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Joe Wallin, a Seattle-based attorney, crafted an equity crowdfunding bill for Washington state. (TVW)
Joe Wallin, a Seattle-based attorney, crafted an equity crowdfunding bill for Washington state. (TVW)

Small investors gain access to elite world of private startup equity Add to ...

At first blush, Facebook Inc.’s $2-billion (U.S.) deal to buy virtual reality hardware maker Oculus VR Inc. has all the hallmarks of a modern-day Silicon Valley acquisition: A group of talented engineers start a company, build a popular new technology, and sell it for an obscene amount of money.

But there’s another group of people who, despite playing an instrumental role in making Oculus’s technology a reality, will see none of that cash – the thousands of ordinary people who donated money to back the project.

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Oculus, like many tech startups, began as a project on the popular crowdfunding site Kickstarter. The project’s founders started out in the summer of 2012 asking for $250,000 to build a virtual reality headset. Some 9,500 donations later, they raised almost $2.5-million.

But because Kickstarter is, at its core, a donation site, none of those backers will see any financial gains from the Facebook acquisition announced on Tuesday. Indeed, the world of private startup equity is entirely off-limits to all but the wealthiest investors.

That will soon change, due to a new set of laws coming into effect in a number of U.S. states. In what may be one of the most significant transformations of American investment law, everyday investors will have a chance to contribute to crowdfunding-style startup campaigns and get an equity stake in return. Securities regulators in Canada have also unveiled a set of proposed rules that would allow startups to sell small amounts of stock via crowdfunding sites.

“Say you have a startup and you want to raise 200 grand – that takes a long time,” said Joe Wallin, a Seattle-based attorney who crafted an equity crowdfunding bill for Washington state. “Crowd-funding can make it a little easier for startups to raise money.”

This month, Washington lawmakers overwhelmingly passed Mr. Wallin’s bill, setting the stage for a new kind of investment model.

Currently, the vast majority of North American startups raise money under a Securities and Exchange Commission regulation called Rule 506. The regulation allows companies to raise an unlimited amount of money, but under a number of strict conditions. For example, the companies are forbidden from widely advertising their search for private investment.

There are also limitations on who is eligible to invest. Under the regulation, only individuals with a net worth of more than $1-million or with an annual income above $200,000 a year can invest in companies raising money. “In order to invest in an early-stage startup, you have to be accredited,” Michael “Luni” Libes, founder of Seattle-based startup incubator Fledge, said. “Only 3 per cent of Americans qualify, and not all of them invest.”

However, a clause in a two-year old federal law designed to make it easier for small businesses to raise money allows for a crowd-funded equity scheme at a federal level, using a model similar to that used by popular services such as KickStarter and Indiegogo. As individual states tired of waiting for the Securities and Exchange Commission to create the mechanisms to implement this, they started to build their own.

Broadly speaking, in such a system, any individual investor can buy an equity stake in a private startup just as they would participate in a crowd-funding campaign – but instead of a final product or special perks, they’d receive an ownership stake. More than half a dozen states have introduced or passed crowd-funding-related bills in the past year alone. Washington, however, appears to be best-poised to turn the mechanism from theory to reality, thanks to its bustling startup sector.

“When I started out, I had to take food home from events because I didn’t have enough money for rent and food,” said Colin Christianson, a Seattle-based entrepreneur who founded a digital production and media company called Tenacious Ventures, funding it partially with credit card debt. “Crowd-funding would have allowed me to move much more rapidly and not have to struggle so much. Where it took me to get in two years, I could have gotten to in six months to a year, had I been able to take advantage of crowd-funding.”

But the new model comes with considerable risk and little in the way of precedent. A long-standing criticism of traditional crowd-funding sites is the large number of projects that fail to deliver the product or service promised to backers, often with few consequences for the creators. Should that become commonplace in the crowd-funded equity market (a likely outcome, given the high failure rate of technology startups), countless retail investors may find themselves left with worthless private shares.

“If you look at crowd-funding advocates … the last thing they want is a bill that results in a bunch of fraud and a bunch of people getting pissed off,” Mr. Wallin said.

To prevent this, the creators of crowd-funding bills have built myriad protections into the wording of the legislation. In Washington, for example, investors who make less than $100,000 a year will only be allowed to invest the greater of $2,000 or 5 per cent of their annual income in crowd-funding equity sales. Prospective startups also have to be approved by Washington’s Department of Financial Institutions.

Washington likely won’t see a fully functioning crowd-funding equity market until 2015. But startups across North America will be watching closely to see how details like residency requirements are enforced. Should a large number of crowd-funded startups go under and retail investors lose money, even the bill’s biggest political supporters may quickly change their minds.

“There’s going to be businesses that fail and people who lose money,” Mr. Wallin said. “But there’s also going to be successes.”

Follow on Twitter: @omarelakkad

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