In 2008, presidential candidate Barack Obama realized he could raise a lot more money from millions of individual donors on the Internet making small contributions than he could by begging hundreds of traditional party big donors to write big checks. That discovery revolutionized American politics, and something similar may be about to happen to American business.
That’s thanks to new rules released by the Securities and Exchange Commission Wednesday to allow “crowdfunding” of new companies, mostly through online fundraising efforts by start-ups. The concept, which was given the legal go-ahead under last year’s JOBS Act, could change the whole concept of start-up company financing.
Today, entrepreneurs have to go hat in hand to a few large financial institutions and venture capital firms that act as the gatekeepers of capital and decide which companies get financing and which do not. Under the new model, nascent companies would be able to sell equity stakes online to a potential pool of millions of investors who believe in the company’s product or idea. And if they have a hot enough idea, they can skip the VC office beg-a-thons altogether, giving average people a chance to get in on hot new offerings and entrepreneurs a chance to hold on to more equity in their companies.
That sounds great in theory, but in practice many observers are worried about scam artists and fraudsters taking advantage of the new rules to churn out bogus offerings with hot-sounding names, and take advantage as well of naïve investors on the Internet. So the SEC has been wrestling with how to allow the new funding practice without encouraging fraud.
(Read more: Real estate’s new frontier: Crowdfunding)
The answer came Wednesday, as the commission outlined a proposal to subject crowdfunding to strict investment caps—to limit the exposure of individual investors to any one investment, and to limit the amount that companies would be able to raise through crowdfunding—meaning that at first, financing entirely by crowdfunding may only be useful for the smallest of companies or those in the earliest start-up stages.
“There is a great deal of excitement in the marketplace about the crowdfunding exemption,” SEC Chairwoman Mary Jo White said Wednesday at a hearing to consider the new rules. “And I am pleased that we are in in a position today to adopt a rule proposal that would, upon adoption, permit crowdfunding to begin.”
Under the proposed rules, companies would only be able to raise a maximum aggregate amount of $1 million through crowdfunding offerings in a 12-month period.
And investors would face similar caps: The SEC said in one year they would only be permitted to invest up to $2,000 or 5 percent of their annual income or net worth, whichever is greater, if both their annual income and net worth are less than $100,000. Alternatively, the SEC said people could invest up to 10 percent of their annual income or net worth, whichever is greater, if either their annual income or net worth is equal to or more than $100,000. During the 12-month period, these investors would not be able to purchase more than $100,000 of securities through crowdfunding.
(Read more: Crowdfunding for medical devices hits Web)
The companies would be subjected to certain disclosure requirements, too. Those include the following, the SEC said:
•Information about officers and directors as well as owners of 20 percent or more of the company.
•A description of the company’s business and the use of proceeds from the offering.
•The price to the public of the securities being offered, 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.
•Certain related-party transactions.
•A description of the financial condition of the company.
•Financial statements of the company that, depending on the amount offered and sold during a 12-month period, would have to be accompanied by a copy of the company’s tax returns or reviewed or audited by an independent public accountant or auditor.
And finally, crowdfunding would only be permitted through an SEC registered intermediary, either a broker dealer or a “funding portal,” which would be a new category of SEC registrant.
The SEC said it will seek public comment on the new rules for 90 days, and will then review comments and decide whether to modify or adopt the proposed rules.
—By CNBC’s Eamon Javers. Follow him on Twitter: @eamonjavers