The Securities and Exchange Commission on Wednesday formally proposed new rules that would allow entrepreneurs to raise capital from anyone in the country through online investment portals.
The new rules, which were approved unanimously by the five-member commission and now enter a three-month comment period, would give companies the green light to start widely selling securities through what are known as crowdfunding portals. Right now, entrepreneurs can offer equity deals through the marketplaces only to accredited investors.
“Crowdfunding presents a number of opportunities,” SEC Commissioner Michael Piwowar said moments before the vote on Wednesday. It allows small firms to “access capital from sources that were previously unavailable” while giving “all investors, not just so-called accredited investors, the opportunity to invest in entrepreneurs and their ideas at an earlier stage than ever before,” he added.
Many consider the crowdfunding provisions the most substantial of several regulatory changes authorized by the Jumpstart Our Business Startups Act in April 2012, which was meant to ease financing restrictions for small and new businesses. Once the new rules are approved, for the first time, entrepreneurs will be able to sell stakes in their firms over the Internet without registering their investors with the SEC, and under the current guidelines, they would be able to raise up to $1 million a year through crowdfunding.
It “changes the paradigm we have used for the past eight decades,” Piwowar said.
Companies would be required to file certain information to federal regualtors, including details about the firm’s owners, descriptions of the financial health of the company and intentions for using the proceeds from investores. Once the offering is complete, firms would be required to file annual reports to the SEC.
On the investor side, securities obtained through a crowdfunding portal could not be resold for one year after purchase.
Congress initially gave regulators 270 days to create rules that would allow businesses and investors to proceed with equity-based crowdfunding. However, a flood of concerns over investor protections have slowed the process.
“Because this has not been done before, we know very little about the dynamics about how this financial innovation will work,” including who will invest, what companies will use the portals, and what type of fraudulent activity to expect, Commissioner Kara Stein said during the meeting on Wednesday. “We still have a lot to learn.”
Ryan Feit, a board member for Crowdfund Intermediary Regulatory Advocates (CFIRA), which lobbies on behalf of the emerging crowdfunding industry, called the unanimous vote “a great sign,” noting that previous regulatory changes triggered by the JOBS Act were initially voted down by some members of the commission.
“Leading up to today, there was a lot of concern that the SEC was going to poison the well by making the rules so onerous that nobody would ever use crowdfunding, but it’s now clear that’s not the case,” Feit said in an interview.
Daniel Gorfine, director of financial markets policy at the Milken Institute, a think tank in Washington, said that “it looks as though the commissioners are trying to balance the proper investor safeguards without preemptively squashing a new innovative tool.”
Gorfine was also encouraged to see that the SEC plans to require funding portals to create communication tools for investors to converse about companies seeking financing.
“It shows that they get it in terms of what’s different about crowdfunding,” Gorfine said of the requirement. “What makes these portals so interesting is that the crowd can share their views and opinions with one another on these offerings.”
Still, some have concerns about various details in the proposal. For instance, the rules would require firms raising more than $500,000 to be audited by a third party — a costly hurdle for new firms that have ambitious funding goals but may not be generating revenue yet, said Feit.
“That could put a real freeze on companies looking to raise more than a half million dollars,” added Jason Best, one of the founders of Crowdfund Capital Advisors, a consulting firm for entrepreneurs and investors.
Commissioner Stein emphasized that the rules are merely a starting point for discussions over the best way to implement equity- and debt-based crowdfunding, noting that the draft includes nearly 300 questions for parties interested in crowdfunding.
She added that regulators are torn on a number of details; for instance, how to determine new investor limits, which preclude individuals below certain annual-income and net-wealth thresholds from investing more than a certain percentage of their income in crowdfunding. Some have suggested investors should be able to choose whichever number (either their net wealth or their annual earnings) allows for a higher investment limit. Others have argued the lower limit should be applied.
In addition, SEC officials are still contemplating whether to allow foreign crowdfunding portals to register and operate in the United States. Stein said she hopes investors and business owners will weigh in with their suggestions and concerns in the months ahead.
“The proposal before us today appears to offer great promise of offering capital to small businesses so they can survive and hopefully thrive, but it may also present great risks to investors,” she said. “Getting the balance right will likely take time and careful refinement.”
“If we don’t get it right, I fear the promise of crowdfunding will be lost,” Stein added.
John Callaghan, one of the founders of New York-based crowdfunding portal iCrowd, says that while he was “very encouraged” by some of the proposals, his company does not expect to actually begin taking advantage of them until the third or fourth quarter of next year, as regulators will still need plenty of time to review suggestions after the three-month window for comments closes.
Callaghan noted that, on one of the more straightforward rule change in the JOBS Act, which lifted a ban preventing firms from widely advertising their private securities offerings, it took regulators more than a year from the time they initially pitched the rule change to its implementation last month.
“On that earlier one, there were maybe three important variable they had to address, whereas here, they are creating a brand new type of financial intermediary and a whole new regulatory process,” he said. “It’s important the regulation be done right, and that will take some time.”