Finally – Legal Investment in Small Businesses

SECYou no longer have to be super wealthy to invest in a new startup company or small business. On October 30th, the Securities and Exchange Commission (SEC) announced new rules that will make equity crowdfunding legal, something investors and small companies looking to raise money have been waiting a long time for. While not perfect, the rules are a step in the right direction to allow capital to flow freely and efficiently to new business ideas and products, which could unleash exciting opportunities.

What is Equity Crowdfunding?

Many people are familiar with the idea of crowdfunding in general — raising money from a large group of people. The two biggest crowdfunding platforms are Indiegogo and Kickstarter. But have you ever noticed that both platforms only allow you to receive products in exchange for your contribution? In other words, you may get a t-shirt or the first product that rolls off the assembly line, but you can’t have an ownership stake in the company: that would have been illegal.

This problem became glaringly obvious to people when Oculus Rift, a virtual reality headset in development, was purchased by Facebook for $2 billion. The project was initially launched on Kickstarter, and those who helped get the company off the ground were given an early prototype of the product in return. But when Facebook made the acquisition, these backers received nothing because they didn’t actually have any shares in the company.

Previously, only accredited investors, or those who were already wealthy, were able to participate in these investments. Now there is the potential for anyone to invest in companies looking to raise capital. This is important for a number of reasons.

First, is the fact that it is the not-yet-wealthy investors who have the most to gain. Wealthy investors who invest only a few thousand dollars into a company are not likely to see a big enough return to move the needle in comparison to their other investments. But a young person who spots a good opportunity can get a big boost to their personal balance sheet.

Second, this opens the door to an entirely new and more efficient way of raising capital for small companies and startups. Previously, these people could only go to their closest relatives and friends for help. It’s hard to get in front of a venture capital firm, and most startups are too small for them to be interested anyway. Beyond that, the small startups were left with either getting a bank loan, racking up credit card debt, or taking out another home mortgage.

In addition, venture capital firms may not fully understand the product or service a company is trying to sell, as they may not have expertise in that area. But average investors have localized knowledge in specific fields where they have experience, and they may be a better judge of whether something will be a flop or a success. For example, someone who works in the food service business will be able to assess whether a new cooking device will actually save time and money, while someone on Wall Street may not have a clue.

The Good and the Bad

Unfortunately, the securities industry is one of the most highly regulated areas of finance, and the new rules are not exactly simple. Although the 686 pages of the final rule are still being combed through, it is clear there will be many restrictions.

For example, companies will be limited to raising $1 million or less, and investors will be limited to how much they can invest as well. It looks like investors will be allowed to invest a minimum of $2,000 per year, but beyond that the amount they can invest will be determined by their net worth and income (never mind the fact that they are legally able to blow as much money as they like at the casino!). The offerings will also have to be done through a registered and approved crowdfunding portal or platform. The rules will likely go into effect sometime in mid-2016.

Nevertheless, this is at least a step in the right direction. Hopefully, as the concept proves itself, the SEC will relax some of these restrictions and allow entrepreneurs to harness the power of the internet and the localized knowledge of investors, and in turn bring new products and services to the market to make our lives better.

Chris Kuiper, CFA is currently a student and researcher at George Mason University, pursuing a Master’s of Economics. His previous experience includes asset management, investing and banking.