Regulators regulate. It's what they do. So it is newsworthy when politicians cooperate to relax nannyish prohibitions and allow ordinary investors access to potentially risky start-up ventures. Yet that is what happened in 2012, when President Barack Obama signed the Jumpstart Our Business Startups (JOBS) act, letting individuals participate in early-stage financing of promising new businesses and share in the potential rewards. Indisputably good news.
Did we mention that regulators regulate? It took the Securities and Exchange Commission four years and 500 pages of new rules to finally implement the 10-page law. Still, better late than never, and this week the final version goes into effect. Crowdfunding of equity investments officially reached the masses on Monday, ushering in an experiment that could serve to remind legislators and regulators of the power and dynamism of free market forces.
Christopher HopkinsWhat is crowdfunding you may ask? It is a disruptive technological innovation in raising capital for new business ventures that rivals Uber, Airbnb and Amazon in its potential to change the rules of the game. It allows companies, charities and worthy causes to efficiently raise money from large numbers of supporters over the internet.
Crowdfunding began around 2003 as a funding vehicle for aspiring creative artists. Musicians began soliciting donations from hundreds of aficionados on the web to finance recording projects. By 2009, platforms like Kickstarter and Indiegogo were hosting web funding of small tech startups and innovative products as well as relief efforts and charities.
This early iteration was known as rewards-based crowdfunding and served primarily to facilitate support from fans and supporters but not to provide an investment return other than gratification and enjoyment or free products.
Meanwhile, a profit-oriented cousin called debt-based crowdfunding was rapidly developing. Platforms like Lending Club and Prosper collected a fee to connect borrowers seeking loans with individuals willing to lend small amounts at interest rates higher than available yields on CDs. Also called peer to peer lending, this channel has been so successful that big investment banks are now buying pools of loans from the crowdfunding platforms.
The obvious question arose: if you can raise debt capital (loans) on the internet, why not equity? This channel is the latest, but holds perhaps the greatest potential for disruption. Early ventures were open only to accredited investors with net worth of $1 million, but the passage of the JOBS act creates an opportunity for ordinary investors to participate. The rules announced this week by the SEC removed the final hurdle and fired the starting gun for expanded equity crowdfunding.
While the new rules are predictably over-restrictive, they nevertheless represent a welcome step toward boosting the new business startups so essential to reinvigorating U.S. economic growth and vitality.
As of Monday, small companies may sell up to $1 million in shares every 12 months directly to the public without the expense of a traditional IPO filing with regulators. Sales must be conducted through existing broker dealers or crowdfunding portals approved by the SEC. Individuals are limited in the amount they may purchase based upon net worth, but even the smallest investor may commit $2,000 per year. Shares must generally be held for a year before reselling except to an accredited investor.
According to a Wharton School study of Kickstarter projects, the success rate of crowdfunded ventures has been remarkably high, with 90 percent of projects delivering results as promised. That compares most favorably with traditional venture financing, where three quarters of investments flop.
Although it has taken four years and hundreds of pages of rules, the result is welcome. Capitalism thrives only in the presence of liberal risk taking, both by entrepreneurs and by their investors.
Christopher A. Hopkins, CFA, is a vice president and portfolio manager for Barnett & Co. in Chattanooga.