Why You Can’t Be A Shark On Shark Tank

[Update: This post is an expansion on the previous post, 4 Economic Reforms to Ignite Startups in America. The laws originally mentioned in this post are now changing rapidly. It is actually becoming easier for anyone to invest in startups. The history, explanations and recommendations in this post are still valid though]

Have you ever dreamed about investing in startups like the Sharks on Shark Tank? Investing in startups is risky but potentially lucrative. Both the investor and the entrepreneur stand to make a lot of money if things go well.

Want to get in on the ground floor of the next big startup as an angel investor? It’s your money, so as long as you understand the risks, you can invest in a startup!

…well, that’s not entirely accurate.

Unless your net worth is over $1 million excluding your primary residence or you earn more than $200,000 annually ($300,000 combined if you’re married), you are effectively, and sometimes even legally barred from investing in startups.

The law that prevents you from angel investing like a Shark

Average Americans are not allowed to be angel investors like the Sharks on Shark Tank.

The SEC divides Americans into two categories– people who have over $1 million in assets or who make over $200,000+ annually are considered “accredited investors”. Everyone else who falls below this line is considered a “non-accredited investor”. The SEC’s reasoning for this? They assume if you don’t meet these arbitrary financial thresholds, you probably aren’t savvy enough to be investing in startups– how demeaning is that?

If you are not an accredited investor, in order to invest in a startup you better be lucky enough to know the founder personally, because startups who publicly seek investors cannot take money from you. That isn’t the case for accredited investors– they can invest in any startup they wish, and those startups can connect with them in a growing number of ways thanks to the rise in equity crowdfunding.

What’s worse, even though a small business can technically accept 35 non-accredited investors in a private fundraising round, the moment they accept money from just one non-accredited investor, various SEC disclosure requirements are triggered, which takes time and money to comply with. This alone essentially forces small businesses to avoid accepting investments from non-accredited investors altogether.

The lack of investment opportunity is a big concern in terms of growing income inequality as well. The most lucrative time to invest in a fast-growing startup is while they’re still small private companies, so some of the best investment opportunities are only available for wealthy individuals.

This means the only opportunity for average Americans to invest in fast-growing businesses is the stock market. But thanks to some poorly designed laws and a whole heap of unintended consequences, those opportunities are becoming increasingly limited as well.

The IPO and public markets have changed

After the stock market crash of 1929, Congress enacted laws severely restricting how privately-held businesses could raise money from investors– which is understandable since back then, information did not flow as quickly and as transparently as it does today. This forced a lot of investment activity to move from private investments to the stock market.

Then in 2002 in response to the Enron, Tyco International and WorldCom scandals, Congress passed the Sarbanes-Oxley Act which forced companies listed in the stock market to comply with stricter internal controls and financial disclosures. The goal of SarBox was to try and regain the public’s confidence in the stock market. Unfortunately, SarBox came with a whole host of unintended consequences– due to the increased costs involved for companies to be listed on the stock exchange, as well as the reduced need for these companies to raise capital in the stock market thanks to thriving private markets, less companies are deciding to go public and are waiting longer than usual–

Year IPOs per year Median Age
1980-1989 204 7
1990-1994 344 9
1995-1998 473 8
1999-2000 428 5
2001-2013 103 11

Source: http://bear.warrington.ufl.edu/ritter/IPOs2013Age.pdf

When companies wait longer to go public, they are typically much larger by the time the public has the opportunity to invest in them– four of the six largest IPOs occurred in the last 4 years, and all six within the last six years. As a company grows larger, their future growth potential shrinks. Therefore, by the time a company goes public today, the hypergrowth stage is most likely behind them, and along with it the potential for a truly outstanding return on investment.

Crowdfunding picks up the slack

Because the stricter SEC laws have forced companies to wait longer before going public, the private markets have been playing a larger role in financing them, since the companies still need money from somewhere. The crowdfunding industry is primed to be the main source of deal flow. Seed-funding rounds and angel investments are increasingly taking place on crowdfunding platforms, making these “private” investment opportunities just as available as the stock market, yet completely cut-off from average investors.

The following crowdfunding platforms are already up-and-running and connecting businesses with accredited investors–

The crowdfunding industry isn’t waiting for the government to update the rules– the industry is already a viable option for businesses to raise money and investors to find investment opportunities. The longer the industry runs on archaic policy guidelines from the SEC, the longer it will take for these platforms to mature, the longer small businesses will have to deal with a subpar crowdfunding industry, and the longer the average investor will miss out on potentially lucrative investment opportunities.

JOBS Act Title III to the rescue?

Luckily, legislation known as the JOBS Act has already been passed by Congress to try and modernize the laws. You’re probably asking yourself– “if it’s already passed by Congress, then what’s the problem?” Congress left it up to the SEC to define some of the specific rules that will govern the crowdfunding industry, and the SEC has yet to define some of the most important parts.

Many provisions of the bill became effective immediately, but the SEC dragged their feet in defining rules for two of the most important provisions — Title II and Title III. Although it took the SEC over 15-months to define the rules, Title II finally lifted the ban on general solicitations, allowing private businesses to publicly announce the terms of investments they are seeking and paved the way for mainstream crowdfunding platforms to operate. Title III defines the remaining crowdfunding laws and opens the doors wide open for the industry to flourish.

Unfortunately its been over 9-months since the SEC proposed rules to JOBS Act Title III that have yet to be adopted.

The SEC’s proposed rules for JOBS Act Title III

The SEC proposed rules for JOBS Act Title III back in October 2013 for a 90-day public review, at which time they would adopt the rules and put them in place. That deadline has long passed. Below are some of those proposed rules–

Financial Limits–
The proposed rules set certain thresholds and limits, including but not limited to–

  1. Companies can only raise $1 million through crowdfunding in a 12-month period
  2. Individuals with both an annual income and net worth of less than $100,000 can only invest $2,000 or 5% of their income into crowdfunded securities in a 12-month period, whichever is greater.
  3. Individuals with either an annual income or net worth greater than $100,000 can invest up to 10% of their annual income (capped at $100,0000) in crowdfunded securities over a 12-month period.
  4. Non-US companies cannot raise money on US crowdfunding platforms
  5. Companies already reporting to the SEC cannot raise money on crowdfunding platforms
  6. All crowdfunded securities cannot be resold for a period of one year

Disclosure rules for companies raising money via crowdfunding–
Companies crowdfunding must report certain information to both the SEC and their potential investors, including but not limited to–

  1. Select information about all officer and directors of the company, as well as owners with a 20%+ stake in the company
  2. Description of the company and how the proceeds will be used
  3. Price of the security offered, target offering amount, deadline to reach target, and whether the company will accept funds in excess of the target
  4. Description of the financial condition of the company
  5. Financial statements of the company that depending on certain thresholds would have to be accompanied by the company’s tax returns, or must be reviewed and audited by an independent public accountant or auditor
  6. Companies would have to amend these details as the crowdfunding campaign was live to reflect any changes
  7. Companies relying on the crowdfunding exemption to offer and sell securities would be required to file an annual report with the SEC and provide it to investors.

Requirements for crowdfunding platforms–
The JOBS Act Title III requires all crowdfunding campaigns to take place on SEC-registered intermediaries– either a broker-dealer, or a new entity called a funding portal — that would have to abide by the following rules–

  1. The platform must provide investors with educational material
  2. The platform must take measures to reduce the risk of fraud
  3. The platform must make information about the company available
  4. The platform must provide communication channels to permit discussions about the offering
  5. The platform must facilitate the offers and the actual sale of the crowdfunded securities
  6. The platform must not offer investment advice or make recommendations
  7. The platform must not solicit offers to buy the securities offered on its own website
  8. The platform must not impose restrictions on compensating people for solicitations
  9. The platform must not hold, possess or handle investor funds or securities

Recommendations for improving JOBS Act Title III

The crowdfunding industry is maturing and becoming an increasingly important part of the startup financing ecosystem– and it’s not waiting for policymakers to catch up. Without improving these rules, we will not be efficiently providing businesses with the cash they need, and we will be alienating majority of the population from these potentially lucrative investment opportunities. The proposed rules are obviously an improvement on the status-quo, but below are concerns I have as well as recommendations to the SEC on how to improve them–

Current rule– “Companies can only raise $1 million through crowdfunding in a 12-month period”

Recommendation: $1 million may seem like a lot, but when it comes to successful crowdfunding campaigns, $1 million is a fraction of what the possibilities are. Successful Kickstarter and Indiegogo campaigns beat this mark, and those are simply donation-based. If a company needs more than $1 million in funding, they should be able to raise it if we want crowdfunding to be a viable industry. Should there be a ceiling on the amount a company can raise?

Current rule– “Individuals with both an annual income and net worth of less than $100,000 can only invest $2,000 or 5% of their income into crowdfunded securities in a 12-month period”

Recommendation: People can invest as much as they want in the public markets with no limit. Sure, the stock of a developed public company is more stable than that of a small startup, but penny stocks sure aren’t. People also aren’t limited to how much they can gamble in casinos. So why limit people to how much they can invest in American startups? Additionally, how is this going to be tracked? The companies can’t track it because they have no control of how much an individual invests in a company other than their own. The crowdfunding platforms can’t track this because they can’t control how much an individual invests on platforms other than their own. So who’s left, the SEC? How are they going to track it?

Current rule– “Individuals with either an annual income or net worth greater than $100,000 can invest up to 10% of their annual income (capped at $100,0000) in crowdfunded securities over a 12-month period.”

Recommendation: This still raises the follow problem of who’s responsible for tracking this and how it will be done. There are also further implications of having a maximum cap, especially one as low as $100,000. One of the biggest concerns venture capitalists and angel investors have with crowdfunding is that it can complicate future fundraising rounds due to the sheer number of investors involved. Therefore, if one individual wants to sweep in and fully-finance one particular crowdfunding campaign, that should not only be allowed, but might even be the most ideal situation. However, as the rules stand, if a company was raising the maximum of $1 million and an investor came along who had the means to fund the entire round, not only would they not be able to, but nine other individuals would have to commit in order to complete the round.

Current rule– “All crowdfunded securities cannot be resold for a period of one year”

Recommendation: I keep going back-and-forth on this one, but it’s worth at least discussing. In general, adding liquidity to an asset is a good thing. Therefore, removing restrictions to liquidity on crowdfunded securities should be a good thing.

Current rule– “Financial statements of the company that depending on certain thresholds would have to be accompanied by the company’s tax returns, or must be reviewed and audited by an independent public accountant or auditor”

Recommendation: How are brand-new businesses with no history treated? How expensive and burdensome will these requirements be? This rule has the potential to derail the crowdfunding market like SarBox derailed the IPO market.

Current rule– “The platform must provide communication channels to permit discussions about the offering”

Recommendation: This rule is too specific in assuming how crowdfunding platforms will operate and therefore will hinder the development of new platforms and new business models. Is a communication channel good practice for a crowdfunding platform? Sure. Should it be mandated? Probably not. If it’s that necessary, a platform will naturally include it or risk getting beat by the competition and going out of business.

Current rule– “The platform must not offer investment advice or make recommendations”

Recommendation: This also worries me for being too specific. Platforms would have to be careful anyway with making investment advice at the risk of legal accountability. However, this rule may limit innovation in the industry. What if a platform wanted to develop a proprietary ranking system to provide investors with a way to sort offerings and also encourage businesses to meet certain financial characteristics similar to how Morningstar rates mutual funds with stars or Yelp rates restaurants with stars? Would that not be allowed?

Current proposed rule– Burdensome executive compensation disclosure

Recommendation: This seems unnecessary. If a company wants to release this information because they feel it will help them attract more investors, they should. But if they don’t want to for whatever reason and risk not attracting as many investors, they should have that right as well.

Small business is ingrained in our culture. The SEC needs to define rules for Title III of the JOBS Act as soon as possible to empower average investors, startups and small businesses by giving the crowdfunding industry the policy framework it needs to prosper. Let’s urge the administration and the SEC to finally take some action and finish what it started!

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Stephen Steinberg

Stephen Steinberg

Stephen is the Founder of Vapor Fresh, a line of safer plant based cleaning products for the sports & fitness industry, as well as Founder of Animate Yerba Mate, a brand bringing quality unsmoked organic Yerba Mate teas to the USA.