With the holidays upon us, some may decide that an investment in a small company is the perfect holiday gift. The Tennessee Department of Commerce and Insurance’s (TDCI) Securities Division wants to remove the mystery for investors about recently finalized rules that spell out specifics about how companies are allowed to offer and sell securities through crowdfunding.
“Crowdfunding is a means by which companies – mostly small companies or startups – can raise funds for capital formation through the Internet without the often burdensome cost of registering the securities [equitable shares in the company] with the Securities and Exchange Commission or state regulator,” said assistant commissioner for the Securities Division of the Tennessee Department of Commerce and Insurance Frank Borger-Gilligan.
Here’s a primer for investors to help them learn more about the do’s and don’ts of crowdfunding investments:
Small businesses once had two primary ways to raise capital from outside investors. They could solicit investments from wealthy or “angel” investors through private placement offerings; or register the securities with the Securities and Exchange Commission and offer the investments on a national exchange.
As the cost of registering a public offering is steep, and access to “angel” investors is not available to most, many start-ups are never able to get off the ground. Crowdfunding allows a company to seek small individual investments from a large number of average people online.
Traditionally, investments are offered and sold through intermediaries, such as broker-dealer and investment advisers, who must be registered with the SEC and licensed in each state in which they transact business. Crowdfunding, however, allows individuals to invest in companies through what is known as an online “funding portal.” A funding portal is essentially a website that facilitates the investment transaction between the issuer and the investor.
Under new crowdfunding rules adopted by the U.S. Securities and Exchange Commission, a company will be able to raise up to $1 million in a 12-month period through crowdfunding.
Investors with an annual income and net worth less than $100,000 would be permitted to invest up to $2,000 or 5% of their annual income in the same 12-month period. Investors with incomes greater than $100,000 would be permitted to invest up to 10% of their annual income or net worth, whichever is greater.
Additionally, one of the key investor protections provided in the crowdfunding rules is the requirement that the transactions take place through an SEC-registered intermediary, either a broker-dealer or a funding portal. The rules, in fact, will create a new type of SEC registrant specifically for funding portals and will subject them to certain requirements and prohibitions.
It’s a common misconception that investors could already invest in companies through online platforms such as Kickstarter or Indiegogo.
“Those platforms allow individuals to contribute money to companies or projects in exchange for ‘rewards,’ such as a T-shirt or a coffee mug,” said Borger-Gilligan. “Companies presently cannot use those platforms to raise capital in exchange for shares or an ownership stake in the company.”
For those considering a crowdfunding investment, the Tennessee Securities Division offers the following five tips to consider:
- Those seeking to raise funds through crowdfunding may be well-intentioned, but inexperienced.
- The information about the investment may be limited to what is provided through the funding portal. Investors may need to rely on their own research to determine the company’s track record.
- Due to limited regulatory oversight over these offerings, investors may be left on their own to pursue costly private lawsuits when things go wrong.
- Crowdfunding investments are often illiquid and it may be difficult for investors to resell these securities due to the lack of a secondary market.
- Although the SEC rules are final, they are not effective until May 16, 2016. Crowdfunding investments cannot be offered legally until then. Beware of offerings that seek investments immediately.
As with any investment opportunity, you need to do your research before you invest.
“Investors must be very cautious when it comes to online crowdfunding investments,” said Borger-Gilligan. “All investments have risk, but small businesses and startups have even greater risk than normal. Nearly 50 percent of all small businesses fail within the first five years.”
If you have any questions about crowdfunding offerings, you can always contact the Tennessee Securities Division at 615-741-2947 or 1-800-863-9117.