The Wall Street Journal recently reported that the Securities and Exchange Commission (SEC) is considering easing the regulations on how private companies raise capital.
The areas that the SEC is going to review are general solicitation rules, the 500 share holder limit and regulations around crowdfunding. Easing these regulations will have a major impact on how startups raise capital and will help more startups raise funding.
Let’s review each of the regulations and see how startups could benefit.
General Solicitation
The SEC restricts the solicitation of private securities to the general public. This is done to protect investors who could be targeted in a marketing campaign and could possibly put their life savings into a risky investment. Private companies like Facebook or Twitter don’t have to share financial details with the public, so if you buy their private stock there is a lot more risk involved than buying shares of a public company, like Google.
Accredited investors are currently the only group that has access to purchase private securities. Relaxing the regulations on broadcasting that opportunity would not ultimately change the investor base. As Dan Primack points out in his Term Sheet column: “I know that a Tesla Roadster base price is $109K -- but that doesn't change the fact that I can't afford to buy it.” In other words, being solicited to purchase shares of Facebook and knowing the stock is trading for $37 dollars a share with a minimum purchase of $500K doesn’t mean that I can or will buy.
The ease of restriction on solicitation would mean a startup could message out to their social networks when they are looking for capital. This type of broad communication is not available today.
What if Twitter could have messaged out to their early adopters and others that they were looking for additional funding? They had a large foundation of followers who saw the potential of the service and would have possibly invested, which would have given those investors a great return based on the current valuation. There is certainly risk in soliciting funding from your user base when your startup is just beginning. Take the Vonage IPO as an example.
In 2006, the IPO was presented to Vonage customers as an opportunity to invest and take advantage of what was thought to be the next big thing in telecommunications. Early investors, a lot of them Vonage customers, watched as stock dropped 30% in the first week. This caused many issues for Vonage including a lot of unhappy customers. As an investor, we have to do our homework on any potential investment opportunity, regardless of how we found out about it. Receiving a solicitation about private securities should not change investor due diligence behavior.
I, like many, read about new startups online and often wish I could invest in them. If the idea is good enough, I will reach out directly and pursue them on my own. I am not alone, and startups could increase the number of funding partners if only they could promote their concepts to a broader audience. We are inundated every day with solicitations from a variety of companies to buy their products, but ultimately we decide whether to pursue or turn away. The same allowance should be given to private securities.
500 Shareholder Limit
The SEC thought process is that at a certain point, in this case 500 shareholders, a company has become large enough that it should start providing detailed insight into company operations. This number was instituted when brick-and-mortar was the main form of enterprise and your investors were within a 50 mile radius of the company. This outdated threshold must change to accommodate new ways of doing business. A private security has an ethical obligation to keep its shareholders informed, and this should not be based on an arbitrary number. Increasing the investor shareholder limit will help startups in a number of ways.
A startup company will be able to stay private longer, which could give them a competitive advantage. Under current regulations, when a private company hits 500 shareholders, there are several reporting requirements that it must file with the SEC. The company must disclose information on its operations, information on officers/directors including salaries, and financial condition of the business, which is audited by an independent CPA. This information would be made public and is very valuable to a competitor.
Preparing for and facilitating reporting can cost a startup $50,000 to $200,000 annually. Being able to delay this formal reporting and associated cost while the startup is still in its infancy will help improve probability of future success. This money could be better used during initial start up to grow profitability for shareholders.
Startups would be able to allow more investors to participate with smaller investments. This is especially important for crowdfunding.
Crowdfunding Regulations
