Investing

The New Crowdfunding Rules: What They Mean For Investors

Sherwood Neiss | November 8, 2015

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Sherwood (Woodie) Neiss is a principal at Crowdfund Capital Advisors and a leader of the securities-based crowdfunding movement. In the second of a three-part series, he looks at what investors need to know about the newly approved Regulation Crowdfunding rules (aka Title III), which go into effect on May 16, 2016.  

The new crowdfunding rules approved by the S.E.C. make good on the promise of the JOBS Act to give all individuals, regardless of their financial status, the opportunity to invest in private startups and small businesses. This is a big shift from the securities law that have prevailed since the 1930s, which erected high hurdles for small companies to raise money from anyone but the wealthiest investors.

So is this your chance to get in on the next Google, Twitter or Uber?  Probably not. However, this is an opportunity for you to DIVERSIFY into these opportunities. We stress the word diversify because investing into startups and small businesses is risky.

In its final rules, the S.E.C. cites all sorts of examples of how the majority of startups and small businesses fail within the first 5 years. Be smart and don’t put all your eggs in one basket.  Consider only putting a small percent of your overall investments into crowdfund opportunities.  This way if one fails, you won’t lose your retirement.  Put your money behind people that you know and businesses that you have experience in—this will also mitigate your risk.

Investment Limits

While you might believe you can do whatever you wish with your money, the government doesn’t believe so.  As a means to protect you, they’ve limited how much you can invest. The legislation allows anyone to invest up to $2,000 in aggregate a year. Above that, it depends on if your annual income and net worth are over or under $100,000 a year. And even of you are over that threshold, you’re still limited to $10,000 per year or 10% of your income or net worth in investments. It gets tricky, so we put together this calculator to help you figure out the maximum you can invest.

The Process

In order to invest in a crowdfunded company, you must open an account with a crowdfunding intermediary—either a crowdfunding portal or a broker-dealer (the latter is held to higher regulatory standards and therefore is able to recommend investments and handle your funds). The intermediary may allow you to sort through offerings based on a combination of objective criteria, such as by the percentage of the target offering amount that has been met or geographic proximity, for those looking for local deals.

Related: What the New Crowdfunding Rules Mean for Entrepreneurs

Once you make your investment—and you may do that via a credit card, according to the final rule revisions—your money will sit in an escrow account until the company either hits 100% of its funding target.  If it reaches the end of its fundraising period without  meeting its funding target, the money will be returned to you. If the company hits its funding early, it can choose to close sooner with a five day notice to the SEC and investors.

Change your mind? The rules build in a little time for buyer’s remorse: You’ll have up to 48 hours prior to close to cancel your order.   

Liquidity

Once the offering closes, you’ll need to sit tight if it’s an equity investment. Any potential return on your investment (and there is no guarantee) will be years off, when the company gets acquired or sold or some other liquidity event takes place. As an investor, you must hold the securities for a period of a year before they can be resold, unless you sell them back to the company, to an accredited investor, to a family member or family trust, or as part of an S.E.C.-registered offering. (The S.E.C., which has talked of the need for venture exchanges, plans to study the secondary trading market over the next three years).

The S.E.C. has opened the door for rating systems to develop around crowdfunded securities

If that long and uncertain time horizon makes you uncomfortable, look for securities structured as debt or revenue-share arrangements that pay regular interest or royalty payments. But, like equity shares, these securities cannot be resold for a period of one year.

Beneficial Owners

In the case that your investment makes you an owner of more than 20% of a crowdfunded company, be prepared for extra disclosures. The company will need to submit information about you and other “beneficial owners” to the S.E.C. so that the government knows who you are and that you aren’t a bad actor. It’s a bit draconian, in our view, but consider it fallout from the financial crisis and subsequent Dodd-Frank regulation.

Sherwood Neiss

Get Ready For Crowdfund Ratings

Intermediaries must by law do some basic vetting of companies to week out bad actors. And the S.E.C.’s disclosure requirements for companies raising capital are intended to give investors the information they need to make informed investment decisions. But there may be other ways to evaluate an offering that draw from  the wisdom of the crowd.

By permitting funding portals to let investors rate issuers or offerings—whether with stars or comments—the SEC has opened the door for rating systems to develop around crowdfunded securities. The goal is to allow other potential investors to see what others think of these deals. It will be interesting to see how this information is used by the crowd to guide their investment decisions and brings more transparency to the funding process.

Crowdfunding represents new opportunities for investors beyond the stock market. But be careful and do not invest more than you can afford to lose. The rules require that you positively affirm that you understand this every time you make an investment. So if you lose your shirt and want to sue, the form you signed certifying that you understand the risk will likely be used against you.

Read more about crowdfunding in our Investor Guide

Sherwood Neiss is a principal of Crowdfund Capital Advisors, a crowdfunding advisory, implementation and education firm.

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