What Title III Of The JOBS Act Really Means by George Gaprindashvili, PitchBook
Last week, the U.S. Securities and Exchange Commission (SEC) approved Title III of the Jumpstart Our Business Startups (JOBS) Act, allowing non-accredited investors—individuals with an income of less than $200,000 per year or a net worth of under $1 million—to invest in startups. The ruling, which will go into effect 180 days after publication in the Federal Register, has generated a good deal of excitement, but it’s important to understand how the parties involved will actually be affected.
There are rather strict limits on how much individuals can invest under Title III. These limits are intended to protect investors who engage in equity crowdfunding by capping the amount of money they can risk, but they also prevent the possibility of big payouts for most.
- Individuals with an annual income or net worth of less than $100,000 can invest in all crowdfunding issuers during a 12-month period the greater of $2,000 or 5% of annual income.
- Individuals with an annual income or net worth of $100,000 or more can invest 10% of annual income, not exceeding an amount sold of $100,000.
Let’s do the math. Say you’re a middle-class American making $50,000 annually. You would be able to invest $2,500 per year through crowdfunding platforms. Given that a fundamental strategy in venture investing is diversification, it wouldn’t be smart to throw your entire limit into one startup. So you invest $250 across 10 deals. Fast forward eight years; nine of the companies you’ve invested in have failed and one was acquired for $100 million. Great news, right? Not exactly. Your initial $250 investment is likely the only money you’ll ever put into the company because startups utilizing Title III must raise their funding within 12 months, so by the time you’re ready (or allowed) to re-up your investment, the company is already thinking about raising over $1 million or bringing on institutional investors, both events that would exclude your involvement. At this point, not only are you unable to invest further in the company but each institutional round it raises will dilute your stake. Even for unaccredited investors with an income of more than $100,000, these limitations severely cap potential profits.
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The Early-Stage Company
Startups/small businesses arguably stand to gain the most. As described above, any one investor doesn’t really benefit a great deal from the Title III ruling, but a big group of those investors can provide startups with large sums of capital. This opens up a huge door for these businesses, making it easier than ever to raise funding. But companies that choose to leverage Title III and issue securities to unaccredited investors face regulatory burdens of their own. Aside from limits on how much they can raise (maximum of $1 million) and how long they have to raise it (12 months), startups are required to disclose financial data, including the use of proceeds from the offering and financial statements accompanied by information from tax returns. The preparation and disclosure of this information will require companies to spend time away from their business, as well as resources on lawyers and accountants. The time and capital commitment required to satisfy SEC regulations before a startup can even begin to raise money through crowdfunding can reach hundreds of hours and thousands (maybe tens of thousands) of dollars. This will likely prevent a lot of companies looking to raise a relatively small amount of funds from utilizing Title III.
Furthermore, companies that choose to crowdfund face creating busy cap tables that can hinder their ability to get institutional investment down the road. According to John Medved, CEO of equity crowdfunding platform OurCrowd, “Venture capitalists react negatively to messy cap tables, especially those that have potentially hundreds of individual investors. Thus any startup company that ultimately seeks to bring in major venture capital funders should make sure that individual investors are aggregated in a special purpose vehicle (SPV) or other nominee structure that results in a single cap table line item.” Title III does not currently allow this.
Finally, only U.S.-based issuers can currently leverage Title III so startups in active VC regions like Israel, Germany and the U.K. are out of luck, at least for now.
The Crowdfunding Platform
Crowdfunding platforms already exist and have for some time now, they just haven’t been allowed to let unaccredited investors purchase equity in businesses. Companies raising capital on sites like Kickstarter and Indiegogo don’t sell securities; instead, they provide investors (who are really actually just supporters of the product) with “rewards” like discounted pre-orders and free gear. The glaring example here is Oculus, which initially raised funding on Kickstarter and left its early “investors” with nothing but a headset when it got acquired by Facebook for $2 billion. Platforms like OurCrowd, CircleUp, FundersClub and SeedInvest have been in existence for years, operating under a venture capital exemption and engaging in Title II accredited investor crowdfunding.
But Title III gives all of these crowdfunding platforms a new structure to think about. Donation crowdfunding sites like Indiegogo now have the option to facilitate the sale of securities, allowing supporters to become investors. Equity crowdfunding platforms will now be able to cater to millions of non-accredited “angels.” But will they? Unlike the Title II exemption, equity crowdfunding platforms that utilize Title III will have to register with the SEC as a broker-dealer or a funding portal, placing restrictions on how they can be compensated and prohibiting them from offering investment advice, soliciting purchases, handling investor funds and more.
Title III will enable essentially everyone to invest in startups, companies to raise capital more easily and online platforms to facilitate the sale of securities, but the SEC’s regulations, though meant to limit investor risk and prevent fraud, may prove too burdensome for this type of equity crowdfunding to thrive.