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Regulation and Compliance > State Regulation

So You Can Invest in Crowdfunding. Now What?

By Danielle Andrus

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Title III of the Jumpstart Our Business Startups (JOBS) Act, passed in mid-May allows investors to participate in crowdfunding opportunities to fund new startups. However, there are some limitations that need to be worked out.  

“It’s a new process. It takes a few visionary people who are willing to try something that’s new in order to prove that it actually works,” said Ron Miller, CEO of StartEngine, one of the 11 funding portals regulated by the Financial Industry Regulatory Authority as of June 15 under Regulation CF. “There’s some hesitancy only because it hasn’t been done before.”

StartEngine serves accredited and non-accredited investors. The platform currently hosts about 15 companies, with another 30 in process and aims to fund 5,000 companies over the next five years, Miller said.

Although crowdfunding is new for investors, Miller said they should approach it in a way that is “consistent with what we know about good investment strategy in general,” and “this particular sector of startup investing and growth business investing should represent the high-risk, high-return sector” of an investor’s portfolio.

He suggested most investors shouldn’t consider investing more than 3% to 10% of their investment portfolio in these types of businesses, and that they diversify across the startups that they invest in.

“It’s really important that individual investors not get so excited about an individual offering that they allocate the entire high-risk, high-return portion of their portfolio to one individual company,” Miller said. He also suggested that investors spread that allocation across at least three companies, and maybe as many as 10.

“Our friends the venture capitalists taught us well; that the overwhelming majority of these investments are not likely to work out. However, with a good diversification strategy, the one or two that are going to be tremendously successful are going to offset the losses from the companies that didn’t work out.”

However, the limitations the regulation places on entrepreneurs may stymie investment at first.

“Raising capital is not an easy process. Even with these new rules, it takes a lot more than simply posting your campaign on a crowdfunding site,” Miller said. “There’s a strategy and process” for entrepreneurs to create compelling campaigns and promote them.

“That process takes time, money, effort and smart thinking in order to create an effective strategy that gets in front of the right people,” he said.

The biggest limitation for entrepreneurs, according to Miller, are the strict regulations on how they can advertise that they’re raising capital, Miller said. Those restrictions “can get quite complex,” he said; “I think it’s those complexities and limitations that make it difficult for the entrepreneur to freely promote their campaign.”

Another challenge is that investors must be identified individually.

“Today, the rule requires that any investor become directly listed on the cap table of the company as an individual shareholder.” However, he said, “If there are, for example, hundreds or maybe even thousands of investors, it best serves [entrepreneurs], for administrative purposes, that those investors be aggregated into a single pool, most often referred to as a special purpose vehicle.” Finally, the amount firms can raise through this channel is capped at $1 million.

Many of these challenges are addressed in the Fix Crowdfunding Act, H.R. 4855, which passed the House Financial Services Committee with a 57-2 vote on Thursday. The act increases the maximum that startups can raise through Regulation CF from $1 million to $5 million and allows single-purpose funds to use crowdfunding to raise capital.

It only covers capital raised through Title III; startups using Title IV or Regulation A+ to raise capital, wouldn’t be subject to the new maximum.

The biggest challenge, however, has less to do with the rule and more to do with developing the “overriding knowledge and expertise, and proven track record […], the steps that are necessary to create and promote your campaign.”

Miller said, “What’s needed is a pathway” where new entrepreneurs can follow the steps of those who have gone through the process before them. 

— Read Court of Appeals Affirms SEC’s Reg A+, Rejecting States’ Arguments on ThinkAdvisor.

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