More and more, the term “crowdfunding” is being used for a dizzying variety of business funding options. The term seems to be used for everything from Kickstarter community projects to real estate projects to advertising startup deals to accredited investors to investing in tech companies that are ready to go public.
These broad uses of “crowdfunding” are confusing to me and many others. Even worse, the blurring of terms can impact understanding of the important regulatory differences applied to the variety of investment options. The distinctions are important to understand because the regulations for each are quite different – and for good reason.
In terms of rules or regulations, the number one dividing line among these different kinds of financing as I see it is between investments available only to accredited investors versus financing by any and all investors. Crowdfunding applies to the later.
Why is this distinction important? Although accredited investors are required to meet income and wealth thresholds, the bigger distinction in my opinion is the sophistication and professionalism of accredited investors – particularly angel investors. What does this mean? Typically angel investors bring a career of business experience and/or focused industry knowledge to their investments, which helps them make informed investment decisions. They tend to do many angel deals to diversify and minimize portfolio risk. Additionally, many angel investors continue their investment education to improve how they analyze investment opportunities and support their portfolio companies to spur further growth and success. And finally, many angels are active investors – they spend time with their portfolio companies to help them reach success. These distinctions don’t apply to the vast majority of general public investors. This is why the government adds more regulations to protect the interests of non-accredited investors.
So how did all of these new investment options evolve to create such confusion? For many decades all investors had pretty much the same investment options. Then in the last decade, investors and entrepreneurs developed new investment options using the Internet and social media. These innovations led to interesting new ways to invest like rewards- or project-based crowdfunding (AKA Kickstarter and Indiegogo) and privately connecting accredited angel investors to invest in deals together via private websites (AngelList got this trend started).
In 2012 Congress added to the excitement with the Jumpstart Our Business Startups Act (JOBS Act). This law created new paths for funding companies, forever changing America’s capital markets. The complicated JOBS Act includes several new options (or “Titles” in Washington vernacular), with three in particular:
- Title II: General Solicitation – allowed for public advertising of securities offerings, as long as all investors in the offerings were accredited investors. SEC rules for this have been in operation since September, 2013.
- Title III: Crowdfunding – this most famous part of the JOBS Act allowed for anyone in the public to make an equity investment in a promising company, with limitations. The SEC has not yet published rules for this, so equity crowdfunding is not yet permitted on a national basis (although more than half of the states have authorized it within their borders). Perhaps new rules will come this October.
- Title IV: Regulation A+ - allowed for public offerings of up to $50 million with “mini-registration” requirements, and investors can be unaccredited. These rules, which I believe support “mini-IPOs,” became effective in June, 2015.
To me, only Title III is true crowdfunding (along with product, rewards and lending crowdfunding). However confusion arises because others refer to all three JOBS Act titles—and other things—as crowdfunding. I guess this confusion is less important than this, though: rules that govern investment in which only accredited investors are qualified, like Title II, have fewer limitations for both investors and issuing entrepreneurs and include more exemptions from public registration.
Accredited investors, even in Title II generally solicited deals, are exempt from securities registration and there are no limitations on the amount of capital issuing entrepreneurs can raise or how much accredited investors can invest. In contrast, JOBS Act legislation requires the SEC to include several limitations in its rules for Title III equity crowdfunding: deals cannot exceed $1 million per year, all investments must be completed on regulated platforms or brokers, and investors are limited on how much of their income or net worth they can invest, among others.
Why does this matter? Angel investors are an important part of the accredited investor community. Because of their sophistication and the correspondingly reduced regulations, angels have been able to invest larger and larger amounts of capital in 50,000 plus entrepreneurial startups every year over the last decade. I like the way Michael Raneri explained it in a Forbes article earlier this year. His comment about venture capitalists also applies to angel investors:
"Private company investing, especially in early stage startups, can be risky business. Venture capitalists who do it are professionals. They know the risks. They know that most individual startups will not produce big paydays. They expect perhaps one in 10 investments to pay out, and they know their money will be tied up for perhaps seven to 10 years. Individual investors are typically less able to bear these kinds of risks, or feel comfortable with the lack of liquidity. Most won’t be able to afford to invest in enough companies to play the odds, and they won’t have the experience necessary to pick the most likely winners."
Sophisticated, accredited angels build their professionalism through experience, education, and sharing ideas with other investors. They focus on building relationships that attract high quality deal flow, conduct thorough due diligence, and pay the right price for assets. They are also taking on more responsibility and active roles in driving performance and exits of portfolio companies and are increasingly active in incubating other companies around them. Christopher Mirabile, Chairman of the Angel Capital Association, explained the growing professionalism of angels in a recent podcast.
But don’t get me wrong - crowdfunding is an exciting option in the world of entrepreneurial finance. I can’t wait to see its impact on American startups in coming years. But it is important to understand that different types of investing are truly different, especially with respect to regulatory distinctions. To ensure that a variety of investment options are available to support an investor’s sophistication level, it’s important for the startup ecosystem to be careful not to lump all investors under the same “crowdfunding” umbrella.
