Upstart Arizona companies have a new way to raise money as a state equity-crowdfunding law debuts. But while this represents a potentially exciting opportunity, investors must be wary.
Arizona’s new equity crowdfunding law takes effect July 3.
It might spur economic development by helping tiny companies gain financing. It might enrich some shareholders.
But it certainly brings new levels of risk to the investment marketplace.
The law, which Gov. Doug Ducey signed three months ago without any dissenting votes in the Legislature, allows fledgling Arizona companies to raise modest sums of money by selling shares to Arizona residents through Internet intermediaries.
The law seeks to capitalize on the crowdfunding trend, in which people make donations, often to receive perks or rewards, through websites such as Kickstarter and Indiegogo. In fact, websites and social media likely will prove to be critical tools for matching companies with investors.
Under the new law, Arizona companies seeking financing will be able to raise up to $1 million over a 12-month period, assuming they haven’t undergone a financial audit in their prior fiscal year. If they have been audited, they can sell up to $2.5 million of securities.
The new rule is designed to ease the many disclosure, regulatory and cost hurdles associated with selling shares in the stock market. “It’s a great tool for startups and growing tech companies with a story to tell,” said Kevin Walsh, a securities-law attorney at Quarles & Brady in Phoenix.
A blueprint for the Arizona law was provided by a provision of the federal Jumpstart Our Business Startups Act, passed in 2012 but for which equity crowdfunding rules haven’t yet been finalized by the Securities and Exchange Commission. Another section of that act lets corporations raise funds through mini-IPOs or initial public offerings, though at greater cost than with equity crowdfunding, Walsh said.
Economic-development officials hope the rule will attract promising young companies, or at least keep them from heading to the roughly 20 other states that have adopted similar laws. “Arizona is trying to prevent a brain drain,” Walsh said.
But equity crowdfunding won’t work for everyone. Some companies will still find it more worthwhile to apply for traditional bank loans or financing from venture capitalists, especially those requiring more than $2.5 million. Other companies won’t qualify because they won’t be able to meet various Arizona-centric requirements such as having their headquarters here, generating at least 80 percent of their revenue in the state and having at least 80 percent of their assets here, said Walsh, who expects to provide legal guidance to companies interested in equity crowdfunding.
Nor is fundraising success guaranteed. Companies won’t be able to accept more than $10,000 from any individual unless that person is an accredited investor — someone worth of at least $1 million or who earned at least $200,000 (or $300,000 if married) for the past two years. Investments will be restricted to those made by Arizona residents.
For investors, the companies most likely to seek money through equity crowdfunding would be among the newest, smallest and riskiest around. Arizona counts roughly 200 corporations, according to researcher Morningstar Inc., yet roughly three-quarters of them are struggling “penny stocks,” with stock trading near or below $1 a share. Many equity-crowdfunding companies would be even smaller, less mature and more speculative than the state’s penny-stock corporations.
“There will definitely be people who lose money, and some of the companies won’t be able to make it,” said Neal Van Zutphen, a certified financial planner at Intrinsic Wealth Counsel in Tempe. He suggests people view equity crowdfunding commitments as their most speculative investments — not far removed from visiting a Las Vegas casino.
One reason equity-fundraising companies will be riskier is that there’s no guarantee their shares will trade in an organized market. The most likely exit strategy for a company would be acquisition by another entity or person, though the most successful might dream of selling shares one day in an IPO. The lack of liquidity means investors should be prepared to hold on for years.
Also, investors will receive much less disclosure material from companies — even recent audited financial reports might be lacking.
On the other hand, equity-crowdfunding deals offer a chance to get in on the ground floor. In some cases, prospective investors might already know the principals of a start-up company — as relatives, neighbors or former co-workers, offering a chance to join up with them early.
“It’s an exciting opportunity, especially for people with connections to a local business,” Walsh said.
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