Crowdfunding

Crowdfunding is a new and evolving fundraising alternative that marries social media and finance. With crowdfunding, entrepreneurs reach out to the “crowd”—including their friends, customers, neighbors, supporters and social network—for funding. The idea is that lots of smaller sums of money can take the place of one or two large investors or patrons, and that technology can help streamline the process.

The idea is not new—we raise funds this way for political campaigns (well, until they became dominated by superPACs, billionaires and special interests) , the Girl Scouts and even the Statue of Liberty. What’s new is the Internet and social media.crowdfunding

Crowdfunding is about more than money. It’s also a powerful marketing tool that can help entrepreneurs create awareness for their product, build a loyal customer base and find their tribe.

Most crowdfunding campaigns work like this: an entrepreneur creates a campaign, usually including a video pitch, that explains the project or venture, how much is being raised, what the money will pay for, and what backers get in return. The entrepreneur then reaches out to her network through social media and other channels in the hopes that people will be persuaded to back her campaign. Some crowdfunding platforms are “all or nothing,” meaning if your fundraising falls short of your goal, you get nothing.

Simple enough, right? But crowdfunding comes in different flavors, and that’s where things get a little tricky. There are two main types of crowdfunding: donation and rewards-based crowdfunding and investment crowdfunding.

Rewards-based Crowdfunding

This is the most common type of crowdfunding, popularized by sites such as Indiegogo and Kickstarter. These sites let people contribute money to artistic or creative projects, such as films, music or video games. As described above, the artist or entrepreneur would create a campaign to persuade people to back the project. The campaign is posted on a web site, along with varying donation and reward levels. For example, a $10 contribution might get a thank you note or Twitter shout-out. For $30, a t-shirt. Big spenders get bigger rewards—maybe scoring an invitation to the film opening or CD launch party. And of course, all contributors get the satisfaction of knowing they contributed to something they believe in.

Sometimes contributors are paying up front for a product that they would like to see developed—a music CD from their favorite artist, or a new video game.  This is a form of pre-selling. Other sites focus strictly on donations, where you’re supporting a cause or an individual in need.

The important thing to remember is that, in all these cases, there is no financial return, so securities laws do not apply—and that simplifies things tremendously!

This “micro-patronage” or rewards-based crowdfunding model has been wildly successful. On Kickstarter alone, more than $1 billion has been raised since 2009. There are also rewards-based sites that specialize in niche markets, for example, Plum Alley for female entrepreneurs; ioby for community-based projects, Pubslush for books, and Barnraiser for food. 

We are big fans of rewards-based crowdfunding, but it has its limits. Rewards are great for creative projects, but some people balk at funding a business this way. And let’s face it, we can’t all be Medici’s. Sometimes we need to make a return on our money.  That’s where investment crowdfunding comes in.

Investment Crowdfunding

Imagine Kickstarter, but instead of a contribution, you’re making an investment in a small business, with the potential to share in the upside of that business.

This is the brave new world of investment crowdfunding ushered in by the Jumpstart Our Business Startups  (JOBS) Act, a bipartisan bill signed into law in April 2012. The landmark legislation updated the nation’s 80-year old securities laws and relaxed longstanding rules that made if difficult, if not impossible, for small, private companies to reach out to the public (meaning ordinary investors) for capital.

The JOBS Act allowed for two types of investment crowdfunding: one form that is open to wealthy investors only (known as Title II), and another that would allow any individual, rich or poor, to invest in private companies through crowdfunding (Title III).

Securities Laws

Why did we need a law to make it possible for people to invest in small companies? That’s a long discussion, but in a nutshell, it has to do with our system of securities laws that was put into place during the Great Depression. Those laws (the Securities Acts of 1933 and 1934) basically said this: if you were wealthy, you could invest in anything you want. But if you were not wealthy—that is to say, 95% of the population—then you were pretty much relegated to publicly-traded companies. The intention was to protect mom and pop investors. Publicly traded companies were required to disclose comprehensive financial information on a regular basis—those voluminous quarterly reports and filings that companies publish but few people ever really read. So the idea was that investors would be armed with the information they needed to make an informed decision and avoid scams.

Those rules have stood for eight decades. But times have changed. The Internet makes information way more accessible than it was in the 1930s. And the cost of going public has soared, putting it out of reach of all but the largest companies.  Lawmakers over the years carved out exemptions to the rules, namely Regulation D, Regulation A and Rule 147 (also known as the intrastate exemption). But these exemptions also require a fair amount of costly legal and accounting work. The one time it’s absolutely okay and easy for private companies to get funding from regular (non-wealthy) investors is when they have a substantial, pre-existing relationship with those people—in other words, friends and family. But that can be a bit of a gray area, too. And not everyone has a rich aunt.

The motivation behind the JOBS Act was to update our 80-year old securities laws for the Internet age and make it easier for smaller companies to raise capital.

 Accredited Investor Crowdfunding

Title II made it legal for private companies raising money from investors to come out of the closet and announce it. Sounds like a no-brainer, but before the JOBS Act, there were strict rules about how much a company seeking investment could say, and to whom. That was clearly a problem: it’s kind of hard to raise money when you can’t tell anyone. Title II does away with that restriction, allowing companies to freely advertise the fact that they are seeking investors— they can announce it at a conference, advertise on the radio, or blast it put on the web. This is known as “general solicitation.”  Companies raising money this way use Regulation D Rule 506(c), a new securities exemption that allows for general solicitation.

But there’s a catch. While companies can widely advertise their fundraise under Title II, they can only accept money from accredited investors. (An accredited investor is defined as a person with $1 million net worth, not including primary residence, or with $200,000 in income for the past two years, or $300,000 for a couple). For that reason, Title II has been called “rich man’s crowdfunding.”

Title II rules were officially adopted by the S.E.C. in July 2013, and dozens of crowdfunding portals today cater to accredited investor crowdfunding, including SeedInvest, WeFunder, Localstake and Crowdfunder, to name just a few. Some sites, such as Fundrise, Loquidity, Realty Mogul and Patch of Land,  focus on commercial real estate. All told, close to 5,000 companies had raised money via Title II through 2014, according to Crowdnetic.

 True Crowdfunding

Title III is the truly revolutionary centerpiece of the JOBS Act. Also known as Regulation Crowdfunding, it makes it possible for small companies to raise money from the general public—wealthy, not wealthy, friend or stranger—as long as the investment takes place on a web site operated by a traditional broker-dealer or an S.E.C.-sanctioned crowdfunding portal, and certain other requirements are met.

This kind of mainstream crowdfunding promises to open up a huge new pool of capital that was previously off limits for entrepreneurs and small businesses.

Specifically, the law allows companies to raise up to $1 million in a 12-month period from the public. Investors are capped at the greater of $2,000 or 5% of their income, if their annual income or net worth is less than $100,000. The final rules also impose a limit on how much those with an income or net worth greater than $100,000 can make: they are limited to $10,000 per year or 10% of their income or net worth.

Under the final rules,  issuing companies are required to:

  • provide investors with basic information about the company, its finances and principals
  • use a broker-dealer or an S.E.C.-sanctioned crowdfunding portal
  • supply tax returns, independently reviewed or audited financial statements, depending on the amount being raised (first time issuers and those raising under $500,000 do not need audited financials)
  • provide a description of ownership and capital structure of the firm
  • file annual ongoing financial reports with the S.E.C. and investors

The JOBS Act was hailed as a game-changer for local investing, because of its potential to democratize investment opportunities for all investors and open up new sources of capital for entrepreneurs and small businesses.

After a lengthy delay, the S.E.C. approved a final set of rules for Regulation Crowdfunding on Oct. 30, 2015. The rules go into effect on May 16, 2016—more than four years after the signing of the JOBS Act! But the S.E.C. used the time to study comments from industry participants, and the final rules reflect some common sense changes that improve upon the draft rules.

See our related coverage on Regulation Crowdfunding:

The New Crowdfunding Rules: What They Mean For Investors

The New Crowdfunding Rules: What They Mean For Entrepreneurs

The S.E.C. Holds Crowdfunding Portals to High Standards

 Reg A+,”Mini-IPO”

Another piece of the JOBS Act that fulfills the ideal of mainstream crowdfunding is Title IV, also known as Regulation A+. It falls somewhere between small-scale crowdfunding and a full blown IPO (initial public offering).  Under the new Reg A+ laws, which go into effect in June 2015, companies can raise up to $50 million dollars (with audited financials and ongoing disclosure requirements, but no state-by-state review), or up to $20 million (with no audited financials required, but registration in each state the securities are offered). In both cases, they can freely advertise the offerings and raise money from both accredited and non-accredited investors. Companies must also register with the S.E.C., although the process is slightly less onerous than a full blown IPO. For these reasons, Reg A+ is considered the “mini-IPO.”

Title IV updated a little-used federal exemption called Regulation A, dramatically boosting the amount that can be raised (from $5 million to $50 million) and addressing some of the hurdles, such as dual registration, that kept companies from making use of it. For more detail, see our coverage here.

Reg A+ is perhaps the most promising piece of the JOBS Act, at least for companies with substantial capital needs. But it may be overkill for smaller businesses with more modest funding needs.

 Intrastate Crowdfunding

While the wait goes on for Title III, an intrastate crowdfunding movement has been building. So far, 29 states have enacted laws that allow investment crowdfunding within their state borders, and more have efforts under way. The laws vary, but they generally allow any small business based in a state to raise money from any resident of the state, accredited or not.  If you reside in one of these states, you may invest in local companies today. Intrastate crowdfunding has the potential to be a true form of local investing. (To wit, Oregon calls its law a Community Public Offering, or CPO!)

That said, there are challenges with intrastate crowdfunding—not least of which is a ban on advertising an offering across state borders. That means that promotion in a newspaper, radio ad or Internet site that can be seen by someone from out of state could get an issuer into hot water. The S.E.C. is working on updating  Rule 147 to fix that and other issues, so stay tuned for these changes in 2016.

This kind of community crowdfunding has clear benefits for entrepreneurs and investors:

Pros:

  • Less risky: Because investors have greater knowledge of the local market and the specific companies and people involved, they are better able to make informed investment decisions. And they’re able to invest in a business they know and love. 
  • For business owners, it’s a way of gaining not just investors, but loyal customers and ambassadors who will spread the word and root for you 
  • Eliminates the financial gatekeepers and increases the likelihood of funding for entrepreneurs, especially women and minorities
  • Helps entrepreneurs vet their ideas and provides valuable input into products and services under development, avoiding costly mistakes
  • A powerful tool for community engagement
  • Flexibility: Can be structured as debt, equity or revenue-sharing

 Cons:

  • Resources: Crowdfunding campaigns require a lot of time and social media savvy
  • Tax implications: crowdfunding platforms report funds raised to the IRS. Even money raised on a rewards-based site may be considered taxable income (although that may be offset by expenses)
  • Investor Relations: Many business owners may not be prepared for having 100 or 1,000 new ‘owners.’ Although their rights are limited, these investors may nonetheless demand time and attention
  • Legal liability: Investors are allowed under the JOBS Act law to sue companies for misleading information or material omissions. It just takes just one disgruntled investor…
  • IP protection: a crowdfunding campaign can expose your great idea and intellectual property for all to see—and copy
  • For investors, small companies always involve a degree of risk, and even the best entrepreneurs may fail for unexpected reasons

Debt, Equity or Revenue-sharing?

Much of the crowdfunding conversation to date has centered on buying equity shares in brand new startups.  But crowdfunding can also be used to make loans to established small businesses. Debt funding of existing small businesses is arguably less risky: the business is a known entity with a proven track record and a revenue stream to make interest payments on a loan. Another alternative is revenue-sharing, where a company may offer to pay investors a share of its monthly revenue until a certain amount of money (typically principal + a premium)  is paid back.

Equity investing in a startup, on the other hand, involves more speculation—especially if the investment is made from afar. Investors may have to wait years for the company to be acquired or, in rare cases, to go public to realize a return. We’ll see plenty of splashy crowdfunding startups promising global investors a shot at the next Facebook or Oculus. But at Locavesting, we’re excited about the potential for platforms that set their sights closer to home, bringing together a community’s investors and businesses.

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Resources:

Accredited investor definition:

http://www.investor.gov/news-alerts/investor-bulletins/investor-bulletin-accredited-investors#.VJGsI8AAJA

Text of the JOBS Act:

https://www.govtrack.us/congress/bills/112/hr3606/text

Up-to-date list of states with intrastate crowdfunding laws: http://crowdfundinglegalhub.com/2014/07/11/state-of-the-states-compariative-summaries-of-current-active-and-proposed-intrastate-crowdfunding-exemptions/

An online resource and review site that can help you compare and choose crowdfunding platforms:

http://crowdsunite.com/