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How would you like to solicit investors for your small business using a Kickstarter model? In the past you were only allowed to seek equity investments from “accredited investors," but thanks to the Security and Exchange Commission’s (SEC) new crowdfunding rules things will change in May of 2016.
Before we talk about the future, let’s look at the past. Previously, small business investing has largely been off limits to smaller investors. Let’s say that you were a startup looking for some cash to help get your new business off the ground. You could go to family or friends and ask for money or you could ask a bank, but getting a small business startup loan was - and is - difficult.
If you wanted to fund a certain project, platforms like Kickstarter and Indiegogo would let you seek donations for your project, but those who did donate money to you got no equity in your business. Instead of equity, you'd have to offer some kind of perks to encourage people to fund your project through donation-based crowdfunding platforms. Such perks might include anything from a free newsletter, to early access to the product, to trips to meet the project developers. The more valuable the perk, the higher the donation requirement to receive it.
Under the old rules, a business owner could use a crowdfunding model to find equity investors, but the crowd was quite small. Anybody investing in a small business had to be an “accredited investor”—somebody who has more than $1 million in assets not counting their primary residence. Or they have earned at least $200,000 for at least the past two straight years. Most business owners don’t know a large number of people who meet those rules—essentially the 1 percenters.
The New Rules
Making good on a promise it made late last year, the SEC revised crowdfunding rules to make it easier for investors with a smaller net worth to take a stake in a small business. But those rules also make it somewhat difficult and costly for small businesses to use crowdfunding to seek investors. They also limit the total amount of capital that can be raised this way, as well as limiting the percentage of their net worth that non-accredited investors are allowed to invest.
1. Caps on the Amount
Under the new rules a business can raise a maximum of $1 million in a 12-month period by selling shares of their business to the public (ie, non-accredited investors).
2. Must Use an Exchange
A business owner won’t be able to hop on Craigslist and start selling shares of their company in exchange for an equity stake. They will have to go through an accredited exchange, to offer equity stakes. Those broker-dealer model exchanges will collect all required documentation from the owner before offering the funding opportunity. Expect to pay a substantial fee for using the portals.
3. Unaccredited Investors
Good news, non-1-percenters can get involved in crowdfunding under the new rules. There are no minimum income requirements; however, the SEC has set these limitations on the total amount that can be invested by unaccredited investors in a 12-month period:
- An individual whose net worth is under $100,000 can only invest either:
-- 5% of the lesser of their annual income or net worth
- If an individual's annual income and net worth are both equal to or more than $100,000, they may invest up to 10 percent of the lesser of their annual income or net worth
- During the 12-month period, the aggregate amount of securities sold to an investor through all crowdfunding offerings may not exceed $100,000.
4. Reporting Requirements
If you plan to solicit crowdfunding money, prepare to act more like a publically traded company. The SEC requires you to disclose the pricing information including the target offering amount, the deadline to reach that amount, and whether you will accept money in excess of your target. In other words, when an investor makes an investment, what will be the value of their equity stake?
Next, you have to provide information on your company’s financial health including information from your tax return and either reviewed or audited financial statements if this is the first time seeking funding under the new rules.
As part of the documents required for listing, a company has to provide the names of all officers, directors and people who own at least 20% of the company.
Finally, companies have to file an annual report with the SEC and provide it to investors.
Small business owners may see interest from people holding a self-directed IRA wishing to invest through non-traditional means. It’s possible to invest in products outside of traditional stocks, bonds, and ETFs. Self-directed IRA holders have purchased property, for example, but the rules surrounding those purchases are vague. The IRS tells account holders what they can invest in but the list of prohibited investments is murky.
In the case of crowdfunding, the Unrelated Business Taxable Income rules or UBTI imposes an additional tax on tax-exempts like retirement accounts if they invest in income from operations of an active business. Most small businesses will fit that definition. Because the tax can be as high as 39.6%, using retirement funds to invest in crowdfunding activities will only be tax inefficient for a select few, according to experts.
Investors Are On Their Own
The SEC wants people to know that these investments are exceedingly risky. Startup owners may have little financial experience and because individual investors have to hold their investment for at least one year, there’s little liquidity to be found early on. There are no protections in place like the FDIC and any conflict would be settled in court.
Critics complain that the rules surrounding crowdfunding are so strict that too many small business owners can’t be involved. Others say that creating a system to keep fraud to a minimum is essential to establishing credibility and an ongoing funding option. And anybody interested in seeing the crowdfunding platform grow doesn’t want to see large amounts of investors losing their money.
Either way, small business owners will have access to a much larger pool of investors than before. Once the exchanges are online and the rules fully take effect, small business owners desperate for cash may be able to find the funding they need to power them through the next stage of growth. But the rules are complicated, and before your business dives in, it would be wise to consult with an attorney who specializes in equity funding.
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