Equity Crowdfunding for Investors. Matthew R. Nutting

in several startups and, by doing so, diversify the risk and increase the chances of a hitting one out of the park.

      The potential rewards of angel investing are not just financial, though. There are also strategic benefits, which may include:

      • Close association with talented developers and inventors, brilliant entrepreneurs, and well-connected directors of the companies.

      • Participation in company management or governance based on professional expertise, possibly as a board member, paid consultant, or strategic partner.

      • An up-close, insider look at innovative business models, new products, cutting-edge technology, and proprietary research.

      • The opportunity to invest in future rounds of later-stage angel, venture, and pre-IPO financing.

      In the process of seeking financial returns and strategic benefits, angel investors can also derive social rewards: boosting community development (especially when the investors and issuers represent the same metropolitan area or region), creating new jobs, supporting favorite products and brands, and helping good people make their dreams come true. The rewards and benefits from successful ventures reach far indeed.

      In 2012, a peak year for angel investment, more than 268,000 angels funded roughly 67,000 seed-stage, startup, early-stage, and growing small businesses in the United States. The total amount invested in those deals was almost $23 billion. That does not include venture capital investments, which involve funds (or pools of capital), rather than individuals, typically investing at later stages of business development (but still pre-IPO).

      The most popular sectors among individual angel investors in 2012 were software and healthcare. Trailing these two leading sectors, in order of popularity, were retail, biotech, industrial/energy, and media.1

      That gives you an idea of the volume of angel activity in America – before the rules changed.

      The Old Rules

      Before the legalization of equity crowdfunding, for the vast majority of Americans, investing in fast-growing startups was either highly impractical or illegal.

      Based on legislation enacted in 1933 – as long as most of us can remember – angel investing was largely closed to all but (1) the wealthiest people in America and (2) founders of private companies2 seeking capital and their family and friends, known as the “three Fs.” The legal basis for those restrictions began with the Securities Act of 1933 and was further shaped by the Securities and Exchange Commission (SEC) and federal courts. In Chapter 2 we will explain just enough of that regulatory framework to help you understand the new equity crowdfunding rules, but here is the nutshell version:

      • Issuers of private company stock, whether in startups or existing businesses, could offer shares to an unlimited number of “accredited investors,” which includes individuals with a net worth of at least $1 million or annual income of $200,000 ($300,000 for married couples). Those issuers could also sell shares to as many as 35 nonaccredited investors per round of financing, as long as those nonaccredited investors were smart enough to understand the risks of buying private securities and had a personal relationship with the founders or their close advisers.

      • Private issuers and their registered intermediaries (broker-dealers, for example) could offer shares only to people with whom they had “substantial” prior relationships, with a few exceptions. They could not engage in “general solicitation,” which means they could not advertise an investment offering to the general public.

      For Americans who did not have such wealth or relationships with issuers (or their intermediaries), the door to angel investment was locked tight and the curtains were drawn. The doors to other kinds of private securities, too, were barred (and still are) for most average Americans, including venture capital, private equity, hedge funds, and other “alternative” investments. So don't blame yourself for not being remotely aware that Apple shares were available for purchase in 1977 or that Facebook was looking for early investors in 2005, when they were startups.3

      The Game Changer

      The rules changed radically in 2012 when Congress unlocked that door to angel investing and lifted the ban on general solicitation. The Jumpstart Our Business Startups (JOBS) Act, signed by President Barack Obama on April 5, 2012, aimed to give small companies a boost by making it easier for them to raise capital. Title III of the JOBS Act created an exemption to the registration requirements of the Securities Act of 1933 to allow startups and growing businesses to sell equity to all investors, not just accredited ones, through online crowdfunding portals. This “crowdfunding exemption” was codified as Section 4(a)(6) of the Securities Act. The concept of registration and exemption can be confusing, so we will clear it up in Chapter 2.

      In 2015, the Securities and Exchange Commission, alongside the Financial Industry Regulatory Authority, are expected to issue rules for the operation of equity crowdfunding portals, swinging the door to online angel investing wide open. The SEC and FINRA will continue to regulate equity crowdfunding, adjusting the rules and attempting to police the system against any fraud.

      The new Section 4(a)(6) of the Securities Act limits the amount of capital that a company can raise via equity crowdfunding to $1 million per year,4 and it limits the amount of money that nonaccredited investors can invest based on their net worth or income, to make sure nobody goes broke via crowdfunding. (We will describe these limits in detail in Chapter 3.) But it does not limit the number of investors to whom a company can sell shares via a funding portal. Whereas traditional angel deals typically required investors to put up tens or hundreds of thousands of dollars apiece just to walk in the door, equity crowdfunding investors may be able to buy shares for as little as $1,000 and perhaps less. So companies that issue shares on crowdfunding portals or through broker-dealers, based on Section 4(a)(6), can expect to receive many smaller investments from a much larger number of investors. This essentially turns the traditional angel deal on its head: from a small group of large-dollar-amount investors to a big group – a crowd – of small-dollar-amount investors.

      If 268,000 angel investors funded startups and early-stage companies in 2012, when such deals were effectively restricted to a tiny segment of the population, now that those restrictions have been lifted there is no telling how many more investors will participate in the angel capital market. We can be a nation of angel investors, boosting opportunities for entrepreneurs to raise capital, hire employees, and pay taxes – not just in the metropolitan areas and high-tech corridors where angel capital tends to cluster, but everywhere.

      Enter at Your Own Risk

      Although the door to angel investing, at least the online version, is now open to all investors, not everyone is prepared to walk through it. Investors who have never done an angel deal, even those who consider themselves sophisticated when it comes to investing in publicly listed stocks and bonds, need to get familiar with a new universe of securities investing. Seed and early-stage investments include substantial risks as well as the possibility of exciting returns and benefits. You need to understand how angel investments can affect your overall portfolio in terms of diversification, asset allocation, liquidity, and long-term financial objectives. That will be covered in Chapter 8.

      For all investors, including accredited investors who have actually done angel capital deals but don't understand the nature of crowdfunding, we will delve into the evolution of crowdfunding, from donation- and rewards-based crowdfunding to lending- and equity-based crowdfunding. This brief history offers lessons about the risks, rewards, occurrence of fraud, and wisdom of the crowd (or madness of it, depending on the context).

      Ultimately, for those of you who have carefully weighed the pros and cons and believe that you (and/or your community) will benefit from investing in startups and growing private companies, we present four chapters on

1

Jeffrey Sohl, “The Angel Investor Market in 2012,” Center for Venture Research, University of New Hampshire, April 25, 2013. Among angel clubs (comprising accredited investors only), the sectors that attracted the most capital in 2012, ranked by the Angel Capital Association, were: healthcare, Internet, software, mobile/telecom, business products/services, energy/utilities, computers, consumer products/services, electronics, industrial, environmental services/equipment, media, and financial services.

2

Private company securities are those not registered with the Securities and Exchange Commission and not listed on a public stock exchange.