Economy & Business

New Rules on Startups: A Boon for Small-Time Investors

(Lightkeeper/Dreamstime)

A Halloween treat for small-time investors: On October 30, the Securities and Exchange Commission, one of a handful of federal agencies charged with regulating U.S. financial markets, announced long-awaited amendments to its rules that allow all individuals to invest in equity offerings from unlisted startups. Under the new SEC rules, anyone can invest up to $2,000, or up to 5 percent of their annual income or net worth, in equity offerings of up to $1 million over the course of a year. Until now, only accredited investors — those who either have high incomes (over $200,000 in each of the last two years, or $300,000 if filing jointly with a spouse) or high net worth ($1 million or more, not including the value of a primary residence) — had the freedom to make these investments. With this rule change, the SEC has removed yet another hurdle in the evolution of our financial system toward a decentralized and democratized future, in which banks matter less and individual investors and entrepreneurs matter more.

How revolutionary is this rule change? Accredited-investor rules were designed to ensure that unsophisticated middle-class investors weren’t seduced into making investments they couldn’t begin to understand, and many fear that weakening these rules will fuel speculative bubbles and fraud. There is, however, a precedent for these new rules. The SEC has only brought the U.S. regulatory approach in line with the approach already taken in the United Kingdom and elsewhere, where equity crowdfunding platforms such as Crowdcube and Seedrs are well established. Seedrs, in fact, has announced plans to launch in the United States, on the back of the SEC announcement.

And the rule change builds on the explosive growth of peer-to-peer lending. Over the past few years, peer-to-peer lenders such as the Lending Club and Funding Circle have made it much easier for small businesses and entrepreneurs to meet their borrowing requirements without ever having to deal with a bank. But peer-to-peer lending mostly caters to small businesses that are relatively established and often profitable. Younger, less established businesses need equity investment, not debt, and this is where a more democratized equity-investment regime for new, unlisted firms is so beneficial.

As John Haltiwanger’s work shows, it is new, fast-growing startups that are responsible for most of the job creation nationwide, and there is still a “startup deficit” in the United States. Since the 2008 crisis, the rate of formation of such new firms has collapsed, and it remains at levels far below those we saw over the past three decades.

The collapse in the formation of startups

Source: “Haltiwanger’s ‘Startup Deficit,’ ” Jonathan Ortmans, Ewing Marion Kauffman Foundation

Equity crowdfunding can help reverse this decline. Just as peer-to-peer lending platforms enable individual lenders to lend small amounts of money to many borrowers, equity crowdfunding platforms enable even startup investors with small pools of capital to build up a well-diversified portfolio. Similarly, the SEC has wisely allowed startups to submit “reviewed rather than audited” financial statements, which allows startups to raise much smaller amounts than it would be feasible to raise via more-institutional channels.

More significantly, equity crowdfunding can help broaden and diversify the type of ventures that get financed. Venture-capital firms are geared to invest in a particular sort of new firm, one that has the potential to grow at an exponential rate and dominate its market. But there is no reason for individuals on equity crowdfunding platforms to be restricted in such a manner. Profitable small businesses that would like to undertake small but risky expansion plans can tap into equity crowdfunding, as can businesses that have no desire for market domination but can profitably serve a small niche.

#share#Startups today tend to go public at a much later stage than they did in the past. In this environment, equity crowdfunding provides an opportunity for small investors to participate in the value creation that they otherwise cannot. Some commentators are concerned that most investors are ill equipped to evaluate the quality or the risk of the startups that seek their investment. There is no doubt that investing in unlisted startups at the “seed” stage is a much riskier proposition than investing in even the riskiest of the publicly listed companies.

It is condescending, however, to suggest that small investors cannot grasp this elementary fact. The SEC rules limiting the amount (5 to 10 percent, at most, of income or net worth) that a non-accredited investor can invest through equity crowdfunding further reduce the risk that small investors will invest too large a sum of money. The ability to invest small sums of money in each investment opportunity means that even a small portfolio can be well diversified. Will many crowdfunding investors lose money in the next boom-and-bust cycle? Almost certainly they will, just as investors lost money by investing in publicly listed startups in the aftermath of the 2000 dotcom bust.

Moreover, we already allow small investors to “gift” as much money as they want on platforms such as Kickstarter. To limit them from investing in the same venture as a part owner with the legal protections against fraud afforded by being an owner is simply insane. If we can allow individuals to collectively donate millions of dollars to ventures without any ownership stake, we can certainly allow them to invest a million dollars in the same ventures while receiving an ownership stake in return.

The growth of the Kickstarter funding model also highlights that individuals fund projects based on more than just a pure monetary interest. When individuals invest their money directly in ventures that they care about, they are motivated by much more than just the prospect of riches. But we can do better than allowing individuals to donate money on a hope and a prayer. Expecting everybody to move to a “gift economy” is unrealistic. We can enable a genuine capitalism for the masses, in which individuals can fund projects that provide them with a non-monetary payoff but with all the legal protections afforded by “corporate” capitalism.

— Ashwin Parameswaran is co-founder of the peer-to-peer lending startup Unbolted, in the United Kingdom.

Recommended

The Latest