As SEC Mulls Equity Crowdfunding, CA Entrepreneurs Test Other Options

California is one of the dominant U.S. producers of fruits, nuts, vegetables—and tech startups. In the Silicon Valley, the startups sprouting up each season are nurtured by a host of accelerators and incubators as well as VCs and angel investors providing seed funding. That still leaves some startups hungry for cash, but California is not one of the states that have opened up a much-touted alternative route to startup fundraising—a controversial method called equity crowdfunding.

Even so, California already has a contingent of fundraising platform companies eager to facilitate equity crowdfunding once the Securities and Exchange Commission issues long-awaited regulations that will make it legal nationwide. In the meantime, some of them are experimenting with alternative fundraising avenues that already exist. Their new models may eventually co-exist with equity crowdfunding, or influence its use.

Equity crowdfunding is a mechanism that allows young private companies to sell small ownership stakes, usually through online portals, to thousands of investors who might only have modest incomes. The idea is a twist on original crowdfunding services such as Kickstarter, where some artists and tinkerers have raised substantial sums—at times $1 million or more—from fans who may send in as little as $25. Those contributors usually receive only small thank-you gifts in return.

But if such startup backers could receive company shares instead, equity crowdfunding supporters say, those small investors could grab an early stake in fledgling companies that might some day turn into the next billion-dollar tech titans. Critics of equity crowdfunding worry, though, that unsophisticated investors could lose their shirts on these deals.

Under U.S. securities regulations, wealthy investors are free to invest in private companies, which is considered riskier than putting money into public companies. But under longstanding rules, the government has limited the ability of private companies to seek capital from people of modest means, or advertise their securities offerings to the general public.

In recent years, though, Congress has relaxed those longtime restrictions. Equity crowdfunding was authorized in its broad outlines by Title III of the Jumpstart Our Business Startups Act (or JOBS Act) in 2012, as a way of stimulating the U.S. economy by freeing up access to capital for startups that are not ready to become publicly traded companies.

California equity crowdfunding portals

After the JOBS Act passed, aspiring crowdfunding portals started popping up in California. They avidly awaited the detailed SEC rules that would implement equity crowdfunding and allow young private companies to sell securities to ordinary investors nationwide. But several years have passed, and the SEC regulations have yet to come out. Rather than continuing to wait, more than 20 states have created their own rules for equity crowdfunding rounds, allowing in-state companies to sell securities to in-state investors. Those states include Massachusetts, Illinois, Texas, Michigan, Wisconsin, New Jersey, and South Carolina.

Similar bills failed in the California legislature. But the state’s fundraising portals, rather than folding their tents, are still trying to make a business out of helping startups raise money in novel ways. They’re using a variety of SEC rule changes—some called for by the JOBS Act—that re-draw longstanding boundaries around private companies selling securities. These changes grant some of the outcomes sought by supporters of full equity crowdfunding, by allowing startups to raise more money from a wider array of investors.

Among the California entities exploring these new fundraising routes are San Francisco investment bank WR Hambrecht, founded in 1998, and Santa Monica, CA-based online fundraising portal FlashFunders. Each has chosen its own operating mode from a selection of SEC-created options with alphabet soup names, including Regulation A+, and Regulation D 506 (c).

The expanding range of regulatory openings is now complex enough that experts have been creating spreadsheets to keep track of the differences. But to sum up, each of the new rules loosen up one or more SEC restrictions designed to protect investors, especially small investors who can’t afford the kind of losses that wealthy individuals might take in stride.

The jumping off point: Conventional early stage funding rounds

The traditional fundraising path for startups—still very much in use in Silicon Valley—arose under established rules that prohibited them from publicly advertising for investors. Instead, young companies privately approach venture capital firms and well-off individuals known as angel investors, who may share the investment opportunity with other potential funders. By this clubby private route, interested investors often join together in syndicates to supply capital to the young company in exchange for ownership stakes.

Those securities are sold under Regulation D 506 (b), which not only forbids advertising the offering to the general public, but also sets other conditions. Most of the individual investors buying the shares must qualify as “accredited investors,” who must have a net worth of at least $1 million or an annual income of $200,000 or more. A company raising money can legally rely on the investors themselves to self-certify that they’re eligible.

(Note: A startup can also allow as many as 35 “non-accredited investors” who don’t meet those wealth criteria to participate in such funding rounds. These might be family members of the startup founders, for example.)

New twists on traditional private funding rounds

Several changes have opened up the traditional startup funding route to investors who are … Next Page »

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Bernadette Tansey is Xconomy's San Francisco Editor. You can reach her at btansey@xconomy.com. Follow @Tansey_Xconomy

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