Investing in startups used to be an option only for accredited investors, or people with a net worth of at least $1 million or income of $200,000 a year. Thanks to the regulation crowdfunding portion of the JOBS Act, it’s now an option for everyone.
Regulation crowdfunding is so controversial that it took the SEC four years and 600 pages of rules to finalize it. The rules were meant to protect investors while allowing businesses easier access to capital. It was a delicate line to walk. If the regulatory burdens on businesses were too expensive, no company — with other funding options — would pursue crowdfunding, leading to the worst-case scenario: only companies who couldn’t convince professionals would try to raise funds from unsophisticated investors. But if there were no protections at all, investors could easily be fleeced by scam artists.
The SEC got the balance nearly perfect, putting in tons of common-sense investor projections that aren’t an unreasonable burden on startups. But they missed two important details. As a result, everyday “retail investors” are structurally disadvantaged to wealthy investors until Congress passes the Fix Crowdfunding Act.
Right now, the rules contain these two provisions:
Companies are effectively capped at 500 retail shareholders. The SEC didn’t exempt crowdfunded securities from something called the Exchange Act. This means that even if a small business has more than 500 retail investors and $25 million in assets, it’s forced to report much like a public company. This is very expensive. Even Uber doesn’t do it!
“Single-purpose-funds” are not allowed. Wealthy investors are allowed to invest in special funds that only exist to invest in one company. The manager of this fund (often investing on the same terms) has a fiduciary obligation to look after those investors, and uses their sophistication and superior leverage to advocate for their interests during negotiations with venture capitalists. Retail investors don’t have these protections.
Here’s how those rules stack the game against middle-class investors looking to earn a return like professionals:
You can’t build a portfolio
Many companies will not accept more than 500 investors. As a result, for a company that wants to raise $1 million, the effective minimum investment will be closer to $2,000 instead of $100. However, most middle-class investors are legally restricted to investing less than $4,000 per year.
As a result, most investors can’t follow one of the most basic rules of thumb: don’t put all your eggs in one basket. Investors are limited to investing in no more than one or two companies a year.
You have no voting rights. No professional will advocate for you.
Accredited investors who invest through a “single-purpose-fund” typically invest under the same exact terms — with the same voting rights — as a professional “lead investor”. The lead investor may negotiate better terms, defend against unfair dilution by negotiating with venture capitalists, mentor the company, and represent small investors on the board.
Unfortunately, single-purpose-funds are not allowed in Regulation Crowdfunding. No professional investor will defend your interest, and, even worse, most companies do not offer voting rights.
This isn’t because founders are trying to take advantage of the crowd. Rather, founders are scared that collecting thousands of signatures from online strangers will endanger their follow-on financing and cripple the governance of their business. In contrast, there is no such risk when granting voting rights to a single fund where a lead investor acts as a fiduciary for smaller investors. From a founder’s perspective, that’s similar to dealing with a venture capital partner.
Your stake might be re-purchased. You have no pro-rata rights.
Without a single-purpose-fund, and with the threat of reporting like a public company with over 500 retail shareholders, many companies who crowdfund do so with securities that can be repurchased at fair market value.
If your stock is repurchased, this might not sound bad. You might think, “Oh, wow, I made 5 times my money in a year!” But this is a bad deal for someone trying to create a diversified portfolio, where the big wins must pay for all of the losses (which, with startups, is nearly every other investment). Imagine if you purchased Facebook stock in 2004, and were forced to sell in 2005. You’d be pretty unhappy.
The professionals do the opposite: they use their pro-rata rights to invest more in their best companies at each stage of financing. That’s one of the secrets that professionals follow to obtain better returns: put more money in the winners. They make lots of small bets to figure out who those winners are.
Congress to the rescue
Members of Congress on both sides of the aisle are working on a solution. After Senator Bennet (D-Colo.) wrote a letter to the SEC, Congressman McHenry (R-N.C.) introduced the Fix Crowdfunding Act, which contains those fixes. Thanks in large part to Rep. Maxine Waters (D-Calif.), the Financial Services Committee voted 57–2 on a compromise along the lines of what we at Wefunder recommended in our letter to Congress.
The bill passed a full House vote at 394-4 on July 5.
The ball is now in the Senate’s court. We hope that Senator Bennet (D-CO), Senator Merkley (D-Ore.), and Senator Daines (R-Mont.) will help pass the bill this year. But, given the chaotic election season, the jury is out.
So, why invest in a startup?
Despite the buzz in Silicon Valley, entrepreneurship is dying across the rest of America ; according to the Kauffman Foundation, the percentage of young people starting a company fell from 10.6% in 1989 to 3.6% in 2014.
Venture capitalists and banks have both failed to invest in a diverse cross-section of America. Our country has stagnated; the rich get richer, and it’s ever harder for entrepreneurs to get access to the capital to start a company.
The good news is we can now all help support the American Dream by investing small amounts in more deserving businesses. Instead of eating a steak dinner or booking a trip to Vegas, try investing $100 in a founder working to solve a problem you care about.
That’s good for society.
Invest like you are buying socially good lottery tickets — with a good surprise should things work out. But don’t invest because you are trying to earn a return like the professionals do. Until Congress passes the Fix Crowdfunding Act, the current regulations stack the game against you, and the middle class won’t have the protections the wealthy enjoy.
Nicholas Tommarello is the co-founder of crowdfunding platform Wefunder.