Crowdfunding Rule Adds Competition for Marketplace Lenders

Starting in late January, small businesses seeking funds to hire more workers or expand operations will have a new option: crowdfunding.

New regulations approved by the Securities and Exchange Commission on Friday will permit business owners to raise up to $1 million per year from everyday Americans through online portals.

The rules were seen as a victory for entrepreneurs, many of whom have been clamoring for final rules on crowdfunding at a time when they've struggled to obtain conventional financing. They also create new investing opportunities for middle-class Americans who generally don't have much chance to invest in new or growing companies.

Sen. Mark Warner, a Virginia Democrat who has been a champion of crowdfunding, said that the long-anticipated ruling "will allow more smaller investors to participate in America's entrepreneurial economy.

"Crowdfunding promises to democratize startup activity and entrepreneurial innovation across the country, and offers exciting, even game-changing opportunities for rural areas, which often have limited access to capital," he said in a statement.

The new regulations would seem to impose fewer burdens on small-business owners than the agency's 2013 draft rules contemplated. Still, it remains to be seen if crowdfunding will emerge as a viable source of financing for small businesses.

One problem is that many small businesses looking to raise either debt or equity online have little in the way of money or sophistication, and that can be a problem when trying to navigate complex regulations, said Viktoria Krane, the chief executive officer of Lendoor, a crowdfunding site.

"Not necessarily the next Facebook, but the next local auto mechanic," she said, describing the typical small business that turns to crowdfunding.

[Coming next week: Marketplace Lending + Investing. Hear how participants in this fast-growth niche are using data and technology to propel lending into the 21st century.]

For such companies, which may be seeking to raise $20,000 to $50,000 in startup capital, the costs of complying with the SEC's regulations may not make financial sense, she added.

Krane founded New York-based Lendoor in 2013 with plans to become a national crowdfunding portal operating according to the SEC's rules. But as the agency dragged its feet, Lendoor changed its strategy and started operating in Texas, which had adopted its own crowdfunding rules.

Now the company is switching gears again, repositioning itself as a place for entrepreneurs to raise money from friends, relatives and other people in their social networks.

Because those fundraising pitches will not be open to the general public, the company will not be subject to the SEC's new crowdfunding rules.

"After two years of waiting, I would have expected to be a little bit more excited," Krane said. "But my feelings are mixed."

Several other observers were more upbeat about the SEC's long-delayed action. Douglas Ellenoff, a securities lawyer with Ellenoff Grossman & Schole, said that the final rules do not require as much scrutiny of a company's financial statements as the 2013 draft would have.

He called the rules a "big win" for business owners and said that he expects crowdfunding to become a significant source of small-business financing over time. "I think it's going to be a slow, steady ramp," he said. "It won't happen overnight."

The rules cap the amount that a company can raise through crowdfunding at $1 million during a 12-month period. The firm will need to disclose its financial statements and describe how it plans to use the proceeds, among other steps. The requirements are less steep for companies seeking to raise smaller amounts of money.

The appeal of crowdfunding is that it opens up these sorts of investments to hundreds of millions of Americans who do not have accredited investor status, either by virtue of their income or net worth.

Individual investors will be barred from investing more than $100,000 in crowdfunding over a 12-month period, and there are further limits based on the investor's income. For example, an investor who has an annual income of $75,000 would be allowed to invest no more than $3,750 in crowdfunding over the course of a year.

The regulations also establish rules for the portals. The sites will be required to register with the SEC and implement measures to reduce the chance of fraud, among other steps.

Those legal responsibilities do not exist for sites like Kickstarter and Indiegogo, where people invest their money in projects without the expectation that they will earn a profit or even get repaid.

It is not yet clear how many crowdfunding portals will register with the SEC. But numerous fledgling sites have been waiting for the agency to finalize its rules, according to Debbie Klis, a partner at Ballard Spahr. "I think they'll pop up faster than you think," she said.

The crowdfunding portals could provide fresh competition for the large crop of firms that are making small-business loans online, often at very high interest rates.

The new rules also provide a new potential class of investors for so-called peer-to-peer lending sites, most of which are currently open only to accredited investors.

At least in its early stages, crowdfunding seems unlikely to take a big dent out of bank lending to small businesses. That is because many of the companies that turn to crowdfunding hope to raise smaller amounts of cash than banks typically lend, they or lack the credit profile to qualify for a bank loan.

For the SEC, the crowdfunding regulations are the last of several rules that the agency was required to write under the Jumpstart Our Business Startups Act of 2012.
SEC Chairman Mary Jo White described the rulemaking process during a Friday meeting as "extraordinarily complex" but said that the regulations deliver "a strong set of investor protections."

The crowdfunding rules were approved on a 3-1 party-line vote, with Republican Commissioner Michael Piwowar casting the dissenting vote.
"The rules will spin a complex web of provisions and requirements for compliance," he said.

"Even if you are Warren Buffett or Bill Gates," he complained, "you are limited to investing no more than $100,000 during any 12-month period in all crowdfunding investments."