Up until now, anyone hoping to become the next Mark Zuckerberg has had to pass through the infamous venture-capital gauntlet: high-stakes pitch sessions with moneyed potential investors whose millions could transform a fledgling startup into a billion-dollar unicorn.
But starting Monday, founders won’t need to grovel in front of millionaires to win crucial seed money. Newly enacted rules now allow ordinary Americans to buy equity in young privately held companies. That's right: You no longer need to be a millionaire to invest in a startup.
But the program isn’t without its risks and limitations. Here’s what you should know about equity crowdfunding.
Who Can Invest?
Anyone — with some strings attached.
Investing in private startups like Uber and Snapchat — as opposed to publicly traded companies like Apple or IBM — was previously a privilege open only to those defined as accredited investors, those who have $1 million in assets or make $200,000 a year.
But following the passage of the 2012 Jumpstart Our Business Startups Act and a protracted rulemaking process at the Securities and Exchange Commission, anyone can bet on the next Facebook. But that doesn’t mean you can bet your house. Those with incomes below $100,000 can invest a maximum of $2,000 annually, or, alternatively, 5 percent of their income or net worth.
People who make more than $100,000 are limited to investing the lesser of two options: 10 percent of their annual income or 10 percent of their net worth. Participating companies can raise a maximum of $1 million over a 12-month period under the rules.
How Is This Different From Kickstarter?
Kickstarter and similar crowdfunding platforms may have helped spur lawmakers to carve out these new investing privileges, but the services they offer are fundamentally different.
When you contribute to a Kickstarter campaign, you may get some kind of reward, whether it’s a simple thank-you gift or a fully functional final product. What you don’t get, however, is equity in the company. Kickstarter campaigns don’t offer shares.
Under the SEC’s new equity crowdfunding rules, however, ordinary investors can pile into private security offerings of the sort once reserved for company insiders, big money managers and the wealthy. In the event that a company takes off, early equity in the company can pay massive dividends.
Though Kickstarter has said it won’t allow equity crowdfunding on its platform, at least a dozen similar companies have sprung up in the past few years to serve the new market, including Wefunder, NextSeed and StartEngine.
What Are the Risks?
In many cases, investing in a startup is tantamount to throwing away your cash.
Not every startup succeeds. In fact, research suggests a majority of young companies end up failing, at least as investments. A study published by the Harvard Business School last year found that 70 to 80 percent of startups fail to return invested capital. The odds aren’t exactly as long as the lottery, but neither are they in your favor.
Worse, some worry that the loosened restrictions could create breeding grounds for unscrupulous securities dealers to prey on naive investors. “Ninety-nine percent of these deals will prove to be unprofitable,” securities lawyer Andrew Stoltmann told the New York Times, calling the program “a disaster waiting to happen.”
Part of the debate centers around disclosure. The rules specify just how much young companies must open their books to potential investors to win funding. Companies hoping to raise a 12-month maximum of $1 million must share their audited financial statements with new investors, though there are exceptions for younger firms, who may not need to audit their statements. That could spell trouble down the line.
Why Does It Matter?
Congress passed the JOBS Act in order to spur new business creation. Despite headlines regularly cheering the newest and flashiest Silicon Valley unicorn, the American business sector has grown less and less fertile in the past few decades.
The rate of new business creation is hovering around the lowest levels seen in the nearly 40 years that the U.S. Census Bureau has tracked business dynamism. The rate of job creation associated with startups has similarly fallen. Blame for the dual trends has fallen on everything from overregulation to the increased concentration of industries into a few mega-corporations.
Regardless of the causes, the hope is that opening up small-business financing to the masses will help till the field for a new crop of startups.
“Because of this bill, startups and small business will now have access to a big, new pool of potential investors — namely, the American people,” President Barack Obama said upon signing the JOBS Act in 2012. “For the first time, ordinary Americans will be able to go online and invest in entrepreneurs that they believe in.”
Starting Monday, America will find out if more investors is the cure the economy has been looking for.