As SEC Mulls Equity Crowdfunding, CA Entrepreneurs Test Other Options

California is one of the dominant U.S. producers of fruits, nuts, vegetables—and tech startups. In the Silicon Valley, the startups sprouting up each season are nurtured by a host of accelerators and incubators as well as VCs and angel investors providing seed funding. That still leaves some startups hungry for cash, but California is not one of the states that have opened up a much-touted alternative route to startup fundraising—a controversial method called equity crowdfunding.

Even so, California already has a contingent of fundraising platform companies eager to facilitate equity crowdfunding once the Securities and Exchange Commission issues long-awaited regulations that will make it legal nationwide. In the meantime, some of them are experimenting with alternative fundraising avenues that already exist. Their new models may eventually co-exist with equity crowdfunding, or influence its use.

Equity crowdfunding is a mechanism that allows young private companies to sell small ownership stakes, usually through online portals, to thousands of investors who might only have modest incomes. The idea is a twist on original crowdfunding services such as Kickstarter, where some artists and tinkerers have raised substantial sums—at times $1 million or more—from fans who may send in as little as $25. Those contributors usually receive only small thank-you gifts in return.

But if such startup backers could receive company shares instead, equity crowdfunding supporters say, those small investors could grab an early stake in fledgling companies that might some day turn into the next billion-dollar tech titans. Critics of equity crowdfunding worry, though, that unsophisticated investors could lose their shirts on these deals.

Under U.S. securities regulations, wealthy investors are free to invest in private companies, which is considered riskier than putting money into public companies. But under longstanding rules, the government has limited the ability of private companies to seek capital from people of modest means, or advertise their securities offerings to the general public.

In recent years, though, Congress has relaxed those longtime restrictions. Equity crowdfunding was authorized in its broad outlines by Title III of the Jumpstart Our Business Startups Act (or JOBS Act) in 2012, as a way of stimulating the U.S. economy by freeing up access to capital for startups that are not ready to become publicly traded companies.

California equity crowdfunding portals

After the JOBS Act passed, aspiring crowdfunding portals started popping up in California. They avidly awaited the detailed SEC rules that would implement equity crowdfunding and allow young private companies to sell securities to ordinary investors nationwide. But several years have passed, and the SEC regulations have yet to come out. Rather than continuing to wait, more than 20 states have created their own rules for equity crowdfunding rounds, allowing in-state companies to sell securities to in-state investors. Those states include Massachusetts, Illinois, Texas, Michigan, Wisconsin, New Jersey, and South Carolina.

Similar bills failed in the California legislature. But the state’s fundraising portals, rather than folding their tents, are still trying to make a business out of helping startups raise money in novel ways. They’re using a variety of SEC rule changes—some called for by the JOBS Act—that re-draw longstanding boundaries around private companies selling securities. These changes grant some of the outcomes sought by supporters of full equity crowdfunding, by allowing startups to raise more money from a wider array of investors.

Among the California entities exploring these new fundraising routes are San Francisco investment bank WR Hambrecht, founded in 1998, and Santa Monica, CA-based online fundraising portal FlashFunders. Each has chosen its own operating mode from a selection of SEC-created options with alphabet soup names, including Regulation A+, and Regulation D 506 (c).

The expanding range of regulatory openings is now complex enough that experts have been creating spreadsheets to keep track of the differences. But to sum up, each of the new rules loosen up one or more SEC restrictions designed to protect investors, especially small investors who can’t afford the kind of losses that wealthy individuals might take in stride.

The jumping off point: Conventional early stage funding rounds

The traditional fundraising path for startups—still very much in use in Silicon Valley—arose under established rules that prohibited them from publicly advertising for investors. Instead, young companies privately approach venture capital firms and well-off individuals known as angel investors, who may share the investment opportunity with other potential funders. By this clubby private route, interested investors often join together in syndicates to supply capital to the young company in exchange for ownership stakes.

Those securities are sold under Regulation D 506 (b), which not only forbids advertising the offering to the general public, but also sets other conditions. Most of the individual investors buying the shares must qualify as “accredited investors,” who must have a net worth of at least $1 million or an annual income of $200,000 or more. A company raising money can legally rely on the investors themselves to self-certify that they’re eligible.

(Note: A startup can also allow as many as 35 “non-accredited investors” who don’t meet those wealth criteria to participate in such funding rounds. These might be family members of the startup founders, for example.)

New twists on traditional private funding rounds

Several changes have opened up the traditional startup funding route to investors who are well off enough to participate, but who aren’t part of the professional VC and angel networks that have typically participated in “private placements” of securities under Regulation D 506 (b). The first important change was, not surprisingly, the social and interactive possibilities of Web 2.0.

One prominent outfit taking advantage of those possibilities is San Francisco-based AngelList. Founded in 2010, the well-known networking website allows wealthy individuals recognized as accredited investors to find information about startup securities offerings and form investing syndicates, even if they don’t know an insider like a Silicon Valley VC.

Most startups seeking investors through AngelList are fundraising under Regulation D 506 (b), so they can’t advertise to the public. They post a company profile in a restricted area of the AngelList website that is only accessible to accredited investors.

The second significant change in the fundraising landscape stemmed from the JOBS Act. The SEC raised a cap on the number of investors a private company can have before it’s required to become a publicly traded company. The cap was once reached at 500 investors; it’s now set at 2,000.

“That’s a very big deal,” says Swati Chaturvedi, co-founder and CEO of San Francisco-based Propel(x), one of the online fundraising portals have followed in AngelList’s footsteps.

The higher cap not only allows a larger number of accredited investors to buy a startup’s securities. It may also make it possible for each of those investors to put in an amount lower than the usual minimums demanded by startups when they raise money from investing syndicates. These minimums might be pegged at $25,000 or even more. But with 2,000 investors rather than 500, each could invest more modest sums, and the total amount could still meet the startup’s fundraising goal, Chaturvedi says.

Even though only wealthy people can invest, these rounds look just a bit more like crowdfunding.

Startup investing may now be attractive to people who are comfortably off, but not rich enough to bet as much as $25,000 on a single startup, Chaturvedi says. If they like, these upper middle class investors can now invest in a greater number of startup companies because they can commit smaller amounts of money to each one. A portfolio of 10 or more startups may improve the odds that at least one of the companies backed by an individual will pay off handsomely, she says.

Through Propel(x), investors can put up as little as $3,000 to buy into a fund structured as a limited liability company (LLC) or special purpose vehicle, which in turn buys the securities of a single startup. Other investors able to kick in $25,000 or more can invest directly in the startup’s securities.

Propel(x)’s mission, in addition to broadening the U.S. investor base, is to fund young companies whose products are based on significant scientific discoveries in fields such as engineering, life sciences, and chemicals and materials.

Calling itself “an online angel capital platform,” DreamFunded is another San Francisco-based fundraising service company founded after the passage of the JOBS Act. Founder and CEO Manny Fernandez, an angel investor, says DreamFunded accepts investments of as little as $5,000 from accredited investors, and also groups them into funds that invest in a single startup. DreamFunded makes money on fees and other revenues from the administration of these funds.

Two other recent SEC rule changes also create new avenues for private company fundraising.

Seeking money from the wealthy alone, but advertising to the general public

The SEC has introduced a variation of the Regulation D 506 (b) fundraising rules. True to form, the agency didn’t go crazy looking for a creative name for this variant—it’s called Regulation D 506 (c).

Under this option, a private company can freely advertise its securities offerings to the general public—even spreading the word through social media networks like Facebook. But there’s a tradeoff for this privilege. Not only must the company sell the securities only to accredited investors, (no 35 non-accredited family members) it must also take extra steps to verify that the buyers are wealthy enough to qualify.

Santa Monica, CA-based FlashFunders operates under this rule, and it performs those investor verification chores for companies that raise money through its online platform from investors worldwide.

“We allow accredited investors to invest as little as $1,000,’’ FlashFunders CEO Vincent Bradley says.

Although these investment opportunities still aren’t open to people of modest means, the low threshold investment amounts take fundraising closer to the equity crowdfunding model: small investments from a large number of people who learn about startups through Web portals. The hitch is, when each investor contributes a small amount, you need more investors if you plan to raise significant amounts of early stage funding. And current SEC rules limit the size of the “crowd” here, Bradley says.

FlashFunders, like Propel(x) and DreamFunded, folds smaller amounts from wealthy investors into LLCs, which in turn invest in a single startup. But the SEC allows no more than 99 investors in each LLC, Bradley says.

“We need to get rid of that limit,” Bradley says.

That solution would broaden the possibilities for accredited investors. But Bradley is still looking forward to SEC rules that would fulfill the complete equity crowdfunding vision: startups raising money in small increments from thousands of people, including non-accredited, ordinary investors.

Those Main Street investors could also be folded into LLC funds—perhaps hundreds or even a thousand of them at a time if the SEC could be persuaded to raise the 99-investor limit, Bradley says.

A new opening to non-accredited investors: RegA+

Even before the JOBS Act, private companies already had one means to raise money from both non-accredited and accredited investors: an option called Regulation A. But Bradley says it was little used. It involves expenses and financial reporting obligations like those that result from going public—but without all its benefits. Under Regulation A, companies could raise a maximum of no more than $5 million. Also, the fundraising company would have to register its securities offering in every state for review. Issuers have complained of the additional expenses and potential delays. “That was the nail in the coffin,” Bradley says.

But the SEC this year created variations on Regulation A under Regulation A+, which allows companies to raise as much as $50 million in what’s often dubbed a “mini-IPO.” The new rules, which became effective in June, are divided into two options.

Tier 1 offerings can raise as much as $20 million—four times the amount permitted under the original Regulation A. Tier 1 offerings are still subject to review by each state where the securities are sold. But the financial reporting requirements are not as stringent as those governing the second option, Tier 2 of Regulation A+.

Under Tier 2, companies can raise up to $50 million, and they’re exempt from state review of the offering. But they must prepare audited financial statements under GAAP standards, and continue to issue periodic financial reports once the securities are sold.

San Francisco-based investment bank WR Hambrecht has announced that it’s preparing to help companies raise capital under Regulation A+. Santa Monica-based fundraising portal StartEngine has five companies teeing up Tier 2 offerings, says CEO Ron Miller.

Companies can advertise their fundraising campaigns under Regulation A+. They can also “test the waters” before making a formal securities offering by asking investors to register their interest.

After going through that pre-testing process with StartEngine’s help, Phoenix, AZ-based startup automaker Elio Motors has asked for SEC approval to raise $32 million, Miller says. A large majority of the investors interested in the offering are people with ordinary incomes, he says. Elio would use the capital to build prototypes of a high-mileage car that it hopes to sell for about $6,800, Miller says.

“With Regulation A+, companies can convert customers into investors, who then become brand ambassadors,” Miller says. “A company can engage the social media networks of their investors.”

StartEngine doesn’t charge clients during their “testing the waters” phase, but bills them $50 for every investor who actually buys the securities. Each company selling shares sets its own minimum investment, Miller says.

Under Tier 2 of Regulation A+, non-accredited investors can put up no more than 5 percent of their annual income or of their net worth if either of these fall below $100,000. Wealthier investors can invest more, up to a maximum of $100,000. Under Tier 1, non-accredited investors are not subject to a limit.

FlashFunders’ Bradley says the Regulation A+ options may work well for larger companies that have gained some traction, but they still aren’t of much use to smaller companies with limited cash to spend. In Bradley’s view, both Regulation A+ options involve substantial expenses—either state-by-state registration in Tier 1, or detailed financial reporting in Tier 2.

“Either way, it doesn’t make sense for a startup,” Bradley says. FlashFunders doesn’t make use of the new Regulation A+ rules, he says.

Propel(x), which focuses on seed stage funding, nevertheless sees Regulation A+ as a future option for its portfolio companies as they reach the pre-IPO stage, said regulatory affairs staffer Shirley Li in a company blogpost.

The opposition

Not everyone has welcomed all the changes flowing from the JOBS Act. The North American Securities Administrators Association (NASAA), which represents state securities regulators, has warned that small investors could be more vulnerable to fraud and investing losses under the new rules. The regulators’ group has been leery of allowing widespread advertising of securities offerings by young private companies, when their responsibility for financial reporting is still less than that of public companies. NASAA has also objected to regulations that free some companies from state review of their securities offerings.

NASAA points out that states have joined together to streamline their pre-approval procedures by creating a coordinated review process for securities offerings.

The top securities regulator for Massachusetts, William Galvin, has asked a federal court in Washington, DC, to block Regulation A+ from taking effect, arguing that it undermines state oversight of private company securities. In a series of letters, Galvin argued that the states and the SEC are already grappling with fraud complaints stemming from fundraising under the Regulation D 506 rules, which are also exempted from state review.

Unanswered questions

A number of questions about protections for ordinary investors remain unanswered—both under the changes already made by the SEC, and under the full equity crowdfunding regulations still to come from the agency.

One of those questions was raised by FlashFunders’ Bradley, even though he’s an equity crowdfunding advocate.

The JOBS Act places caps on the amounts that ordinary folks can invest in a company raising money through equity crowdfunding. People with either an annual income or net worth of less than $100,000 can put up 5 percent of their annual income or net worth per year. Those with an annual income or net worth of $100,000 or more can invest 10 percent of their annual income or net worth per year, up to a total of no more than $100,000.

Bradley says he approves of the caps placed on non-accredited investors, which will shield them from losing all their savings if they’ve backed a company that fails.

“People will be able to do some damage, but they’re not going to destroy their lives,” Bradley says.

But Bradley says he wonders who will keep track of the total amounts invested by each person of ordinary means, and who will enforce the limits. Conceivably, a small investor could make bets on multiple company offerings, on multiple online fundraising platforms, he says.

“Maybe there needs to be a common clearinghouse that every offering has to go through,” Bradley says.

Another question is—what happens when an investor wants to sell shares issued under one of the new SEC regulations, such as Regulation A+ or equity crowdfunding? Will they be traded on securities marketplaces, and could non-wealthy investors buy them?

Liquidity

Advocates of the new fundraising models have pointed out that young private companies will find it easier to sell their securities offerings if their investors can in turn sell these assets to others. Some online fundraising platforms such as DreamFunded are interested in facilitating such trades.

Market exchanges could give non-accredited investors another way to invest in early-stage companies if they haven’t participated in primary offerings. But these shares could be risky bets if trading volumes are low, and if there’s too little financial information on which to base investment decisions, the North American Securities Administrators Association has warned.

Under existing SEC rules, shares issued under Regulation A+ can be traded immediately, and trading exchanges are already preparing to handle these secondary offerings.

The OTC Markets Group, based in New York, has issued guidelines to pave the way, says spokesman Joe Oltmanns. This means all investors, whether wealthy or not, may soon be able to buy shares that originated as Regulation A+ securities.

The OTC Markets Group is focusing on Tier 2 offerings, where the governing SEC rules match up with its own requirements for trading on one of its marketplaces, the OTCQB Venture Marketplace, Oltmanns says. No Regulation A+ securities have traded yet, because most of the issuing companies are still in the “testing the waters” stage,” or their offerings are still awaiting approval by the SEC, he says.

Non-accredited investors might be free to risk an unlimited amount of their money to buy Regulation A+ shares in a secondary market. Oltmanns says he knows of no mechanism that could track the total amount an individual of modest means is investing in various securities traded on OTC Markets Group marketplaces.

Innovations may not end with the JOBS Act

Even though the California legislature held back from creating an in-state equity crowdfunding framework, the state’s online fundraising portals and financial institutions look likely to become a significant part of the nationwide test bed for innovations in private company sales of securities. These platforms, in California and other states, are also part of a nationwide constituency that may press for further legislation if they conclude that the prevailing regulations impede the flow of capital to young private companies. Follow-on legislation to the JOBS Act has already been proposed.

For example, U.S. Rep. Patrick McHenry (R, NC), who introduced one of six bills incorporated into the JOBS Act, has proposed a new bill that would foster the creation of secondary markets for the re-sale of securities issued by private companies. Some advocates have proposed the creation of new venture exchanges where Regulation A+ and possibly equity crowdfunding shares could be traded. These proposed exchanges would have lower listing requirements than the New York Stock Exchange and Nasdaq, and might possibly have lower requirements than the OTC marketplaces.

Though the SEC’s regulations for full equity crowdfunding have yet to come out, advocates are already proposing changes to the framework created for it under Title III of the JOBS Act. Under Title III, startups would be able to advertise their offerings on the Internet, and raise as much as $1 million within a 12-month period.

FlashFunders’ Bradley says the fundraising cap should be higher—at least $5 million. He also objects to the limit on the amount a wealthy investor can put in.

“It’s only $100,000 from each accredited investor—even if Bill Gates wants to invest more,” Bradley says.

Bernadette Tansey is Xconomy's San Francisco Editor. You can reach her at btansey@xconomy.com. Follow @Tansey_Xconomy

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