In case you missed it, the Securities and Exchange Commission announced some major changes this week to the ways that startups can raise money. It’s by no means hyperbolic to say that this will forever change the lifecycle of startups. You can definitely expect to see big changes in companies like Indiegogo and Kickstarter next year.
At their core, these new rules allow budding startups to crowdfund their early capital through the sale of shares. Not only this, but unaccredited investors (people with less than $200k in annual income or a net worth of less than $1M) can, for the first time, be involved in this fundraising.
This all kicks into gear on January 29th, 2016. Lets talk basics.
For Newbie Crowdfunding Investors
- Anybody will now be able invest
- People with <$100,000 net worth or annual income may only invest up to $2k annually or 5% of their income each year — whichever is highest
- People with >$100,000 net worth or annual income may invest up to 10% of their income annually
- No investor, regardless of income (that’s right Mr. Cuban), can invest more than $100,000 annually through crowdfunding
- Investors, of course, do-so at their own risk.
For Startups Seeking Crowdfunding
- May only raise up to $1M annually from crowdfunding
- They must have a “specific business plan” and that business plan can not be simply to get acquired or sell. This is pretty ambiguous still.
- They must disclose how they plan to use the money raised
- They must provide financial statements that have been reviewed by a public accountant and any information that may impact an investor’s decision to invest.
- Companies may not raise through multiple crowdfunding platforms (websites) at one time
- There is no more formal audit requirement to check for solvency
For Crowdfunding Platforms
- May not recommend which startups to invest in
- Must be registered with the SEC
- Must provide comprehensive educational material on investing in the platform and how the shares work with each investment
- Must provide comprehensive information on the companies seeking funding — everything required for the startups to disclose
- Info must be provided for at least 3 weeks before offering
- Must provide users with a place to communicate openly about the offering
- Must have “a reasonable basis for believing that a company complies with Regulation Crowdfunding and that the company has established means to keep accurate records of securities holders”
So is this good news? In many ways it seems so. This is a big victory for the SEC in overcoming a number of concerns around protecting lower income investors while still offering a way to allow for crowdfunding — an obviously growing arena — to play its part.
That said, lets do some math on what the average crowdfunding investor can expect.
9 in 10 of the “Good” Startups Fail
This isn’t just a generalization accounting for all of the small startups that quickly close shop. Even a Business Insider analysis of Y Combinator’s best and brightest showed the success rate at just over 10%. Forbes found similar results as well. If we account for all of the companies that seek venture funding, the numbers are much, much lower.
Mathing it Out
Considering the $1M cap on crowdfunding rounds, let’s imagine a company raising for 20% of their company at a valuation of $5M.
If an individual with an annual income of $80,000 invested their maximum of 5% into that company ($4,000) they’d be all set to own a cool .08% of the startup.
If that same startup went on to beat the odds and sell for $10M 5 years later, the investor would of course have doubled their $4k investment and been successful. But considering the success rate of even the most select startups (many of which will likely reject the crowdfunding option altogether in order to work with more experienced investors) it for now seems likely that most crowdfunding investments will be incredibly risky.
Of course, there is always the chance to hit it big with the next big thing. Let’s not forget the graffiti artist at Facebook who made $200M for taking shares to paint a wall over payment in FB’s early days. Expect to see diversified investments across many startups as well as third party advisor sites take on popularity in 2016.