Regulations under the JOBS Act, including Regulation Crowdfunding, Regulation A+ and Rule 506(c), have dramatically opened up investment opportunities in private companies to non-accredited investors. Nonetheless, non-accredited investors still face significant limitations on their ability to participate in the market for private securities – which at least one commentator has called the “new public markets.” Because the JOBS Act regulations restrict the crowdfunding special purpose vehicles available to non-accredited investors to single issuer funds, such investors are denied a tool that would facilitate broad-based, diversified investing in private securities.
Existing regulations, such as Rule 506(c), allow persons who qualify as “accredited investors” under the Securities Act to purchase equity in early-stage companies through special purpose vehicles and thus can facilitate investor diversification in crowdfunded companies; however, no regulation presently allows non-accredited investors the same right. While the “Fix Crowdfunding Act,” (HR 4855), which passed the U.S. House of Representatives with broad bipartisan support and is expected to pass the U.S. Senate, would allow special purpose vehicles to hold securities sold under Regulation Crowdfunding, such vehicles would be limited to the acquisition, holding and disposition of securities of a single issuer.
While the pending legislation provides several benefits to issuers, such as a cleaner capitalization table and the ability to deal with one person as a representative of all crowdfunding security holders, it does nothing to enable non-accredited investors to build a diverse portfolio of private securities. This is especially concerning with respect to investments in crowdfunded equity securities: Equity securities sold pursuant to Regulation Crowdfunding or Regulation A+ are likely to be in early-stage companies where significant downside risk can be mitigated by potential major gains from other highly successful investments.
Such broad-based, diversified investing is a powerful tool for investor wealth creation. In fact, a powerful parallel comes from a study of venture capital funds, which tend to invest in emerging and startup companies similar to those likely to use crowdfunding.
The study found that the best-performing venture funds achieved their performance not because they had a fewer number of failed investments but because their successful investments were highly lucrative. In fact, the best performing funds in the study contained more deals that lost money in absolute terms than less successful funds. However, their “hits” more than offset their “misses.” Unlike in debt crowdfunding, where investors have downside protection by being structurally senior in payment to equity, equity crowdfunding takes on a higher risk of loss in exchange for greater upside – and diversification is a powerful tool to allow investors to manage the risks of equity crowdfunding.
However, the existing regulatory scheme does nothing to address the fact that the typical crowdfunding investor is likely only to be able to invest in one-off investment opportunities. While accredited investors have access to sophisticated venture funds that invest in multiple private companies each year, these funds do not permit non-accredited investors to participate. Given their lack of access to multi-issuer special purpose vehicles, and limited time to research independent crowdfunding issuances, non-accredited investors are severely limited in their ability to pursue an investment diversification strategy.
Further, as each crowdfunding investor must evaluate each potential investment separately, the SEC effectively is leaving investment decision-making to individuals, who, because of their non-accredited investor status, are deemed to be financially illiterate. Even those with some investment literacy may not have time to research and diligence multiple potential investments. The result is that individual non-accredited investors are limited to concentrated investments in a few private companies, which substantially – and perhaps unacceptably – increases their risk exposure compared to the investment risk profile afforded to accredited investors investing in venture funds.
Some have expressed concerns that permitting non-accredited investors to invest in a portfolio of crowdfunded companies could expose them to possible exploitation by less than scrupulous portfolio managers. However, the regulatory structure in place under Regulation Crowdfunding already provides significant protections that may protect investors from the worst of such exploitation.
First, non-accredited investors have strict limits as to the amounts they can invest in crowdfunded securities. That is, the total exposure of such investors is already capped and so multi-issuer special purpose vehicles would allow them to diversify at their existing levels of exposure. In addition, the requirement that any paid manager of a special purpose vehicle be a registered investment manager ensures the SEC’s ability to monitor multi-issuer special purpose vehicles and take action against exploitation of non-accredited investors. Finally, Regulation Crowdfunding requires that crowdfunding portals register with the SEC, and tasks them with a gatekeeper function, which serves to ensure that investors and managers have adequate information as to any crowdfunded security in which they wish to invest.
Despite its potential to bring new investors into the private securities markets, the regulatory environment for crowdfunding appears to continue to view crowdfunding through an improper “Kickstarter” paradigm. Regulators, it seems, see crowdfunding as a way for interested investors to make “passion-based” investments in business to which they have an emotional attachment. The potential for crowdfunding, however, is greater and more meaningful – it instead should be seen as a way of expanding access to private markets to non-accredited investors. And by making it easier for these investors to diversify their investments in private companies through a fund of crowdfunded companies, the crowdfunding regulations would be more attractive to prudent investors and thus more likely to facilitate capital formation for smaller issuers.
Adam Hull is a partner in the Dallas office of Gardere Wynne Sewell LLP. Adam represents private equity and venture capital funds in the acquisition of companies across a wide variety of industries, including technology, life sciences, midstream natural gas, oil and gas field services, hospitality and manufacturing. He also represents issuers in venture capital and private equity financing and regularly advises companies on general corporate compliance and governance matters.
Rick Jordan is a partner at Gardere Wynne Sewell LLP where he splits his time between the firm’s Austin and Dallas offices. He is the current Chair of the Emerging Business/Venture Capital Committee of the Business Law Section of the State Bar of Texas. Rick represents investors and issuers in venture capital financings primarily in the technology, life sciences and biotech sectors, and regularly serves as lead counsel on mergers and acquisitions transactions as well as securities and corporate governance matters. He also acts as outside general counsel for both public and private companies.
Christopher Babcock is an associate in the Dallas office of Gardere Wynne Sewell LLP. Chris assists clients in a wide range of corporate and securities transactions, including mergers and acquisitions, private equity investments, corporate governance matters, venture capital financings and securities offerings.