The SEC has finally finalized its crowdfunding rule (presser) under the JOBS Act. The health innovation crowdfunding crowd has been waiting for these rules for quite some time, as has the rest of the crowdfunding fan club. (It’s only taken three and a half years.)
So, was it worth the wait?
The crowdfunding rule (full text) sets the stage for broader participation in early-stage investing and may empower crowdfunding platforms (“intermediaries,” in SEC-speak) to compete with angel funding platforms servicing “accredited investors” (SEC-speak for high net worth folks who can afford to lose their entire investment in a startup). It is a democratizing move consistent with the ethos of the internet and digital innovation.
Let’s look at some of the particulars and then think about whether this is a good thing for startup companies (“issuers”) that might want to sell securities rather than their products or promotional T-shirts, and for intermediaries — such as Kickstartr etc. — that might want to have a role in matchmaking individual investors with issuers. (Kickstartr itself has reportedly said it’s not interested in going down this path; IndieGoGo is interested, though.)
The rule provides:
- Issuer can raise no more that $1 million in aggregate through crowdfunding in a 12-month period
- Individual investors’ investments are capped – in a 12-month period, an individual may invest up to the following amount in a crowdfunding offering:
- If annual income or net worth is less than $100,000, the greater of
- $2,000 or
- 5% of the lesser of annual income or net worth.
- If each of annual income and net worth is greater than $100,000, 10% of the lesser of the two
- If annual income or net worth is less than $100,000, the greater of
- Investor may not invest more than $100,000 in all crowdfunding offerings in a 12-month period
- Issuers must file with the SEC and disclose to intermediaries and investors
- Price, pricing methodology, deadline to reach target offering amount, and whether the issuer will accept oversubscriptions (which are limited)
- Financial condition of issuer
- Financial statements
- First-time crowdfunding issuer offering $500,000-$1,000,000 – reviewed financial statements
- Follow-on offerings, or audited financials available – audited financials
- Description of business and use of proceeds
- Information about officers, directors and any owners of 20% or more of issuer’s securities
- Certain related-party transactions
- Intermediaries (funding portals) must
- Register with the SEC and join FINRA and maintain appropriate books and records
- Provide educational materials to investors
- Do some due diligence on issuers to prevent fraud
- Post certain issuer information at least 21 days prior to offering and during entire offering period
- Provide discussion platform about intermediary’s offerings
- Disclose intermediary compensation
- Limit acceptance of investment commitments to investors with current accounts on the platform
- Have reasonable basis for believing each investor complies with applicable limits
- Provide notices to investors confirming investment commitments and “closing” of investments
- Comply with funds maintenance and transmission requirements and offering completion, cancellation and reconfirmation requirements
- Intermediaries may not
- Provide platform access to issuers they have reasonable basis to believe have potential for fraud or other investor protection concerns
- Have a financial interest in an issuer on its platform, unless the interest is given as compensation for its services
- Compensate any person for providing the intermediary with personal information of any investor or potential investor
- Offer investment advice or make recommendations
- Solicit purchases or sales or offers to purchase securities
- Pay promoters or others for solicitations or based on the sale of securities
- Hold or handle investor funds or securities
Clearly, while opening the gates to broader participation in equity financiang, these rules add significant burdens to startups seeking crowdfunding and to intermediaries operating funding platforms. Some of the freewheeling vibe may continue (in issuers’ “description of business” or discussion boards on the intermediary’s platform, for example), but communications by intermediaries will be limited to the information contained in traditional “tombstome” ads in financial publications, and intermediary investment positions in issuers will be pretty much limited to payment in securities for services provided by the intermediary. There will be a significant compliance burden, and folks active in this space are not accustomed to that.
It will also be interesting to see how much attention crowdfunding attracts among traditional broker-dealers. They would likely be able to satisfy the regulatory requirements for establishing a crowdfunding platform relatively easily, and may eat the crowdfunding pioneers’ lunch if they aren’t careful. Some sector-specific crowdfunding platforms have previously aligned themselves with more broad-based platforms (e.g. Health Tech Hatch and IndieGoGo); that trend may continue, and we may also see other sorts of alliances that crowdfunding platforms may develop with angels, angel funding platforms and/or traditional broker-dealers. Since these regs have been in the works for quite a while, some of these alliances may well be in the works too. Others are likely to develop in the coming months as the digital and traditional incumbents feel their way around the new regulatory edifice. (At 600 pages plus, there’s a lot to take in.)
In the healthcare innovation space, I look forward to seeing whether this new pathway for funding launches viable companies. A few have made the leap from crowdfunding to VC funding (uBiome and Scanadu come to mind), and it seems to me that this approach to funding will level the playing field further between startups offering shiny objects in return for the crowdfunding contribution (e.g., Scanadu) and those that are less corporeal in their initial efforts. It remains to be seen whether publicly-available discussion boards will adequately substitute for early stage investor due diligence, and whether the “wisdom of the crowd” will translate to bankable businesses. It also remains to be seen how many businesses really want this pool of investors. Welcoming investors from among the masses isn’t for everyone. Many startups would rather have an investor who can offer some wisdom and connections as well as cash, and many would rather sell a beta product and get feedback on it than sell a piece of the business.
David Harlow practices health law in Boston and serves as counsel for Flow Health.
I firmly believe that there is a lot of upside to crowdfunding. The microfunding economy also has a ton of upside. Where it really gets tricky, however, is when a company defaults and loses all the money the investors put into it. Yes, it is taking a risk, very similar to the stock market, but these types of deals should come with a lot of caveats in my opinion.