By Garrett Sutton, Esq.
What the heck is crowdfunding? And why has the Securities and Exchange Commission (“SEC”), the government’s stock market watchdog, been so cautious about it all? Three years after the SEC was directed to come up with new crowdfunding rules, they finally delivered.
As to the first question:
Crowdfunding is derived from crowdsourcing. Wikipedia, the free encyclopedia, is an example of crowdsourcing, where the small editorial contributions from many people are leveraged into a bigger whole, a massive compendium of information. When you add money to the concept, you have crowdfunding.
There are three key players in a crowdfunding effort. First, you have the project initiator, the entrepreneurs who put forth the venture. Of course, you have the crowd, who will (hopefully) fund the project. And then you have the internet Funding Portal, which brings the two parties together.
With the passage of the Jumpstart Our Business Startups, or JOBS Act, in the spring of 2012, Congress sought to open up capital formation from smaller investors through crowdfunding. They directed the SEC to come up with new rules within a year to make the raising start up monies easier for new businesses.
Gerri Detweiler and I put the release of our new book, Finance Your Own Business, on hold for a year waiting for these important new rules. The SEC, being a slow, deliberative and political agency, took their own sweet time. We could wait no longer to publish the book. Of course, in the same week the books were printed the rules were released. What else is new?
What is new with crowdfunding are some opportunities for small and new businesses to raise money beginning in the spring of 2016. Let’s answer the key questions:
What is the biggest change?
Smaller investors can now invest. Previously, only accredited investors (those with $200,000 a year incomes or a $1,000,000 net worth) could participate in a crowdfunding offering. Now, those with an annual income or net worth of less than $100,000 can invest up to 5% the lesser of their income or net worth per year, or $2,000 if that is greater. Those with higher incomes and net worth can invest up to 10% of the lesser of income or net worth. At the upper end, investors can only place a total of $100,000 in all crowdfunding offerings each year.
Even with these limits, a whole new market has just opened up.
Can I advertise the offering?
Yes. Prior to the JOBS Act, you could not use any form of public solicitation to advertise your offering. Now, for debt or equity fundings not exceeding $1 million, you can use emails, Facebook, and the like to promote your offering. Before you had to be rich and in the know. Now you just need to be on the internet. Let that sink in for a moment. (Does the word ‘caution’ come to mind?)
How do investors receive the information?
You direct them to a web based Funding Portal such as Crowdfunder, Seedinvest, AngelList or EarlyShares. There are many other Funding Portals, and more to come. Investors review your offering at one of these sites and decide. Know that you can list your offering on only one site. And know, too, that the Funding Portals are allowed to take equity in your business at the same rate as everyone else for the services they render. This may lower your out of pocket costs.
What information must be disclosed?
The strict rules on disclosure still apply. You must be candid about everything in your offering. Not only is this the law but it is the right thing to do. You must give your investors all the information they need to make a reasoned investment decision. For more information on preparing an investment document, see Finance Your Own Business.
In terms of financial information the SEC thankfully dropped the requirement of a full (and expensive!) financial audit for new issuers. If raising $100,000 or more only CPA reviewed financials are needed, with even lesser financials required for lesser raises.
Certain disclosures must also be made directly to the SEC. Be sure to work with a knowledgeable securities attorney when venturing into this area.
What if my company doesn’t raise the full amount?
Then you don’t get to keep any of it. So if you think you can raise $500,000 but $1 million is a stretch go with the smaller amount. If you don’t reach your goal then you will have to refund the investors their money and all of your printing, legal and accounting costs are your responsibility. Not only have you not raised any money but you are out of pocket for the expenses of trying to raise the money. Be prudent.
Another important consideration is that investors can change their mind up to 48 hours prior to closing. Your whole offering could be blown if one or two people back out at the end. Consider exceeding your target raise (which is permitted) so as to have a cushion at closing.
Can I sell my shares?
Not anytime soon. Like regular private placement offerings, shares must be held by the investor for at least one year. Even after a year there most likely will not be a very liquid market for the shares. That day fully arrives when the company registers with the SEC to be publically traded. Still, liquidity aside, to help a friend, to create new jobs or just to have fun rolling the dice, crowdfunding gives everyone a chance.
What else do I need to know?
“You need to be careful,” says Dave Archer, a co-founder of the Reno Angels and the president and CEO of NCET, Nevada’s technology organization. “When you raise crowdfunding money you now have a fiduciary duty to your investors. You must act in their best interest at all times.” Archer cautions that this is new and unchartered territory. “Be sure and do your homework and know exactly what you are getting into before proceeding.” Again, the counsel of a knowledgeable securities attorney will also be extremely important as you move forward.
The SEC took its sweet time developing the rules because there are lots of issues to consider here. Stock promoters and swindlers have always taken advantage of the investing public. Despite the best efforts of the regulators, this will happen again, now on a website near you. But you’ve got to weigh (as the SEC finally did) the inevitable downsides against the significant crowdfunding benefits of capital formation and job creation.
Will the next Google arise from an equity crowdfunding effort? Who can know? But if it does, I sure hope I am in it.
Garrett Sutton is an attorney and the bestselling author of eight business books, including Start Your Own Corporation and Loopholes of Real Estate. His latest book, co-authored with credit expert Gerri Detweiler, is Finance Your Own Business. Garrett can be reached at https://www.corporatedirect.com/.