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On Feb. 28, the SEC released a white paper on Regulation Crowdfunding, which law went into effect on May 16, 2016. Regulation Crowdfunding had been long in the making, with the JOBS Act having been passed on April 5, 2012, and the first set of proposed crowdfunding rules having been published on Oct. 23, 2013.

Regulation Crowdfunding provides the rules implementing Section 4(a)(6) of the Securities Act of 1933 (the Securities Act).

From the time the SEC published the final Regulation Crowdfunding rules and regulations on Oct. 30, 2015, the regulatory framework has met with wide criticism. The most commonly repeated issues with the current structure include: the $1-million annual minimum is too low to adequately meet small-business funding needs, companies cannot “test the waters” in advance of or at the initial stages of an offering, and companies cannot currently use a Special Purchase Vehicle (SPV) in a crowdfunding offering.

To address the feedback and offer a resolution, on March 23, 2016, North Carolina Representative Patrick McHenry introduced HR 4855, titled the “Fix Crowdfunding Act.” The Fix Crowdfunding Act would increase the annual funding limit from $1 million to $5 million. The Act would also allow for the use of special purpose vehicles (SPVs) in the fundraising process. It is thought that an SPV structure helps protect the smaller investors by allowing them to pool funds together with larger investors in an entity that offers separate protections than the offering company itself. Finally, the Fix Crowdfunding Act adds “test the waters” provisions allowing companies to communicate with potential investors and gauge interest before spending significant time and expense on the offering process. The Fix Crowdfunding Act passed the House on July 5, 2016, but there has been no further action.

Background

Crowdfunding generally is where an entity or individual raises funds by seeking small contributions from a large number of people. The crowdfunder sets a goal amount to be raised from the crowd, with the funds to be used for a specific business purpose. In addition, a crowdfunding campaign allows the crowd to communicate with each other, thus adding the benefit of the “wisdom of the crowd.” Small businesses can particularly benefit from crowdfunding as they are not limited by purchaser qualification requirements and, subject to the rules, can engage in general solicitation and advertising. It is intended that crowdfunding offerings will be relatively low-cost and easy to implement; however, the general consensus is that that particular goal falls short.

Title III of the JOBS Act amended Section 4 of the Securities Act, adding Section 4(a)(6) to create a new exemption to the registration requirements of Section 5 of the Securities Act. Effective May 16, 2016, Regulation Crowdfunding, implementing Section 4(a)(6), became effective.

Regulation Crowdfunding allows companies to solicit “crowds” to sell up to $1 million in securities in any 12-month period, as long as no individual investment exceeds certain threshold amounts. Regulation Crowdfunding limits investment amounts per investor for all crowdfunding offerings by all issuers in any 12-month period if either annual income or net worth is less than $100,000, the investment limitation is the greater of $2,000 or 5 percent of the lesser of annual income or net worth, or if both annual income and net worth are equal to or greater than $100,000, the investment limitation is 10 percent of the lesser of annual income or net worth. In addition, the final rule provides an overall investment limitation of $100,000 for any investor in any 12-month period. The investment limitations apply across all crowdfunding issuers during any 12-month period.

Regulation Crowdfunding requires that all crowdfunding offerings be conducted through an intermediary that is a broker-dealer or funding portal that is registered with the SECand a member of FINRA. All offerings must be conducted through the intermediary’s Internet-based platform. Securities sold in a crowdfunding offering are generally restricted for one year.

In offerings more than $100,000, financial statements must be reviewed by an independent accountant and in offerings over $500,000 audited financial statements must be provided, provided however that audits are not required for a first-time offering.

Regulation Crowdfunding also requires that companies and intermediaries provide certain information to investors, potential investors and the SEC prior to making an investment. The offering disclosure document is on Form C. Companies must also provide the SEC and investors with a closing report on Form C-U and an annual report on Form C-AR following the offering.

The registered intermediary has certain requirements designed to reduce fraud. Among others, the intermediary is responsible for filing the Form C with the SEC, must provide communication channels to allow discussion of the offerings on its platform, must disclose compensation received by the intermediary, and must provide educational materials to investors.

The ability to utilize crowdfunding is subject to bad boy restrictions and other disqualifying events. All crowdfunding issuers must be United States entities. Crowdfunding issuers cannot be subject to the reporting requirements of the Securities Exchange Act of 1934 or an investment company as defined by the Investment Company Act of 1940.

The SEC White Paper

The SEC white paper reviewed crowdfunding offerings from the date of inception of Regulation Crowdfunding on May 16, 2016 through Dec. 31, 2016. During that time there were 163 offerings by 156 companies seeking to raise a total of $18 million. The average offering sought $110,000, but allowed over-subscriptions, generally up to the total $1 million statutory limit. The average offering closed in four to five months.

Since first-time issuers are not required to file audited financial statements, many set maximum offering limits at the total allowed $1 million mark. As repeat issuers enter the market, the average size of maximum offering amount may decrease to avoid audit expenses.

Of the offerings, approximately $10 million was raised by 33 issuers, with the average amount raised being $290,000. However, some of these offerings remained open on Dec. 31, 2016, therefore this number would likely be higher today.

For offerings initiated in 2016, 24 were withdrawn by companies or associated with an intermediary whose FINRA membership was terminated and funding portal registration withdrawn, seeking a total of $2.3 million based on the target amount.

Most offerings are solicited in all states. The most popular type of securities was equity, including both common and preferred, followed by simple agreements for future equity (SAFEs) and debt.

The most popular state of incorporation was Delaware, and the most popular location of the business was California, followed by Texas and New York. Most issuers have been pre-revenue start-ups or development-stage companies, with the median company having less than $50,000 in assets, less than $5,000 in cash, $10,000 in debt, no revenues and three employees. The average issuer had five employees, assets of $327,000, and cash of $64,000. However, many companies were growing. The median growth from the prior fiscal year was 15 percent, and median sales growth was 80 percent.

Some of the companies also did prior, concurrent or subsequent Regulation D (15 percent) or Regulation A (3 percent) offerings. None of the issuers had previously been listed on an exchange or subject to the Exchange Act reporting requirements.

As of Dec. 31, 2016, 21 funding portals have registered with the SEC and FINRA. One funding portal had its FINRA membership terminated and withdrew its SEC registration. In addition, eight broker-dealers have conducted crowdfunding offerings. The average funding portal fee is 5 percent, though broker-dealers averaged at 7.7 percent.

The SEC acknowledges that the initial results are probably not indicative of what the crowdfunding market will look like as it matures. In particular, companies, investors and the intermediaries will gain experience and learn from mistakes as time goes on. It is also likely that the number of intermediaries will grow and some may be industry-specific or concentrate on specific demographics.

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Every once in a while you come across an opportunity that seems like a “sure thing.” An opportunity where it feels like you’re looking into a crystal ball – where you can see the future playing out before your eyes.

I felt that way back in the winter of 2005.

At the time, my “sure thing” was the yet-to-be-announced launch of the Apple iPhone. My crystal ball told me this was going to be Apple’s next big thing and would revolutionize the world of mobile phones.

The way to play this could’ve simply been to take a position in Apple. But generally, the upside potential of large cap stocks is limited; you typically won’t see big price movements – of, say, 50% or more – based on the launch of a new product.

So instead, I tried to find a small-cap stock that stood to explode if Apple launched an iPhone.

After months of research, I found the perfect opportunity.

I’ll tell you more about it in a moment, and about how it changed my fortunes.  But first I want to share with you my latest vision – my latest look into a crystal ball...

Smells Like... Money?

The vision I’m talking about relates to a privately-held business.  It’s called Aromyx.

Aromyx produces a technology that’s nothing short of revolutionary.

They’ve created a microchip that can detect, interpret and identify smells and tastes just like a human brain.  For example, let’s say a team of chemists is attempting to create a fancy new perfume for a company like Chanel.  They would put a drop of the new perfume onto an Aromyx chip, and almost magically, an image would appear on their computer screen – an “aromagraph” – representing the reaction of the human brain.

  Based on the aromagraph, the chemists would see how the brain’s reaction to the scent was similar to, or different from, existing scents on the market, and then make adjustments as needed.

  The real-world applications of a technology like this – not just for fragrances, but for consumer packaged goods, foods, beverages, and flavors – are enormous.  

  Currently, in order to test and create new products, companies spend roughly $37.5 billion every year on “human panels.”  Basically, they recruit thousands and thousands of people to participate in focus groups in order to predict how the world will respond to a new product.  That’s a time-intensive process, and costly! Aromyx not only provides a faster and more accurate tool – but at $300 per chip, it creates both a cost-effective solution for its clients, and a money-maker for itself.

This type of technology is the future of consumer packaged goods development – at least, that’s what my crystal ball says.

If the company can capture just 3% of the market, it’s a $1 billion business.

Aromyx is currently raising a round of capital from investors like you. You can see more about it on public fundraising platform, AngelList »

Pull The Trigger?

So to sum up the opportunity: an amazing technology, a multi-billion dollar market, and a company that is currently accepting investments. Should we write a check?

Not so fast!  We know first-hand how easy it is to get excited about opportunities like this and make emotional decisions.  That’s why we wrote The 10 Crowd Commandments, a free, easy-to-digest framework that helps you evaluate early-stage investment opportunity »

Let’s take a quick look at how Aromyx stacks up on the positive side of the Crowd Commandment ledger:

Market demand from paying customers: Although Aromyx’s product hasn’t yet launched, the Senior Vice President for Chemical Procurements from Proctor & Gamble (owner of dozens of brands including Tide detergent, Secret deodorant, and Crest toothpaste) said he’d “buy thousands of these right now” if the chips were available.

Straightforward business model: it costs $100 to make a chip and they sell it for $300. After subtracting the normal costs to run the business, what remains is profit.

Competition: While competition exists, Aromyx has over 29 legal patents – that will help them build defensibility.  

Strong management team: They’ve started and sold companies before.

However, our “Commandments” also give us reasons to be concerned:

While Aromyx has already received millions of dollars in government grants and funding, there aren’t any notable private investors involved – i.e., venture capitalists or angel investors who invest to earn a profit.  As we like to say here at Crowdability, it’s always good to “be a follower” in deals like this.  Following professional investors ensures that someone has negotiated competitive terms and done some serious due diligence.

Another concern is that they’re raising $2 million, but they don’t say exactly what they’ll do with the funds.  For example, will they build their team, sign up 10 new major customers, reach positive cash flow? If we invest today, what financial results should we expect?  They don’t say!  There isn’t a clear explanation in any of their materials.

So what should we do here?

My Crystal Ball

Maybe my experience with the “Apple Crystal Ball” can be of some assistance...

As it turns out, I was right about Apple launching their mobile device.  The iPhone has generated billions of dollars in value for Apple and its shareholders, and changed the entire mobile landscape.

But the stock I was so bullish on – one of Apple’s suppliers – didn’t fare so well.  The company was called Portal Player.  I say “was” for a simple reason: the company is no longer publicly traded.  Shortly before the iPhone was released, Apple announced that they would be switching to a new supplier.  It was “game over” for Portal Player, and “game over” for my investment, too.

Other than the fact that my “crystal ball” seems to have been momentarily broken, what lessons can we learn from my failed investment?

Well, for one thing, even though I was extremely excited about Portal Player, I followed my playbook for early-stage investing – an early set of rules similar to the 10 Crowd Commandments.  The most important rule I followed was this: don’t commit too much of your capital to any one stock!  Yes, despite my enthusiasm for Portal Player, I made only a small commitment to it.  I was diversified.

You see, when it comes to investing in startups and early-stage technology companies, there’s no such thing as a “sure thing.”  To protect yourself, you need to diversify, committing only small amounts of capital to speculative ideas like Portal Player – or to companies like Aromyx.