Capital from the Crowd

31 Oct

By Lucy Parkinson, Research Analyst, LSN

LSN has been diligently tracking the evolution of the crowdfunding story as the JOBS act passes through the regulatory gauntlet. On October 23rd, the SEC announced interim rules for Title III of the JOBS Act, which covers securities crowdfunding. In summary, the proposed rules are as follows:

  • A company may raise a maximum of $1 million via crowdfunding in any 12-month period.
  • An individual may invest a maximum 10 percent of annual income or net worth (income greater than $100,000 anually) or either $2,000 or 5 percent of annual income or net worth, whichever is greater (income less than $100,000 anually). This is a total annual limit for each individual investor.
  • Equity crowdfunding may only be conducted via a registered broker-dealer or registered “funding portal.”
  • Crowdfunding requires an SEC filing 21 days prior to first sale, and requires scaled financial disclosure, including audited financial statements for raises of more than $500,000.
  • Annual reports and possibly more frequent reports (depending on final SEC rulemaking) must be filed with the SEC by any company that completes a crowdfunding round.

So, emerging life science companies could stand to benefit from this new avenue of funding, but it’s shaping up to be both narrowly limited and highly regulated.

In addition to creating opportunities for millions of new potential investors, the new legislation has also introduced a new channel for this capital – the funding portal. Registered brokers will be able to act as funding portals, but we may see many new entities taking advantage of the new, less costly option of registering with FINRA as a funding portal. The new regulations state that a company can only crowdfund via one broker or funding portal each year, and as these portals tend to charge fundraising companies for use (typically by charging either a listing subscription or per-transaction fees) while letting investors use the sites for free, we should see intense competition between funding portals to sign companies up as users.  The portals will list investment opportunities and act as issuers of stock for liability purposes, but aren’t allowed to offer advice to investors about which companies to back, nor are they permitted to invest in the companies they list. (1)

Also, as mentioned above, the cap on fundraising is $1 million per year. That’s a hard limit. $1 million in new capital would be a boon to early-stage life science development looking to get of the ground, but in the highly capital intensive later stages, it’s unlikely to be a cure-all to fundraising challenges; a million dollars won’t pay for a Phase III trial. In addition, there is the regulatory/compliance challenge of dealing with potentially hundreds of new concerned investors who have to be provided with disclosures and regular financial statements regarding your firm.  This is a huge cost burden for a startup company to bear. And as crowdfunded equity can only be resold to accredited investors (an unaccredited crowdfunder can’t sell their stock to another unaccredited investor while the company remains privately held), these are likely to be long-term relationships unless the early stage crowdfunders are bought out by an institutional-type investor down the line.

The life science sector ought to fare better than most in the new world of crowdfunding; many people will want to invest in a cure for a disease that’s touched themselves or their families, and many more would like the opportunity to try out direct investing with a low barrier to entry and high potential returns.  But the reality of the life science industry means that many of these nascent cures will fail to reach the market, and we can’t know how new investors will react to these inevitable losses. This could be the start of a new era, but the proof will be in the pudding.

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(1) Crowdfunding Regulations Summary by Kevin Laws of AngelList

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