Introduction to Crowdfunding

This post is a primer on crowdfunding for entrepreneurs and other people who are not securities lawyers.

Securities

I’ll start by talking a bit about securities and then about equity and non-equity offerings. Bear with me; we’ll get to crowdfunding.

What is a security? The most common types of securities are stocks, bonds and notes. However, just about any instrument representing a share or interest in a company will be a security.

Securities are regulated by federal and state law. The primary federal laws regulating the registration and sale of securities are the Securities Act of 1933 and the Securities Exchange Act of 1934. The primary state laws regulating securities, known as blue sky laws, are variations of the Uniform Securities Act, a model statue created by the National Conference of Commissioners on Uniform State Laws.

Registration and Exemption

Securities must be registered to be sold, unless there is an exemption for the security or for the sale.

The types of exempt securities are limited. They are (a) securities issued by the US or a foreign government, (b) an interest in a banking institution, insurance company, railroad, public utility,(c)  certain options or warrant, (d) securities issued by a nonprofit. (e) securities sold in connection with employee and other benefit plans and (f) equipment trust certificates.

So, generally speaking, companies and individuals wishing to sell securities without having to register them, rely not on exemptions for the type of security, but rather on exemptions for the type of transaction.

Reg D

The most comment exempt offerings are offerings under Section 4(2) of the Securities Act, offerings regulated by Reg D. And the three primary exemptions under Reg D are those under Rules 504, 505 and 506.

The greater the number, the greater the amount that can be raised, but also the greater the requirements.

Rule 504 has the least requirements. However, the maximum amount that can be raised under Rule 504 is $1 million.

$5 million can be raised under Rule 505, provided the sales are made to no more than 35 non-accredited investors, there is no general solicitation or advertising, the investors hold the securities for 6 months and certain financial and other information is disclosed to the investors.

An accredited investor can be certain organizations (which we won’t go into here); a company officer or director, a natural person who has individual net worth, or joint net worth with the person’s spouse, that exceeds $1 million at the time of the purchase, excluding the value of the primary residence of such person; or a natural person with income exceeding $200,000 in each of the two most recent years or joint income with a spouse exceeding $300,000 for those years and a reasonable expectation of the same income level in the current year.

Under Rule 506, there is not maximum amount. However, investors must hold the securities for one year.

Crowdfunding

Now let’s talk about crowdfunding.

Crowdfunding is currently restricted to non-equity funding. That is, there can be no investing or purchasing of securities.

Common sites for non-equity crowdfunding are Kickstarter, Indiegogo, Rockethub, FundRazr, GoGetFunding, Crowdfunder, but there are hundreds of others.

The total fees that are paid by those raising funds are about 7 to 9% for successful crowdfunding campaigns, a bit less for non-successful ones.

The purpose of the crowdfunding campaign can be almost anything. Recent successful campaigns in the news were for 3D printing and the Veronica Mars movies.

But to repeat, the persons giving money are not investors, they are not receiving any equity or securities. They are receiving only the satisfaction of supporting a “worthy” project and maybe some perks such as stickers or t-shirts.

This is about to change.

The JOBS Act

The JOBS Act was signed into law in April 2012. It made two big changes in the ability to conduct securities sales.

First, Title II of the JOBS Act lifted the general ban on general advertising and solicitation. However, it also limited the offering made without the ban to accredited investors.

Second, Title III of the JOBS Act, when implemented, will finally allow equity crowdfunding.

Equity Crowdfunding

The SEC proposed rules to implement Title III in October 2012. The comment period on the rules could end as early as February with the rules potentially going into effect as soon as May 2014.My previous post presented an overview of the rules, however, here are some highlights:

  • Crowdfunding would be done through portals that would include forums for potential investors to ask questions and receive answers.
  • Investor would be limited in the amount they could invest: to the greater of $2,000 or 5% for people earning (or worth) up to $100,000, and lesser of $100,000 or 10% for people earning (or worth) $100,000 or more.
  • The amount that a company or individual could raise would be limited to $1 million a year.
  • Financial statements would be required if raising more than $200,000.
  • Annual filings would need to be made with the SEC.
  • Advertising would be limited to general information and facts.
  • Issuers would have no need to comply with states’ blue sky laws.

Pros and Cons

So what are some of the pros and cons of equity crowdfunding?

The primary benefit is the reduced need to raise capital for friends and family and angel investors. However, this may also mean a reduced need to convince others of the viability of your company or your idea.

Equity crowdfunding may result in a reduced role for angel investors. Angel investors are currently a common source of funds for new companies. But angel investors also are key advisors and mentors to entrepreneurs. A reduction in angel investment may translate to a reduction in needed advice to new ventures and entrepreneurs.

Equity crowdfunding will probably mean more fundings. However, some of these may be in projects that are just plain crazy.

The SEC estimated that the cost of conducting an equity crowdfunding would be $6500 plus another 5 to 15% for intermediaries. This is money that will simply not be available for capital purposes.

Please let me know if you have any comments or questions.

Alan N.Walter