Later this spring U.S. retail investors will get their first crack at a new type of equity investing: buying shares of start-ups and small- to medium-size companies sold by online crowdfunding platforms.
Financial portals have already started registering with the Securities and Exchange Commission to begin offering small investors access to equities when the crowdfunding rule of the Jumpstart Our Business Startups Act, the 2013 law better known as the JOBS Act, goes into effect on May 16. Currently, crowdfunding is limited to so-called accredited investors with deep pockets, who were judged better able to absorb the risks involved.
But companies hoping to cash in on the way Bernie Sanders is raising money for his presidential campaign or the Pebble watch was initially financed may be in for a disappointment. In the more than 600 pages of rules compiled by the SEC for the act’s Title III, which covers crowdfunding, companies can raise a maximum of $1 million in a 12-month period. The rules also limit investors with annual income or net worth of less than $100,000 to investing a maximum of $2,000 per year, or 5 percent of the lesser of their annual income or net worth if that number is greater than $2,000.
As a result of the SEC’s restrictions, crowdfunded equities are expected to get off to a much slower start than in the U.K., where crowdfunding of debt and shares has been growing at exponential rates since the authorities allowed the technique five years ago.
According to market researcher Beauhurst, the U.K. had 293 crowdfunded offerings last year that raised a total of £143 million ($207 million). That was up sharply from 94 deals that raised a total of £16.9 million in 2013.
“Title III is significantly more restrictive than the way equity crowdfunding works in the U.K. and Europe,” says Jeff Lynn, an American who is co-founder and CEO of Seedrs. “And it’s restrictive in a number of regards: the amount that investors are allowed to invest and a whole lot of other thresholds.” Even so, the London-based company — one of the U.K.’s two largest crowdfunding platforms — is gearing up to enter the U.S. market.
U.K. rules are simpler than their U.S. counterparts. British investors simply have to commit to investing less than 10 percent of their net assets. The online portals then administer a simple, multiple-choice written test to ensure that the investors are aware of the risks involved before they are permitted to commit funds. Firms can raise up to £3.5 million ($5 million) in any single offer.
Crowdfunding has been such a success in the U.K. that more than 100 platforms have piled into the business, according to Julia Groves, a director of the U.K. Crowdfunding Association. Those numbers suggest a shakeout of smaller players before long, she adds.
Groves says that the primary factor supporting crowdfunding investments is the generous tax breaks offered to investors in start-up companies by the U.K. government, which she describes as “very significant tax relief.” These concessions allow investors to take a tax deduction of up to 50 percent on any crowdfunding participations and exempt those investments from capital gains taxes. So attractive are the incentives that some crowdfunding platforms only offer shares covered by the tax relief plans.
Sam Robinson, who heads the financial services regulatory team at London law firm Nabarro, says that although there is a perception that early-stage start-ups are the main users of crowdfunding, that is no longer true. In a recent report the firm said the average age of companies that raised funds in 2015 was 3.32 years.
Robinson says most of the companies seeking capital on U.K. crowdfunding platforms are doing so because British banks are much more reluctant to lend money to start-ups than in the past: “Bank finance has fallen away, and once that course of funding became scarce, people have looked elsewhere.”
According to the Nabarro report, 80 percent of companies that raised money through crowdfunding in the past five years are still in business. Although a 20 percent failure rate might come as a shock to many first-time investors, the number is actually modest. Some 55 percent of small companies fail in their first five years, RSA Insurance Group recently reported.
The Crowdfunding Association’s Groves says that another reason some U.K. firms turn to crowdfunding platforms is because they can be an effective tool for marketing the company’s wares. More than half of the investors in Chapel Down, a British wine maker that raised £1 million with a crowdfunded offering, ended up taking advantage of a company offer to investors to buy wine at a discount last Christmas.
“If you can raise money and recruit customers at the same time, that’s a good business plan,” she says.
