At the invitation of The Capital Network, I did a Reddit Ask Me Anything (AMA) all about crowdfunding – the new rules, issues, questions, concerns. Some good questions were raised by our fellow internet citizens, so I thought I’d share them, along with my hastily-typed answers, here.
Why is everyone talking about crowdfunding?
Two reasons: (1) PRODUCT crowdfunding campaigns such as those on Kickstarter and Indiegogo are doing very well and raising lots of attention. Note, on these platforms, you are getting the product, not equity in the company. (2) A whole bunch of EQUITY investing platforms have entered the market and are hoping that the SEC will allow for broad-based equity crowdfunding in the near future. These new entrants are currently making lots of noise/buzz about the prospect. Might be a little premature, since at the moment, those platforms are limited to accredited investors only.
What is the difference between product crowdfunding and equity crowdfunding?
PRODUCT crowdfunding is stuff like Kickstarter and Indiegogo where you pay in advance for the GOOD or SERVICE. Product crowdfunding is alive and well and totally legal under current rules. EQUITY crowdfunding is when a company offers the chance to buy a chunk of ownership in the company to the public. At the moment it is not currently permitted except (i) to accredited investors or (ii) solely inside of a given state if you are in a state where it is permitted. The SEC may broaden that, but their rules will include disclosure, limits and other investor protections.
Why all the hype about crowdfunding? What has actually changed to justify it?
In fact, there has actually been relatively little change to the U.S. laws and regulations so far. The only thing that is really new is the lifting of the ban on general solicitation. Private placements (i.e. all deals other than public offerings) are still limited to accredited investors, even if you are now allowed to generally solicit. And, if you do generally solicit, you bring a bit of extra work on yourself because you have to verify accredited status of the investors. The SEC is expected to publish new rules that may allow unaccredited investors to participate in crowdfunding, but it is my expectation, and the expectation of others who are close to the situation, that the rules will have some meaningful limits on the amount invested, some disclosure requirements and other investor protections. These may be viewed by the market as too stiff to be workable.
What is the new process for validating whether an investor is accredited?
The SEC has not spelled out specific rules. Instead they have laid out a "principles based approach" where, in effect, you can decide what the right level of proof is based on the situation. They have laid out some safe harbors such as showing your tax returns, getting a letter from your lawyer, tax person, or financial advisor, etc., but those are not required. It is up to the company to decide whether they have done enough. Couple side notes: the Angel Capital Association has created an "Established Angel Group" certification which allows companies to rely on EAG status as proof, which makes it much easier to certify angel investors in those groups. Also, there are now vendors coming into the market offering to do it for a fee. And some of the crowdfunding platforms already help or hope to be able to help investors on their platforms with certification.
Thanks, looks like dramatic improvement over their first efforts which would have required tax returns...
Yep, principles-based is much better. Nobody wanted to deal with sharing tax-returns. In addition to being a hassle and really intrusive from a privacy perspective, it was a major identity theft risk waiting to happen.
When do you expect the rules to be completed for non-accredited investors to be able to participate in early stage startups?
Many think that the rules will come out in mid to late 2015, but I think that might be optimistic. I was in a meeting with an SEC commissioner recently, and it really felt like she was talking very much in the future tense - I would not be surprised if they took well into 2016 to publish rules. They are very concerned about market integrity, investor protection and preventing fraud - they have not cracked that nut yet, so the rules might take a while.
Tell me more about general solicitation regulations. I've run an accelerator and awards ceremonies where we always encourage our entrepreneurs to promote their companies freely, what should we be telling them to do now?
In a sense, you are asking what the definition of what general solicitation is. Unfortunately, it is not actually defined anywhere in the SEC rules, and most of the case law and SEC advisory letters date back to, or are at least grounded in the days of newspapers, radio and television. But the concept is pretty simple - think of it as a very public discussion or media item about the terms of your offering with the intention of finding investors. Thus, demo days are the hard case and care must be taken here. Historically, demo days have kind of lurked in a bit of a gray zone. In many ways, the things entrepreneurs say at demo days and pitch contests are pretty close to what is typically thought of as general solicitation, yet most people intuitively feel it really should not be considered general solicitation. True, there are probably going to be some non-accredited investors in the room, but demo days are usually a relatively private gathering where companies make direct comments to an invited audience. Certainly, it is hardly the same as taking an ad out in a newspaper or radio program. As such, most people feel that, on a pragmatic level, they are still a pretty reasonable thing for companies to do. To play it safe, most demo day hosts should suggest the companies leave out the details of their offering and save that information for the f2f follow up meetings after the main event. Fortunately, the Angel Capital Association has a bill before congress called the HALOs Act that carves demo days out of general solicitation.
What is RegA+? Does it really make it easy to crowdfund?
Well, not exactly. Reg A+ is a new set of rules just published in late March by the SEC which are intended to allow money raising WITH DISCLOSURE. This is different than a typical Start-Up/Angel/VC deal which are exempt deals with no disclosure. Think of Reg A+ like a mini-IPO and followed by on-going disclosure requirements. In addition to that, and perhaps more importantly, there does not appear to be any way for market-makers to provide a buy/sell market after the offering, so the question of post-offering liquidity is very much up in the air. Without any prospect of liquidity, it is not clear who is really going to be able to use this. The utility of Reg A+ thus remains very much up in the air. If the SEC and exchanges allow a bit more spread for market-makers, or someone figures out how to make “venture exchanges” work, it may be possible to see some of these A+ deals starting to trade, but the concern is that any trades that do happen will be dark pool kinds of trades.
Is the JOBS act a GOOD or BAD thing for investors? For entrepreneurs? For Joe Shmo’s dipping their toes into investment?
The JOBS act has really not changed enough yet to affect the average investor in either a good or bad way, but it may over time. If the SEC allows for broad-based equity crowdfunding in risky startups without meaningful disclosure or limits, that might, ironically end up being bad for investors in the long run, depending on how you look at it. On the one hand, arguably everyone should have the right to invest in anything they want (freedom is good etc.), but on the other hand, the SEC was created to protect investors from those deliberately looking to take advantage of them. Historically, disclosure and public information has been the solution, and the small number of exempt deals allowed to be done without disclosure was limited to investors believed to be capable of withstanding the loss. As the SEC looks at further democratization of the markets, they are struggling to balance their two competing goals: (1) maximizing capital formation in the markets and (2) protection of investors by the prevention of fraud and protection of the integrity of the markets through sane rules on how it should operate. If they get the balance right it will be great for investors. If they go too light and it is a wild west, it could be bad. If they go too heavy and the resulting rules make equity crowdfunding too much of a hassle for the companies, no one will use it.
What is the best case scenario and what is the worst case scenario of mass crowdfunding?
BEST CASE SCENARIO: If implemented with reasonable limitations and protections, it might allow more companies to be funded and more people to participate. This could be especially good in the hyper-local context, for example, a rural area gets the badly-needed animal hospital it requires.
WORST CASE SCENARIO is inadequate or ineffective controls and limits leads to a free-for-all and a bunch of people, who can least afford to gamble away their savings, lose all their money in a few start-ups and the resulting political uproar brings a regulatory boom down on the early stage investing world which means, compared to now, less investment, higher costs, fewer startups funded, fewer jobs created, less national innovation and competitiveness. Not good at all.
So what's the middle of the road scenario? Which of the three do you think is the most likely to happen?
Not sure how much will change in the end. If the SEC does allow mass crowdfunding, it will undoubtedly come with disclosure requirements and limits. These may have the effect of making the “cost” of that capital higher and as a result, it may turn out that exempt private placements to accredited investors only ends up still being the most attractive and fastest way to raise money.
My friend raised $100k on Kickstarter. Should I do the same? Pros & cons of Kickstarter?
Kickstarter is a great way to raise money for a product, but even if you have a really successful campaign, it doesn’t mean you have a viable company (just a viable product, assuming you priced it correctly). You need to use all that money to build and ship the product. It is also worth noting that you have given away a lot of potentially useful information to your competitors - price, design, features, popularity, and availability date. For many entrepreneurs, that is well worth the trade-off, but for others, not so much.
Do investors view a company with a previous equity crowdfunding round as a good or bad thing?
Not sure there is a consensus here. And it would depend on how well the round was put together. If it has a great lead investor, there is someone good on the board, the valuation and other terms are good, and the company is doing well, no reason it would automatically be viewed negatively. If it is an uncoordinated mess, the terms or valuation are way off market, the investors have no one on the board and responsibility is diffused to the point that each individual investor has just totally checked out, it would likely be viewed as quite a negative - a very unfortunate and avoidable negative. So I guess you could say "it depends." :-)
So if I were to try my hand at equity crowdfunding as an investor, how much access to the startup’s information would I have beforehand? The other investors taking part of the round?
It is going to depend. Most people in a crowd funding round assume someone has done some due diligence on a company, but often is is not clear who, how much, or when. The more common assumption people seem to be making is that they are following an “expert” in the space who just knows a good company when they see one. If you are local, you could go and try to meet the company yourself, but that is not always possible. My suggestion is always to find some experience local angels or angel groups in your community to try and learn the mechanics of angel investing before venturing out onto the platforms where it can be much harder to judge what you are getting into.
For more on these topics, check out What Angels Need to Know about SEC Rule 506(c) and Understanding Crowdfunding.