Crowdfunding, Accredited Investor Definition Changes May Shape Startup Investing in 2016

In late 2015, the U.S. Securities and Exchange Commission (SEC) released two rule changes that may shape the future of equity investments in startups and small businesses. The two new rules directly address issues related to the accreditation of investors – an important element of the angel investment ecosystem that has long driven early stage investments in startups. In December, the SEC released a report on proposed changes to the definition of accredited investors. In November, the SEC released its rules for Title III of the JOBs Act that allows startups to raise equity from both accredited and non-accredited investors through a publicly solicited crowdfunding campaign. The new rules will allow equity crowdfunding to go into effect in May of 2016.

On December 18, the SEC also released a new report on the Accredited Investor definition. The proposes changes may include revising the financial thresholds requirements for natural persons to qualify as accredited investors and the list-based approach for entities to qualify as accredited investors. Potential changes include:

• Leave the current income and net worth thresholds in place, subject to investment limitations.
• Create new, additional inflation-adjusted income and net worth thresholds that are not subject to investment limitations.
• Index all financial thresholds for inflation on a going-forward basis.
• Permit spousal equivalents to pool their finances for purposes of qualifying as accredited investors.
• Revise the definition as it applies to entities by replacing the $5 million assets test with a $5 million investments test and including all entities rather than specifically enumerated types of entities.
• Grandfather issuers’ existing investors that are accredited investors under the current definition with respect to future offerings of their securities.

In addition to revising the financial thresholds requirement , the SEC report also proposes altering the accredited investor definition to allow individuals to qualify as accredited investors based on other measures of sophistication. This would allow investors to be defined as an accredited investor based on criteria other than income and net worth. Potential criteria could include permitting individuals with: minimum amount of investments; certain professional credentials; experience investing in exempt offerings; knowledgeable employees of private funds; and/or, pass an accredited investor examination to qualify as accredited investors.

In an Op-EDd, Marianne Hudson – the executive director of the Angel Capital Association (ACA) – pointed out that the report’s summary includes a potential rule change that would make investments made by accredited investors subject to investment limitations. However, at this time it is unclear what those limitations could potentially be.

After several years of anticipation, startups and other small business will finally be able to raise funds via equity crowdfunding. Proponents of equity crowdfunding contend that 2016 will see several big changes due to the new SEC regulations including:

• A flood of online platforms register with FINRA;
• The emergence of secondary markets to facilitate the sale of previously issued, crowdfunded equities; and,
• As many as 225 million new investors potentially flooding into the private equity market.

In addition, proponents also contend that minority and women owned business may benefit from the new crowdfunding rules because it allows unaccredited investors from more diverse backgrounds to make investment in startups and other small businesses. For low-income communities, the new rules might have dramatic effects on low-income neighborhoods by helping minority-owned businesses grow and create employment opportunities for other minorities.

Others, however, contend that crowdfunding may be more hype than helpful. Adam Wicks from Buchanan Ingersoll & Rooney PC – a large U.S. law firm and lobbying group – highlights four limitations of the new crowdfunding laws:

• Limitation on the amount an issuer can raise;
• Limitation on amount persons may invest;
• Required use of intermediary platform; and,
• Offering disclosure requirements.

Wicks contends that the new rules will likely involve substantial cost and effort for the issuers wishing to take advantage of the exemption.  He also points out that securities issued in reliance on the crowdfunding exemption are subject to resale restrictions, and may not be transferred by any purchaser during a one-year period after the securities are issued, except for transfers to limited specified parties.

In addition to the issues outlined by Wicks, Jonathan Ortmans contends that the adoption of equity crowdfunding will be slow because it takes time for platforms, lawyers, accountants, etc. to get up to speed with the new rules. He also believes that most existing fundraising platforms will jump at the opportunity to offer equity crowdfunding services because it is unclear whether it will be economically viable to do so.