It Just Got a Whole Lot Easier to Fund Your Startup

• By Ryan Tate
• 07.12.13     http://www.wired.com/business/2013/07/the-emerging-vc-machine/

 

Recently installed SEC Chair Mary Jo White has pushed through new rules that let startups openly seek out investments through advertising and other methods. Photo: SEC/Flickr

For all the transparency and disruption that startups have brought into the world, the process of funding them remains largely opaque and old-fashioned.
Money tends to come from exclusive, geographically concentrated networks of entrenched investors, and deals are driven largely through word-of-mouth referrals, the accumulation of various status markers, and a long series of often elliptical conversations and in-person meetings.
But that’s about to change. This week, the Securities and Exchange Commission approved rules that will begin to open, accelerate, and more deeply systematize the process of raising money for startups. The immediate effect of the SEC’s action is that startups and certain other money-raising entities, like hedge and venture capital funds, will be allowed to openly seek and advertise for investments, a process known as “general solicitation.”
The long-term impact will be even deeper, bringing the process of funding of startups onto the internet, where it can be de-mystified, atomized, and mechanized in the sort of digital transformation so many startups have themselves brought to other industries. These effects will initially accrue to the benefit of a relatively limited set of players, chief among them startups and funds that have had trouble raising money, because they’re, say, outside of traditional hubs like Silicon Valley or they’re not in hot sectors like tech. But the new rules will also benefit those who will help facilitate the process of general advertising, including a variety of startup investment portals and legions of old-school investment brokers and advisers.

‘Allowing information to flow more freely will help investors spend their time on diligence rather than networking and allow companies to share their story with more potential investors.’

— Ryan Caldbeck

Ultimately, the changes could undermine the power of traditionally powerful regions like the Valley and traditionally powerful venture capital firms and angel investors who tended to attract the most dealflow in the era when startups had to be careful not to advertise their interest in raising money too widely.
“Allowing information to flow more freely in this market will help all participants,” says Ryan Caldbeck, CEO of funding platform CircleUp, “enabling investors to discover new opportunities more efficiently and spend their time on diligence rather than networking, and allowing companies to share their story with more potential investors.”
But allowing startup investment advertising could also provide a new avenue through which to steer marginally qualified investors into dubious or outright fraudulent investments, as occurred during a narrower lifting of the general solicitation ban in the early 1990s.
“Most startups fail,” says Barbara Roper of the Consumer Federation of America, which pushed unsuccessfully for stronger rules around allowing advertising. “No one believes [the rule] appropriately identifies an investor who can fend for themselves.”
Such concerns from consumer advocates, along with opposing complaints about over-regulation from companies that want to raise funds, were forwarded to the SEC after draft rules on general solicitation were first issued nearly one year (and two SEC chairs) ago as part of the implementation of the JOBS Act, which mandated the lifting of the general solicitation ban but left specifics the SEC. In a 4-1 vote Wednesday, the commission voted to approve rules that were largely identical to those proposed last August.
But the one big difference is telling: Companies that want to advertise for investment have now been given a list of three techniques they can use to ensure that people who respond to their advertisements are allowed to invest in startups under federal securities law. Previously, the SEC had only provided an intentionally vague set of principles that could be followed to vet potential investors.
The effect of this evolution in SEC rulemaking is to allow even more mechanization of startup investment. The very day the rules came out, fundraising and trading platform SecondMarket announced an online service to help fundraisers screen potential investors using one or more of the three vetting techniques. Under federal law, people can generally invest in non-public companies only if they have $1 million in assets or make $200,000 per year (these numbers, which haven’t changed since 1982, should probably be upped).
“You will see a lot of platforms emerge that provide verification services for investors looking to invest in crowd-funded/angel deals,” says Robert Bartlett, a law professor specializing in finance at the University of California, Berkeley.
As of yet, startups are restricted to angel investors. They cannot “crowdfund” from non-millionaires, as allowed under the JOBS Act, because the SEC has not yet issued rules around crowdfunding. But such rules are expected within the next year, and in the meantime, longtime finance wags have taken note of the quantum leap in transparency that allowing general solicitation will enable. As Reuters’ Felix Salmon has noted, the rule should bring online details of even infamously opaque hedge funds, allowing for comparison shopping of the sort that was unthinkable just a year ago. And as Fortune’s Dan Primack has written, a robust, fast, and transparent funding machine/market would let entrepreneurs focus on running their business rather than marketing themselves to investors in the old fashioned, face to face manner.
By excluding any substantial new regulatory curbs to thwart investor exploitation — some have been drafted but remain unapproved — the SEC’s new rules leave consumers vulnerable to shady operators in boiler rooms selling bad investments online and over the phone, as commissioner Luis Aguilar, the lone dissenter, has eloquently said. But the promise of slowly unwinding the old boys’ club of startup venture capital, of coming up with a more open, dispersed, and diverse funding network for entrepreneurs, is mammoth enough to overshadow those risks. Via the JOBS Act and this week’s SEC ruling, the government has set in motion the ad hoc construction of a vast venture capital machine. It will be a scary beast, but one quite likely fairer and faster than the flesh and bones system that preceded it.