This week the SEC released new regulations that let anyone — regardless of wealth — invest in startups. It’s exciting news on the surface but the devil’s in the details. The rules (Title IV) are too burdensome towards startups and small businesses, so only companies within a couple years of an IPO would even consider Title IV. But the “good stuff” (Title III) that’s great for smaller companies is on it’s way and should be here by October.
What’s Title III and Title IV, and what’s the difference?Both come from the JOBS Act, a law that was passed in 2012 that creates new ways for companies to raise capital. Think Kickstarter, but backers get shares instead of pre-orders. The big deal about the JOBS Act is that it dramatically improves access for investors. Without it virtually no one who’s not a millionaire can invest in promising startups .
The high level difference is:
Title III: equity crowdfunding for startups and small businesses. Companies are limited to raising $1m a year this way and the regulations are light enough that small companies can comply. We’re still waiting on the SEC for this to go live.
Title IV: an “IPO lite” for large companies. Businesses can raise up to $50m but are subject to regulations that are expensive and burdensome to comply with. And the more of a pain it is for a company to use new regulations, the less likely a strong company with fundraising options will use Title IV.
Why are the Title IV regulations bad?There are two big catches: you must get SEC approval and you must file periodic, audited financials. You can read more about the details form an article posted by Crowdfund Insider.
The SEC will scrutinize any offering documents you put in front of investors, likely with a similar level of scrutiny as a Form S-1 filing for an IPO. This is going to cost a lot of lawyer time in preparation. And because most early-stage businesses don’t keep audited financials, it’s going to cost a lot in accountant time to produce and maintain.
Sure, businesses of all sizes will want to try this new regulation but it’s going to be unlikely for a strong startup with other fundraising options to want to jump through these hoops.
So what’s good about Title III?It’s something good startups would use. The regulations aren’t perfect but are workable for startups, plus congressman McHenry is working an amendment that makes it even better (like increasing the $1m limit to $5m).
First, companies don’t need the government’s permission to test the waters. A startup can create a profile on a platform like Wefunder and start collecting interest from friends, customers, and experts in the industry. Just because someone isn’t rich (the requirement to invest today) doesn’t mean they don’t understand startups/markets or can be valuable investors.
Second, for small enough raises companies don’t need to provide audited financials (unlike Title IV). Audited financials are a deal-breaker for early-stage startups because they’re expensive and invasive, plus at this stage they aren’t very helpful for investors anyways. There’s a reason why professional angel investors don’t even ask for audited financials.
Third, the logistics of having many investors can be simplified in a way similar to the way “rich person crowdfunding” platforms do it for investors today . McHenry’s amendment makes it easier, but there’s a way to structure these fundraises with the rules as-is.
Fourth, it becomes feasible to accept $100 investments from anyone. This lets investors diversify and spread the risk (and there’s a lot of risk in startup investing). It makes investing more accessible, you could invest $100 in a crazy idea like the Oculus Rift. And it makes it possible for companies to be owned, at least in part, by it’s customers. It helps founders align their interests with the users and I think it’ll result in better companies being built.
What to expect in the near future
It’s really exciting that the SEC is moving forward with implementing the JOBS Act. It has been three years without very much activity, but better stuff is on it’s way. But we’re not going to see any startups or small businesses taking investment from the crowd until Title III gets through the SEC.
 Such as Wefunder and AngelList. Platforms generally use a special purpose LLC that investors invest in, which then invests in the startup. The startup only needs to interface with this LLC but investors maintain financial rights in the startup.