Trader Talk

Equity crowdfunding coming soon for average investors

John Lund | Marc Romanelli | Getty Images

If you're tired of hearing about how venture capital firms have captured all the early-stage financing for exciting new start-ups, I have some good news for you.

Mom-and-pop crowdfunding for the average person is about to become a reality.

On Mon., May 16, the Securities and Exchange Commission will begin implementing equity crowdfunding nationwide for the average investor. This will allow small companies to directly raise debt or equity capital from friends, family, and interested investors. It's the final piece of landmark legislation called the Jumpstart Our Business Startups Act, popularly known as the JOBS Act, that was passed in 2012.

One of its provisions allows new businesses to raise capital from directly from private investors. Initially, only accredited investors — those with $1 million in net worth or who earn at least $200,000 per year — were allowed to invest in start-ups.

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That is now going to change. On May 16, the law will allow individuals to invest in start-ups regardless of their income or net worth, though there will be limits on how much can be invested. I've described it as Kickstarter for non-public companies, but that's not quite what happens.

When you invest in a Kickstarter project, you don't have equity in the company. With equity crowdfunding, you do. You have an ownership stake, with a share of the profits.

There are some protections for investors built into the process. These companies cannot simply go out and solicit on their own. They must present their offers through an investment portal which can be run by a registered broker-dealer or through a portal approved by the SEC. They will have a responsibility to at least reasonably believe that the issuer is presenting factual information and in compliance with relevant laws and regulations.

There are several equity crowdfunding portals that have already gone active, including Zacksinvest and SeedInvest.

So, who will raise money using these portals? There's a limit on the amount of money that can be raised: a maximum of $1 million over a 12-month period, so the most likely users are small businesses. Think Main Street businesses: local services like restaurants and real estate.

Giving back

Daniel Mulcahy, who manages the Zacksinvest portal, estimates that real estate investments could be a significant part of portal investments. Take a builder who wants to buy a lot in his town and put up an apartment building. A bank might be willing to lend, say, 60 percent of the loan, but the builder might have to come up with the remaining 40 percent. That would be perfect for crowdsourcing. Or he may not even feel the need to go to the bank and instead go straight to crowdsourcing!

"There's a lot of investment in the private space that most Americans have not had exposure to," Mulcahy said.

But Ryan Feit, who runs SeedInvest, an investing portal that has 18,000 accredited investors, says there's another potential group: early tech start-ups.

"It could be a mobile app, a software company, a company in the internet of things that makes a better home alarm system," he told me. "A lot of venture-capital people have moved to later stage investing, so, for people who need really early stage investing, crowdsourcing might be perfect for them."

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Still, given the $1 million investing limit, the tech dreams will still largely be in the idea stage. Say you have a travel app that works better than Travelocity or Orbitz. To get it to the next level, he might need more programmers or sales staff. It might be a fully functional prototype to interest investors, but he will need 10 more betas to get it to the level needed. All that costs money.

"Say you just created a mobile app, and you just graduated the year before from the University of Texas," Feit continued. "You could invite your classmates to invest, say, $1,000 each in your start-up."

Suppose you want to be an investor in these small companies. How do the initial investors get paid? As long as the company doesn't fail, there are three ways to get a return:

  1. the company gets bought out and you get a proportionate proceed from the sale,
  2. the company can fund its own growth and starts to pay a dividend, or
  3. an IPO.

Mulcahy estimates that 90 percent of the time investors will get paid back via a buyout.

The era of 'crowd diligence'

Now, you know the downside to all this: risk. As in, you invest in a lot of money in a company or a technology that never gets off the ground.

We hear a lot about the successes but not much about the failures.

This raises very serious questions about whether investors will be sophisticated enough to understand what they are investing in. This is why the SEC was created in 1934 and why they created a special class of investors known as "accredited" investors to invest in "unregistered private investments," essentially companies and ventures that are not public and not subject to much scrutiny. The SEC assumes that if you have a certain amount of net worth ($1 million or more) than you must be reasonably sophisticated.

So, why open equity crowdfunding to the unsophisticated masses now? The argument is that information is much more readily available than it used to be. That's true, thanks to the internet. And, of course, people invest in the stock market with no "accredited" requirements, or investing in their brother's restaurant. You can't guarantee an investment, or prevent people from making bad investments.

The difference, of course, is that the stock market is heavily regulated and companies must provide all sorts of disclosures.

The good news is that companies using crowdfunding portals will also be required to make disclosures. They will need to file a Form C, an initial disclosure form, and regular updates on the status of the fundraising efforts.

Want to learn more? One good way to start is with CNBC, which has its own real-time equity crowdfunding index, created in partnership with Crowdnetic. It's the daily average index of the 50 largest capital commitments by private U.S. companies listed on Crowdnetic's data platform.

You will be able to find the top funded U.S. companies in the crowdfunding space. It's a diversified group: the top three companies raising money in the crowdfunding space are Knightscope (crime prevention using robots and analytics), Mine Shaft Brewing (craft brewing), and VirZoom (virtual reality).

Read MoreThe CNBC Crowdfinance 50 Index

How big is the market? It's not clear, but the potential is large. Feit notes that of the roughly 8 million who could be accredited investors, there are only 370,000 that are active accredited angel investors. Now, another 240 million may be able to invest — people who are 18 or above.

That's a big class of potential investors.

CNBC's special reports page on crowdfunding is live now, with real-time indexes.