By Ed McLaughlin and Wyn Lydecker
The long-awaited approval of equity crowdfunding opens a gateway of capital for small businesses, but it also introduces serious hurdles. What benefits were set in motion when the S.E.C. voted in favor of Title III of the JOBS Act? What are the risks for investors, and what challenges now stand in the way of its implementation?
New Source of Wealth Creation
Equity crowdfunding opens the door for people who earn under $200K or have a net worth less than $1Million (excluding their primary residence) to invest in startup companies. These investors are classified as “non-accredited.”
These investors can now take hold of the chance to invest in the early stages of new businesses, which is when the majority of startup growth occurs. This early-stage window of opportunity has only previously been available to a more wealthy class of investors who can withstand the risk.
Risky Business for New Investors?
While the opportunity to level the playing field for investors is a good one in theory, the New York Times article, S.E.C. Gives Small Investors Access to Equity Crowdfunding, sheds light on the scenario for inexperienced investors who may buy “risky, illiquid” shares. Said another way, if these new investors want to sell their shares, they may find a marketplace void of buyers. In the article, security fraud attorney, Andrew Stoltmann, said, “Ninety-nine percent of these deals will prove to be unprofitable. This is a disaster waiting to happen.”
How Experienced Investors Assess Risk
Ben McClure’s Article, How Venture Capitalists Make Investments Choices, explains how experienced investors assess the risks vs. the rewards. They know how to discern the strength of a startup’s management team, the size of the market, and whether or not they will see a return on their investments. They also know – what they don’t know. McClure lists some of the additional questions seasoned investors know to ask:
- Could regulatory or legal issues pop up?
- Is the product right for today or 10 years from today?
- Is there enough money in the fund to fully meet the opportunity?
Are New Rules a Cash Drain for Small Business?
What will it cost for small businesses to raise funds through equity crowdfunding? Measuring the expense to small businesses and startups in both dollars and time consumption, the article, Why Title III of the JOBS Act May Be a Flop, by Forbes Contributor, Tanya Prive, summarizes the cost to small business founders:
- The S.E.C estimates that small businesses will have to invest about 100 man-hours of their own in-house work and that of hired professionals such as lawyers and accountants. The associated expenses could run from $6K to $20K.
- Given the fact that 2014 saw a funding upswing approaching $2Million in seed-deal sizes, the equity crowdfunding limit of $1Million within a 12 month time-frame may not provide enough capital. Founders may have to engage in additional time-consuming efforts to find more funding.
- The likely need for founders to raise more than $1Million will bring them to an elevated fundraising tier above $500K – at which point the S.E.C. will automatically require a new level of financial statements. In addition, these financials will need to be audited, and this will incur an additional expense of $10K to $40K.
- Current regulations call for the small businesses to file annual reports, which will require an additional 50-95 hours of work every year for the life of the company.
Why Small Businesses Are Worthy Investments
Given their important role in the U.S. economy, small businesses are a deserving group for investment capital. The SBA Office of Advocacy reports these significant small business contributions:
- Small businesses represent 99.7 percent of all employer firms
- They employ about half of all private sector employees
- They pay 43 percent of the total U.S. private payroll
- They hire 43 percent of high tech workers
- Over the past 17 years, small business has generated 65 percent of net new jobs.
Whether you are a startup, a small business looking for working capital, or an investor who wants to place a risky bet on a fledgling company, it’s ultimately your decision and your risk to take. But first, you should become educated about the regulations, weigh the pros and cons, understand the risks and the expenses, and seek out a knowledgeable professional advisor, such as an attorney or accountant, before you take a dive into the equity crowdfunding pool.
Ed McLaughlin is currently co-writing the book, The Purpose Is Profit: The Truth about Starting and Building Your Own Business, with Wyn Lydecker.
Copyright © 2015 by Ed McLaughlin All rights reserved.