Big changes are underway in the investing and crowdfunding world. 2013 saw the introduction of Title II of the JOBS Act, which allowed startups to publicly fundraise for the first time. Prior to the inclusion of Title II, an entrepreneur had to have a “substantial and pre-existing relationship” with a prospective investor in order to receive funding—the government’s way of preventing average people from getting fleeced by frauds. Broadcasting your offering was off the table: no ads, no emails to investors, no talk of fundraising at events and no outreach on social media. Title II changed all that.
But while Title II was a major step forward, it still put restrictions on who could invest: namely, only accredited investors. This means a person an annual income of at least $200,000 or a net worth of at least $1 million. But the new SEC rules that went into effect this May permit anyone, not just the wealthy, to risk $2,000 a year or more investing in small companies in exchange for a stake in the business.
The new rules, called Regulation Crowdfunding, are going to have widespread effects on investors and startups alike. They will democratize the investment process (popular phrase, that), essentially permitting anyone to invest, but also open everyday people up to the risk of losing their money in a bad investment. Startups and other small businesses can now raise money from nearly anyone, but there are rules and responsibilities associated with the process that entrepreneurs need to be aware of before diving in. In addition, this type of equity crowdfunding may not be the most beneficial route to take for a startup, money aside.
So can crowdfunding work for startups, especially proprietary tech-based startups run at least in part by students, like VentureWell’s E-Teams?
We asked Joseph Steig, CFO at Long River Ventures, and our own Program Officer for Venture Development and Investments Christina Tamer about the implications of the new rules and their best advice for startups.
How do you think Regulation Crowdfunding will affect investors? Both traditional investors and the new ones brought on board.
Joseph Steig: “The newest of the new rules that allow small, unaccredited investors to invest small amounts in startups will, I think, be largely negative and problematic for existing, accredited, sophisticated angel investors. It will mean that startups are more likely to have brought on early investors who require management and time. Hopefully it will be minimal and will just legalize some things that were already happening but it has the potential to turn sophisticated investors away from startups that have created a complicated cap table with lots of unsophisticated investors.”
Christina Tamer: “For the everyday investor, Regulation Crowdfunding is an exciting opportunity to get involved at a deeper level with companies whose products and missions they care about. But for existing, accredited investors, Regulation Crowdfunding isn’t likely to move the needle on new deal flow for them. They’ll have to adjust their theses and criteria depending on whether or not they want to get involved in startups that have used crowdfunding. It really depends on their investment style.”
How will the new rules affect entrepreneurs, particularly E-Team-style startups based on proprietary technology? Should science & technology-based startups pursue this kind of funding? What are its potential upsides and downsides?
Joseph Steig: “Crowdfunding likely isn’t a good option for high-growth-potential technology companies. E-Teams should be very cautious about pursuing crowdfunding-type investment from unsophisticated investors. The upside is you can raise early money legally and perhaps more easily. The downside is that you have unsophisticated investors in your cap table. They won’t be able to help with and participate in later rounds. They are likely to have their equity positions crushed by later investors. They are likely to at best cause management problems and perhaps legal problems down the road. If you’re a business that isn’t going to require a lot of capital, sure, it might work. But if you’re going to require significant capital from sophisticated angels and VCs, this is likely to be a short-term fix with long-term negative consequences.”
“Additionally, teams need to think about whether you should take money from people who are non-accredited because by definition this means they probably can’t stand to lose those funds. The same applies to friends and family who are non-accredited.”
Christina Tamer: ”Entrepreneurs need to align their company’s funding strategy with their personal goals, values, and company mission. As Noam Wasserman asks in The Founder’s Dilemmas, do you want to be the King/Queen, or do you want to be Rich? For you, the founder, do you want anonymous investors on your cap table in the early, formative stages of your company? On the flip slide, do you want your customers to buy into more than just your product, but possibly into your company (literally) and your mission too? There are two sides of the coin and what is right for you as an entrepreneur depends on your mission and business model.
“For the most part, we at VentureWell work with startups with proprietary technology and in regulated industries that require an experienced Board of Directors to help strategize and make key decisions and connections. In this case, it’s more likely that startups can benefit much more significantly from an experienced, accredited investor who plays the traditional role of taking a board seat and working to increase value in the company.”
“That said, I would say that it is more likely that E-Teams could use 506(c) rules in order to take advantage of public solicitation while still working with accredited investors for that ‘smart money’ value-add.”
The bottom line
There’s plenty of complexity here: investor opinions vary and the regulations themselves are complicated. It’s also easy to get carried away with the excitement and potential opportunity that comes with crowdfunding, and the blog circuit certainly feeds into the hype. Remember, though, that regulations are constantly changing.
The bottom line is that startups need to: 1) understand the regulations and exemptions at a high level, 2) spend the money on a good lawyer who understands all of the exemptions and will help them do all of the paperwork correctly the first time, and 3) be intentional about their fundraising strategy, including what they want from their investors now, in the short-term, and in the long-term.
Learn more about the regulations here.
About the authors
Christina Tamer has worked with small and growing businesses of all kinds, from venture-backed clean tech startups in San Francisco to women-owned hair salons in Uganda. She worked with Invested Development, a seed fund manager focused on technology solutions to poverty around the world. There, she analyzed ~500 startups and helped build a portfolio of 18 investments. She started her career in social enterprise with Project Have Hope, a non-profit focused on creating educational and entrepreneurial opportunities for displaced women in Uganda.
Tim Binkert leads storytelling activity at VentureWell, managing the blog, the website and its content, and social media.Tim brings years of experience at VentureWell to bear in relating the stories of faculty and early stage innovators who have moved their ideas to impact through VentureWell’s programs. Tim holds a BA from Syracuse University and a Certificate in Professional Writing and Technical Communication from University of Massachusetts Amherst.
Note: none of the content in this article is intended as legal advice.