Raising money from the masses is set to get much easier
The ability of the Internet to match startup companies with people who are willing to give individually small but cumulatively large amounts of money has made it practical for new companies to raise funds outside of the traditional means.
New state and federal laws provide a mechanism that meets the dual objectives of protecting investors while allowing new investors to get in the game.
What is crowdfunding?
Crowdfunding is the pooling of money of numerous individuals or other small investors to support the business or charitable efforts initiated by other people or organizations.
Because the Internet lends itself well to the solicitation of these types of investments, most crowdfunding efforts are done online.
Crowdfunding can take different forms, and it’s been around for thousands of years. In 1884, for example, Joseph Pulitzer raised $100,000 from more than 125,000 people to complete construction of the pedestal of the Statue of Liberty.
But perhaps the earliest type of “modern” electronic crowdfunding is raising money for charitable purposes or disaster relief via text message; after the 2010 Haiti earthquake, the American Red Cross raised over $32 million within one month via small text-message donations.
Popular sites such as kickstarter.com and indiegogo.com allow project creators to solicit and obtain funds from individuals interested in their success (this is sometimes called micropatronage). All donors may receive something back from the recipient (like being a member of a band’s fan club or being first on the list to buy new products), but the donor does not receive any equity ownership in the concept or company. Alternatively, sites like prosper.com let individuals make collective microloans to borrowers in exchange for the right to repayment with a negotiated interest rate.
Equity crowdfunding, which is likely most useful to startup businesses and entrepreneurs (and attractive to investors motivated by the risk and reward of equity investing), permits an individual or company to solicit equity investment from a large number of potential investors in relatively small amounts.
For example, a small Internet startup might need to raise $150,000, and crowdfunding would permit them to raise that amount from hundreds or potentially even thousands of small investors, who would receive stock or other equity in return. This type of fundraising from a broad pool of smaller investors is difficult to impossible under current law, but that may be about to change.
Securities regulation
Crowdfunding that does not involve the sale of securities is relatively unregulated.
Charitable donations are favored under the law, while crowdfunding through sources like kickstarter.com do not provide the donor with any ongoing interest in the endeavor being supported. However, both federal and state law have strict limitations on the means of raising money through the sale of equity in businesses.
The general rule is that every sale of a security (which includes stocks or LLC membership interest, but can be broadly defined as any exchange of money with an expectation of profits arising solely from the efforts of a third party) must be registered or exempt. Registration of a securities offering is often an expensive and time-consuming process (which commonly takes the form of an initial public offering) and is not commonly used for startup funding. Most startup funds are raised through exempt securities offerings.
Title III of the federal JOBS Act, signed by President Obama on April 5, 2012, permits the sale of securities in the United States via crowdfunding. There are a number of limits and restrictions on the conduct of equity crowdfunding, including those outlined in the tips box with this article.
The SEC has been charged with issuing rules to carry out the new crowdfunding law. As of January 2014, the SEC has issued proposed rules, which are open for public comment. After the comment period ends, the SEC will vote to adopt the rules, incorporating any amendments it deems appropriate. Because the SEC’s rules are required to be issued before crowdfunding can start, large-scale crowdfunding will not start until those rules are finalized.
The crowdfunding provisions of the JOBS Act preempt state law regarding registration, documentation and offering requirements, although states are still able to take enforcement action against issuers or funding portals who violate the law. States have considered or passed laws permitting crowdfunding, but that national scope of federal law and the attractiveness of state law preemption make the JOBS Act the most prominent equity crowdfunding law.
What will the impact be?
People are excited about equity crowdfunding, and with good reason.
It opens the possibility of startup companies finding equity capital through funding portals, which will presumably help those companies comply with the filing requirements and the investor limitations of the crowdfunding exemption. As soon as the SEC issues its regulations, expect to see a lot of equity crowdfunding activity.
