A NEW INVESTING FRONTIER: Crowdfunding

The traditional investing world is shrinking as younger workers face the hurdle of saving for retirement, servicing student loans, buying homes, and starting families. The shrinking isn’t in the

Understand how crowdfunding works

number of available choices (like mutual funds or exchange traded funds) but in the number of publicly traded stocks. The number of publicly traded companies decreased roughly 46 percent from the middle of 1996 to the middle of 2016 (1).  Crowdfunding may change how we invest.

Let’s look at one of the broadest domestic indices, the Wilshire 5000. In August 2016, the index had 3,607 stocks, while in 1998 it had 7,562 (2). Ironically, the number of public companies outside the United States has risen by roughly 8,700 since 1996 (2). The lower number of public stocks today can be attributed to the fact that large companies are merging or failing to meet listing requirements, and fewer companies want to go public (2).

WITH FEWER PLAYERS, WHAT DOES IT MEAN?

As the Wilshire example shows, this is happening now. Consequently, on the larger company side, equities like Apple play a more important role in the markets. Remember when Apple was not a major player for the top position in the S&P 500? Today, the stock occupies roughly 3.5 percent of the S&P 500 and over 11 percent of the NASDAQ 100. An article from CNBC discusses how this may negatively affect the popular trend of passively investing in index-based instruments (3):

“Some have gone a step further, arguing that passive investing leads already-overvalued stocks to become even more overvalued, as new money is allocated on the basis of existing (relative) sizes.”

For active mutual fund managers, a shrinking pool may mean holding onto well-known names longer than they would have otherwise. This point demonstrates the influence on mutual managers and investors as the number of stocks decreases. Less flexibility exists for mutual fund managers because money is leaving the arena and there are fewer stocks in which to invest.

This movement plays out like a game of musical chairs, in which the companies are the chair and the investors (including the fund managers) are trying to grab a seat. In our case, the number of investors does not decrease as the number of chairs becomes smaller. We end with people sitting on each other’s laps.

What is an investor to do?

You should continue with a normal course of saving and investing regularly, but you will need to make a few adjustments.

  1. Pay attention to your holdings. Know what you own and how to use it in your portfolio.
  2. Notice where you save money. How much goes into your 401k versus IRAs or Roth IRAs? Do not forget about your emergency savings. IRAs at large firms like Schwab, Vanguard, or TD Ameritrade typically have more investment choices than does a 401k. The point is to make sure you have the flexibility to access the best investments.
  3. Be ready to change as the financial markets change. Two movements are taking place that may change our investing landscape. The first is socially responsible investing, which has captured much press recently. The second change stems from crowdfund investing or the private equity movement.

What is private equity?

Private equity covers many types of investments, though its main characteristic involves not listing on a public exchange like the New York Stock Exchange or the NASDAQ. Private equity typically involves an investment in a non-listed business. Profit, management, and other traditional metrics matter, as they do with a listed business, but you do not have the reporting requirements of listed companies.

Some analysts propose that investing in private equity forces people to become “real investors” because of the lack of liquidity and the longtime horizon needed for the investment to provide returns. Private equity may also include bonds or other forms of debt.

Most closely associated with private equity is the venture capital firm, or VC. VC firms invest mostly in small companies or startups they believe have growth potential.  The institutions receiving the money typically do not have access to enough traditional funding through banks, public markets, and other places. Most of the investments are high risk. Consequently the terms of VC funding do not follow a traditional path.

A new and growing way to access private equity involves raising money through crowdfunding.

What is crowdfund investing?

Think Kiva, Kickstarter, and Go Fund Me; these are popular examples of crowdfunding. It is like a public version of Shark Tank. People put their ideas out there and potential investors can pass,

Understand how crowdfunding works

invest, or sometimes become actively involved in the presented opportunity. One of the key features of crowdfunding is that it allows securities to bypass federal securities laws (4).

Crowdfunding sprang into action with the JOBS Act of 2012, signed by President Barack Obama. The idea behind the act had the “SEC to write rules and issue studies on capital formation, disclosure, and registration requirements” (5). It opened the door for more participants to fund companies or investments that were previously available only to accredited investors.

Who are accredited and non-accredited investors?

In simple terms, accredited investors are high-net-worth or high-income individuals who have access to private investments that do not have to be registered with the Securities & Exchange Commission (SEC). To become an accredited investor, one must meet one of the following criteria:

– Have a net worth greater than $1 million. This value cannot include the value of one’s personal house.

– Have an income of greater than $300,000 for couples (or $200,000 for individuals) for the two previous years. Also, the couple (or individual) should expect to meet the criteria in the current year.

A non-accredited investor does not meet the needs listed above. As we can imagine, accredited investors make up a small percentage of the population. This is where the JOBS Act enters the picture with crowdfunding.

What are the rules for crowdfund investing?

In a press release dated October 30, 2015, the SEC outlined four areas for rules and regulations for crowdfunding, which include (6):

  1. Capital limits on funds raised by the company.
  2. Disclosure requirements on issues of specific information for the security offered.
  3. Investment limits on the amount investors buy.
  4. Framework for broker-deals and funding portals that engage in crowdfunding.

A brief summary of each area

Capital Raising Limits– Companies may not raise more than $1 million through crowdfunding in a 12-month period. Some companies, such as non-US companies and Exchange Act reporting companies, will not be eligible for crowdfunding campaigns.

Disclosure Requirements (as taken from the October 30, 2015 press release)-

  • The price to the public of the securities or the method for determining the price, the target offering amount, the deadline to reach the target offering amount, and whether the company will accept investments in excess of the target offering amount;
  • A discussion of the company’s financial condition;
  • Financial statements of the company that, depending on the amount offered and sold during a 12-month period, are accompanied by information from the company’s tax returns, reviewed by an independent public accountant, or audited by an independent auditor. A company offering more than $500,000 but not more than $1 million of securities relying on these rules for the first time would be permitted to provide reviewed rather than audited financial statements unless financial statements of the company are available that an independent auditor has audited;
  • A description of the business and the use of proceeds from the offering;
  • Information about officers and directors as well as owners of 20 percent or more of the company; and
  • Certain related-party transactions.

In addition, companies relying on the crowdfunding exemption must file an annual report with the Commission and provide it to investors.

Investor Limits– Investors are divided into two groups: income or net worth below $100,000, and those above $100,000.

  • Permit individual investors, over a 12-month period, to invest in the aggregate across all crowdfunding offerings up to:
  • If either their annual income or net worth is less than $100,000, the greater of:
  • $2,000 or
  • Five percent of the lesser of their annual income or net worth.
  • If both their annual income and net worth are equal to or more than $100,000, 10 percent of the lesser of their annual income or net worth; and
  • During the 12-month period, the aggregate amount of securities sold to an investor through all crowdfunding offerings may not exceed $100,000.

Broker-Deal and Portal Framework– Some funding platforms should register with the Commission a new Form Funding Portal and be registered with FINRA. Additional requirements taken from the same press release are as listed below:

  • Provide investors with educational materials that explain, among other things, the process for investing on the platform, the types of securities being offered, the information a company must provide to investors, resale restrictions, and investment limits;
  • Take certain measures to reduce the risk of fraud, including having a reasonable basis for believing that a company complies with Regulation Crowdfunding and that the company has established means to keep accurate records of securities holders;
  • Make publicly available on its platform the information a company is required to disclose throughout the offering period and for a minimum of 21 days before any security may be sold in the offering;
  • Provide communication channels to permit discussions about offerings on the platform;
  • Provide disclosure to investors about the compensation the intermediary receives;
  • Accept an investment commitment from an investor only after that investor has opened an account;
  • Have a reasonable basis for believing an investor complies with the investment limitations;
  • Give investors notices once they have made investment commitments and confirmations upon or before completion of a transaction;
  • Comply with maintenance and transmission of funds requirements; and
  • Comply with the completion, cancellation, and reconfirmation of offerings requirements.

The rules would also prohibit intermediaries from engaging in certain activities, such as:

  • Providing access to their platforms to companies that they have a reasonable basis for believing have the potential for fraud or other investor protection concerns;
  • Having a financial interest in a company that is offering or selling securities on its platform unless the intermediary receives the financial interest as compensation for the services, subject to certain conditions; and
  • Compensating any person for providing the intermediary with the personally identifiable information of any investor or potential investor.

Could crowdfunding change the way we invest?

One of the most noteworthy trends in crowdfunding right now focuses on impact investing and socially responsible investing. As we look forward, though, crowdfunding may solve the problem posed earlier about the declining number of publicly traded securities.

Perhaps we will see a trajectory in packaged products similar to the ETF or mutual fund for the smaller investor. This would create economies of scale while providing diversification and reducing business risk.

Where do I look for crowdfund investing opportunities?

Here is a link for portals regulated by FINRA: https://www.finra.org/about/funding-portals-we-regulate

Next steps:

  1. Educate yourself on crowdfund investing. As with other risky investments, the potential to lose money exists. Make sure you have the capacity to lose the money. If not, crowdfund investing is likely not suitable for you.
  2. What are you looking for as an investment? Is it to have an impact locally or “own a dream business” like a brewery without the stress of running it?
  3. Talk to a knowledge advisor on the topic. Be careful when engaging in this conversation, as many “advisors” are really salespeople. Ask how the advisor receives compensation. If the advisor receives commissions, he/she is a salesperson.

Check out this related article on investment performance.

Sources:

  1. https://finance.yahoo.com/news/jp-startup-public-companies-fewer-000000709.html
  2. https://seekingalpha.com/article/3995691-number-public-companies-shrinking
  3. http://www.cnbc.com/2017/05/17/four-tech-heavyweights-make-up-a-huge-share-of-the-sp-500.html
  4. https://www.sec.gov/spotlight/crowdfunding.shtml
  5. https://www.sec.gov/spotlight/jobs-act.shtml
  6. https://www.sec.gov/news/pressrelease/2015-249.html

 

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