Crowdfunding and a New Chapter of Investing

Joel Anderson |

As we arrive at the end of April, we’ve spent a lot of time focusing on stocks during our series of articles on investing basics for Financial Literacy Month. However, it’s important to remember that these represent just one of the ways a person can invest. That’s why we’re going to take this final installment to look at one of the most exciting new developments in the investment world: crowdfunding.

Protecting Average Investors from Wall Street Predators...

The phrase “new development” isn’t one you frequently hear applied to the world of investing. For the most part, the same set of rules written into the Securities Act of 1933 have always dictated much of who could invest in what companies.

Written during the height of the Great Depression and with the excesses of the Roaring Twenties firmly in mind, these rules were meant to protect the average American from the tremendous risk and even outright fraud that could come from providing seed money to budding private companies. Public companies had stock that traded on major exchanges and laws dictating how frequently they would be audited, or were required to file earnings reports with the SEC that anyone could view. Obviously, risk is relative and plenty of public companies are going to wind up burning investors in the long run, but that basic promise of transparency and careful regulation meant that the government was ready to let even a complete novice take their chances. Not so for private companies, where the requirements for public disclosure are very limited and there are myriad opportunities to outright defraud someone if you’re so inclined.

What followed was a system where only those people with enough capital that they could afford to absorb big losses, known as “accredited investors,” could legally buy shares of a company prior to its IPO. Even then, private companies couldn’t advertise themselves. Accredited investors would have to go through broker-dealers who could further vet prospects to prevent bad actors or bad companies and add another layer of protection.

It was a system that made a lot of sense for a lot of years. Getting reliable information on a small private company halfway across the country wasn’t easy, and it was too easy to trick people into thinking you were something you weren’t. If working class people with limited savings were getting preyed upon by unproven companies pedaling big returns on super-risky investments, thousands of average people could see their savings wiped out by decisions they made without fully understanding the consequences.

Protections Become Barriers...

However, that reality started to change with the Internet. Suddenly, access to information was broad and instantaneous. The sort of tools and reports that even the most sophisticated broker-dealers would have killed for in the 1950s were suddenly available online for free. In this new reality, the protections that once seemed to be crucially important barriers suddenly started to feel unnecessary and paternalistic.

It also started to seem patently unfair, as well. In order to be an “accredited investor,” one had to have net assets of at least $1 million or an income of $200,000 a year. That meant that the most lucrative investments, like getting in on the ground floor for Facebook (FB) or Google (GOOG), was limited to those who were already pretty rich. Even if you were wise enough to see the potential in a company like that, you were barred by law from a shot at growing your savings exponentially unless you already had a lot of savings.

There was also another factor making people start to rethink how this all worked: the donation crowdfunding movement. Sites like Kickstarter and Indiegogo started to show just how large the potential was to unlock the capital available through small contributions from a large swath of society. Starting with smaller art projects raising money from friends, the perception started to change when two films, the Veronica Mars movie and Zach Braff’s Wish I Was Here, each managed to raise multiple millions of dollars on Kickstarter.

However, the consequences of this made some people uncomfortable. Most notably, you started to see private enterprises making large raises on donation crowdfunding sites. While the ability for a company to go straight to its consumers was thrilling to some, and in many ways represented a method for raising money for development by offering preorders to your target audience, others noted that the sort of start-up capital being provided by thousands of small individual investors for these campaigns would usually be good for a stake in the company.



Not so on sites like Kickstarter. Crowdfunding sites were prohibited from offering equity by the Securities Act. Crowdfunding was starting to feel like it was just a loophole that allowed private companies to raise money for free while bilking their “investors” out of any returns. Nowhere was this more concerning than with the Occulus Rift crowdfunding campaign. The virtual reality company used Kickstarter to raise $2.5 million for its prototype VR headset in 2012. Then, a mere two years later, Facebook purchased the company for a whopping $2 billion.

If the nearly 10,000 backers of Oculus Rift’s Kickstarter campaign had gotten a stake in the company, that sale might have meant a huge payday, maybe offering returns on their money approaching 50 or even 100 to 1. However, because of securities laws written during the Roosevelt administration, that option was never even on the table.

The JOBS Act Democratizes Investing

It was with this changing world in mind that congress passed the JOBS Act in 2012, looking to begin easing the restrictive rules that separated private and public companies in a way that would reflect the new reality investors found themselves in. The law included a wide variety of changes, including some that made it much easier for a company to hold an IPO. However, the most exciting portions of the law involved how private companies could raise money.

The JOBS Act lifted most of the restrictions on “general solicitation,” or appealing straight to the public about an investment opportunity. Instead of companies needing to rely on broker-dealers to bring accredited investors to them, they could now take out a billboard in Times Square if they were so inclined.

Perhaps more importantly, the final rules ultimately created several avenues through which an unaccredited investor could invest in private companies. Many of the paternalistic protections remained in place, unaccredited investors are limited to investing just 5%-10% of their income in a given year, and companies raising money from unaccredited investors have more requirements regarding their reporting and auditing, but the opportunity to look beyond the relatively limited options available in the public stock markets was now open to the 95% or so of Americans who wouldn’t qualify as accredited investors.

What’s more, equity crowdfunding, appealing directly to the public in an effort to raise capital via a large number of small investors and offering those investors an actual stake in your company, was now an option.1 So, if the next generation of Oculus Rifts or the sequel to the Veronica Mars movie wanted to go straight to the people again but offer them something more tangible in return than a free headset or some movie tickets, the legal option now exists.

New Risks and New Opportunities

So what has the result been? Well, it’s taken years for the SEC to write the rules for each of the different types of new options, and the differences between them are somewhat complicated. However, despite a few regulatory headaches along the way, all of the options outlined in the JOBS Act will be up and running by May of this year.

And there have already been some success stories, the biggest of which has been Elio Motors (ELIO). Founded by Paul Elio, the company has plans to build and market a hyper-efficient three-wheeled car that would get 84 miles per gallon and sell for less than $7,000. The popularity of the idea meant that Elio could take his idea straight to the people, raising $17 million from 6,000 investors on the crowdfunding platform at StartEngine.

Almost as exciting, the company’s shares then started trading on OTCQX, the top tier of offerings from OTC Markets (OTCM). For the first time in over a generation, a whole slew of small investors had a chance to get in on the ground floor of a promising young company and then sell the shares they purchased for a profit.

It’s an exciting time. Even if Elio Motors winds up being a huge flop, and there’s ALWAYS a chance that might happen, it’s still a clear example of the democratization of finance. Opportunities that were once closed off to just a small segment of the American public now have an avenue to be directed to the general public. Any entrepreneur with a solid idea in need of money to make it a reality can, if they’re so inclined, take their pitch straight to the people and let the chips fall where they may.

Today, there are dozens of online platforms set up to offer the general public a chance to buy into what might wind up being the next generation of great success stories to anyone with an itch to invest. Granted, these represent huge risks, and the vast majority will likely fail without providing their investors any returns, but that has always been the case. Today, any American interested in becoming their own venture capital firm has the chance to get out there, examine the field, and take their shots with the best of them. It may not always work out, but the opportunity may unlock the potential of a new generation of investors that has long been locked out of the process.


1 The final rules actually make it exceedingly difficult and expensive to raise money with the “equity crowdfunding” option, but they also made the rules around something called Regulation A+ such that companies could use that option to raise money from unaccredited investors while using general solicitation. The distinction here is mostly just arcane legal jargon. Reg. A+ is basically equity crowdfunding, even if the law recognizes the two things as being distinct and different.

DISCLOSURE: The views and opinions expressed in this article are those of the authors, and do not represent the views of equities.com. Readers should not consider statements made by the author as formal recommendations and should consult their financial advisor before making any investment decisions. To read our full disclosure, please go to: http://www.equities.com/disclaimer

Companies

Symbol Name Price Change % Volume
FB Facebook Inc. 181.29 1.49 0.83 26,826,540 Trade
GOOG Alphabet Inc. 1,137.51 7.72 0.68 1,778,229 Trade
ELIO Elio Motors Inc 3.05 0.15 5.17 2,465

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