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Is There a Crowd For Equity Crowdfunding?

The total number of Financial Industry Regulatory Authority member retail brokerages has been on the decline for the last five years.

But there is one sliver of the universe that is showing new signs of life: A new crop of broker/dealers and funding portals joining the self-regulatory organization to capitalize on new rules made possible by the Jobs Act of 2012.

About 15 to 20 of these new broker/dealers have signed on with FINRA since 2013, according to Fishbowl Strategies, with another three to six launching soon, in anticipation of a coming wave of issuers and investors expected to enter the market as equity crowdfunding becomes a reality.

The promise is to facilitate transactions online directly between retail investors and private companies or funds, large and small, seeking capital -- a path of financing expected to accelerate with the acts’ easing of restrictions on selling non-registered securities.

While online portals connecting accredited investors directly with non-registered securities, like private equity or hedge funds, existed long before the JOBS Act, they mostly kept their offers behind password-protected gates to demonstrate investor interest in the deal (a restriction on the ability to solicit investments from investors who don’t have a “close relationship” to the issuer.) To the SEC, there was no difference between this and an investment through a traditional intermediary.

But since Sept. of 2013, a new class of exemption to the rules allows purveyors of non-registered securities to market to affluent investors directly. At the time, there was copious handwringing about hedge funds sponsoring Superbowl halftime shows and mom-and-pop millionaires lining up on Main Street to pour money into private equity or venture capital funds. “Obama’s Hedge Fund Free For All,” warned Forbes. The rule was “the most significant change to capital markets since the 1930s” said business website Quartz.

It has not happened. Investments in non-registered securities has risen dramatically - in 2014, there were 33,429 offers raising a total of $1.3 trillion, up from 18,295 raising $595 billion in 2009. But only about two percent of the 2014 offers were solicited under the new JOBS Act rules, according to the Securities and Exchange Commission.

“People thought that things would pick up more than they have,” says Steve Fernando, a member of the executive committee of The Crowdfund Intermediary Regulatory Advocates (CFIRA), a non-profit advocacy group established following the signing of the JOBS Act in 2012. “It’s still progressing slowly as an industry.”

Fernando says some of the more successful funding platforms are supplementing what they’re doing online with offline efforts.

“In the folks that I have experience with being successful, there's a team of investment bankers following up and placing calls and working their Rolodex to get deals placed,” he says.

But Paul Boyd, managing partner at ClearPath Capital Partners, a wealth management firm that caters to technology executives, says there is plenty of pent up demand and a backlog of Reg D deals that have been negotiated and that are moving forward.

Boyd also expects the next phase of the JOBS Act, which will open up online private investing to non-accredited investors for smaller companies.

These rules, finalized late last year and set to go into effect in May, will allow any investor, accredited or not, to invest in unregistered securities online. The tech-fueled vision of bypassing stuffy financial intermediaries and connecting startups with investors directly, as well as the success of different kinds of crowdfunding platforms like Kickstart and IndieGoGo, has inspired a flotilla of startups to enter the space.

The SEC’s rules for equity crowdfunding will require issuers to use a new class of financial intermediary – crowdfunding portals – that will need to register and become members of FINRA.

Raising Capital Online

A lot of the new portals, regardless of whether they are officially recognized as equity crowdfunding portals or not, have affiliated agreements with broker/dealers. Some have launched their own b/ds.

WealthForge launched its own b/d, and provides all the services needed to complete a private securities transaction, including investor accreditation, regulatory filings and escrow. Co-founder and CEO Mat Dellorso says the rules—and bringing the process online—have spurred their growth.

“When you bring the internet and you're allowed to advertise a private security through 506(c), more investors do take part,” he says. “We've completed more than 150 private financing transactions, and that's more than any traditional investment bank. A traditional investment bank might complete three or five a year. We do a lot of these at volume, and we involve a lot of investors; we've had more than 2,500 investors invest through our system. It's a lot more volume because it's more transparent and online now.”

In May 2015, WealthForge made things even easier with an “Invest” button and link issuers can place on their website. When an investor ‘clicks’ the button, it starts an automatic process of filling out documentation, transferring funds and sending the money to the issuer.

“Normally these transactions take weeks and months, but an investor can literally invest in a private placement on our platform in a matter of minutes,” he says.

Dellorso says it’s yet to be seen whether WealthForge will work with issuers and non-accredited investors later this year. He expects 99.5 percent of all capital raises to still be done through the accredited investor solicitation exemption.

CircleUp is another new broker/dealer with a focus on consumer products and retail companies. Bhakti Chai, which makes Fair Trade Certified tea, raised nearly $865,000 on the platform.

The firm charges companies a 5 percent commission to raise capital on its site, says Rory Eakin, co-founder and chief operations officer. In exchange, CircleUp provides the back-office operations needed to complete the transaction online, including execution, investment documents, online signature, and escrow.

And because the company focuses on consumer products, they have developed a series of machine learning algorithms that can evaluate companies looking to come on board.

“They provide us confidential financial information about their business,” he says. “We can compare that to the other ten thousand companies that have applied to CircleUp, and many of them can be in the same categories.”

Eakin doesn’t believe the wider gates for smaller investors coming in May will be important for his business; There are a lot of additional burdens for those companies looking to raise capital through equity crowdfunding than through private placements. For example, companies looking to raise more than $500,000 have to provide audited financial statements, which can be expensive.

Commissions for the smaller companies looking to raise capital may be prohibitive, and it’s not certain that among smaller, non-accredited investors there is a strong demand to make private investments in a still-hazy market.

Still, firms like Folio Institutional, a self-clearing broker/dealer, saw the interest around equity crowdfunding and decided to launch an online equity and debt-funding platform in September. Since the firm can custody the securities, it can enage in secondary-market transactions and potentially, public offerings.

Investor-Driven

Advisors should expect to field a lot of questions from clients on the opportunities in equity crowdfunding as the new rules come online in May.

“My opinion is that people are going to start calling up and saying, ‘Hey, what about this crowdfunding stuff? Is that right for me? Should I have exposure to that asset class?’” Fernando says.  

But Fernando warns advisors to tread carefully.

“I think that there's going to need to be an increasing sense, a call from people that this is safe, that there's no fraud here, that there's enough disclosure documentation provided by the portal so that qualified investors can browse the site and make good, smart, investment decisions,” he says.

“I would have thought that this industry was in full bloom a year ago; it's just starting, in my opinion, to blossom now,” he adds. “I think the next year or two will be really important data points in being able to tell where this is going to be in 10 years.”

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