking only to banks and rich uncles, businesses can publicly ask their customers for investment. Similarly, instead of only investing money through a broker in Wall Street, community members can pool money with their neighbors to invest in the local businesses they want to see and support in their community.

But crowdfunding is not necessarily local or community-based investment: JOBS Act crowdfunding will likely involve raising money nationally. Small businesses who want to raise money from their neighbors or a smaller community may still want to consider the MILE Act or other forms of community-based investment.

This is exciting! When can I start investing?
The regulations will not be effective until 180 days from when they were approved by the SEC, although the forms for web portal registration will be available in January 2016. After that, we will see if national investment crowdfunding lives up to its hype.