I knew the SEC had released its proposed rules in November 2013, and had read a summary of its key provisions prepared by one of the law firms I trust. I had also noted a number of articles critical of the proposed rules. I had not, however, devoted much attention to equity crowdfunding. It was remote from my work on private equity growth investments (usually in the range of $30 million to $60 million) and LBOs (upward of $100 million), and was also not well suited to funding the kind of startups I was interested in joining or co-founding.

Over the weekend, I decided to refresh my recollections of the SEC proposed rules. One, I might get asked about it again, and being able to point to a post on my blog will be a lot less tiring on my voice than trying to be heard over a noisy bar or pub. Two, it might come in handy in the future, if I experiment with smaller startup ideas that might be suitable for crowdfunding.

So, let’s start by looking at what equity crowdfunding is, according to the Securities Act of 1933 (the “SA”), as amended by the JOBS Act and as interpreted by the SEC in Regulation Crowdfunding. Before we do so, however, we need to look at the situation before the JOBS Act to understand why it is such a big deal.

The starting point for sale of securities (equity or debt) in the United States is the SA, which prevents any person from selling securities in the United States unless those securities are either regstered with the SEC or exempted (by law or regulation) from registration. Raising capital through equity crowdfunding, before Title III of the JOBS Act, would have required registration, an expensive and burdensome endeavor to say the least.

Moreover, before the JOBS Act, the sites that bring entrepreneurs and potential investors together (i.e. the equity crowdfunding versions of Indigogo and Kickstarter) would be required to register as broker-dealers under the Securities and Exchange Act of 1934 (the “SEA”) and would be required to comply with all the regulations that apply to broker-dealers.

The JOBS Act added a new exemption from the registration requirements of the SA for equity crowdfunding transactions that meet an exhaustive list of qualifications:

• The company cannot be a foreign company, an investment company or companies that would have been treated by the SEC as investment companies but for the application of an exemption 1, or a blank check company2.
• The company can raise a maximum of $1 million in any 12-month period.
• At the time of the equity crowdfunding transaction, the company must disclose to the SEC, its equity crowdfunding intermediary, and prospective investors fairly extensive information about the financial and operating position of the company and, depending on the amount it intends to raise, the company may have to have its financial statements audited by an independent public accountant.
• The company must also file annual reports with the SEC every year until the company repurchases all the securities issued in the equity crowdfunding transaction, the company stops doing business and liquidates, or the company is required to provide more detailed reports under the SEA.
• Investors in equity crowdfunding transactions are limited in the amount they can invest in all equity crowdfunded transactions in any 12-month period. For investors with annual income or net worth of less than $100,000, that amount is the greater of $2,000 or 5% of their annual income or net worth. For investors with annual income or net worth of $100,000 or more, that amount is the lesser of $100,000 or 10% of their annual income or net worth. To make things easier on equity crowdfunding intermediaries, the SEC has allowed them to rely on representations from prospective investors, at least where the intermediary has no reason to question such representations.
• All equity crowdfunding transactions have to be done through an intermediary who must be either a registered broker-dealer or a funding portal that meets the requirements of the SEA.
• When advertising the equity crowdfunding transaction, the company must stick to just the facts about the company and the transaction, such as the amount of securities offered for sale, the price, the closing date, and the business plan of the company.
• For one year from the equity crowdfunding transaction, the securities sold in an equity crowdfunding transaction can only be sold back to the company, to accredited investors3, as part of a registered offering, or to family members in connection with death or divorce of the investor.

So far, I hope you’re still with me. In summary, it really is not that simple to raise money through equity crowdfunding.

Now, we can get to the real analysis. There are a few problems with the current equity crowdfunding situation under the JOBS Act. But the most significant problem is that it will be bloody expensive to raise capital through equity crowdfunding, especially for amounts below $100,000.

First, the intermediary (whether it is a funding portal or a registered broker-dealer) will need to be paid for its services. Some estimates are pegging this fee at between eight to ten per cent of the gross proceeds. In other words, if you are raising $1 million, you can expect to pay $80,000 to $100,000 out of that $1 million to the intermediary.

Second, anyone planning to raise money through an equity crowdfunding transaction will need to engage equity capital markets and securities lawyers who know their way around disclosure documents and the related due diligence. You can expect this to cost upwards of $10,000, depending on how screwed up the company is, from a legal perspective. Some of the problems I could foresee arising include unclear intellectual property rights (i.e. whether the company, the employees or contractors, or the founder owns the intellectual property used by the company), screwed up capital structures, entrepreneurs mixing personal and corporate finances, poorly documented relationships among the founding team (especially shareholdings in the company), et cetera.

Third, engaging an auditor to prepare audited financial statements in connection with raising between $500,000 and $1 million will cost around $20,000 to $50,000 (ballpark figure).

Fourth, the company will have to pay for ongoing compliance costs after successfully raising capital through equity crowdfunding, which would be at least the cost of audited financial statements, plus some additional fees paid to lawyers to assist with filing the appropriate disclosures with the SEC.

In total? That’s probably between $150,000 and $250,000 of fees and other costs to raise $1 million, or approximately 15 per cent to 25 per cent in transaction costs. By contrast, in a typical private equity transaction, I would expect to see transaction costs of around one per cent to two per cent.

As a result, I’m skeptical that equity crowdfunding, at least in the form proposed by the SEC, will be in any way a viable method of raising capital for entrepreneurs.