The Current State of Crowdfunding
By Roger Royse
When businesses seek third-party investment they quickly run in to two problems: (1) finding investors and (2) complying with regulatory requirements relating to the issuance of securities. Crowdfunding has the potential to solve, or at least mitigate, both of these problems. The crowdfunding scene is currently dominated by donation-based crowdfunding, however equity crowdfunding is likely to increase in the coming years as the SEC finalizes regulations stemming from the JOBS Act.
The choice of crowdfunding method used depends largely on the goals and maturity of the business. Donation-based crowdfunding is best suited to young businesses that are still testing their model. Issuing equity, even under specific crowdfunding regulations, is expensive and therefore more appropriate for businesses with a proven model.
A. Donation-Based Crowdfunding
Donation-based crowdfunding has exploded in the last five years. Businesses can now seek donations on websites like Kickstarter and Indiegogo and, while not typical, there are success stories of businesses raising million dollar sums within just a few weeks. Since its launch in 2009, Kickstarter has raised over $1 billion from a total of 6.8 million people, and has funded 68,000 projects (giving an average amount raised per project of just under $15,000). Indiegogo does not release details on amounts raised, but it is believed to raise substantially less than Kickstarter.
Both websites provide businesses a platform upon which to raise money for whatever purpose they see fit (within reason) without having to give away any ownership interest in the business. For example, a business may develop a prototype model on its own, but then need funding to mass-produce the product e.g. Pebble. Or an artist may seek funding for a film—anything from a small project to one that eventually appears in movie theaters e.g. Veronica Mars or Wish I Was Here.
In return for the public’s donations, the business offers rewards linked to the product for which they are seeking funds. Rewards vary from a thank you email for a $1 donation to a personal meeting with the business owner for a donation in the thousands of dollars. Many donors donate at a level where the reward is the actual product for which funds are being raised. For example, if they donated enough money backers of the Pebble watch could receive one of the watches and the backers of Veronica Mars could get a digital copy of the movie. When used in this way, donation-based crowdfunding looks a lot like collecting pre-payments for goods and services.
One of the key benefits of the donation model is the lack of securities regulation. That said, those raising money should make sure they follow through on their commitments. Earlier this year, the Washington attorney-general initiated a lawsuit against an individual for an alleged failure to deliver packs of playing cards to donors after collecting money through Kickstarter.
B. Equity Crowdfunding
Equity crowdfunding involves offering securities to the public (or a subset of the public that qualify as “accredited investors”). In passing the JOBS Act, Congress authorized the SEC to enact regulations allowing companies to offer securities to the general public. The SEC has not yet released final regulations, however businesses can rely on existing exemptions for private placements to tap the power of the crowd.
1. Funding Portals Under Rule 506
The private placement exemptions under Rule 506 permit some crowdfunding, although there is still uncertainty as to exactly what you can and cannot do. Rule 506 provides two main forms of exemption. Broadly, under Rule 506(b) an issuer can issue securities to up to 35 non-accredited investors, but cannot use general solicitation in doing so. Conversely, under Rule 506(c) an issuer may conduct general solicitation, but it cannot issue securities to any non-accredited investors.
In 2013, the SEC released two no-action letters (FundersClub and AngelList) which implied that issuers could use funding portals for Rule 506(b) issuances so long as access to the portal is restricted to accredited investors. It should be noted that this is a particularly contentious area of law and issuers are advised to approach with caution. If access to the funding portal is not restricted to accredited investors then the issuer can rely on Rule 506(c), however all eventual investors will need to be accredited investors. Accredited investor status will need to be proven with evidence such as tax returns, financial statements, or a letter from the investor’s lawyer or accountant.
2. The JOBS Act
Title III of the JOBS Act instructed the SEC to draft regulations legalizing equity crowdfunding by the end of 2012. The SEC finally released proposed regulations in October 2013 and the comment period expired on February 4, 2014. Six months later the final regulations are still nowhere to be seen.
If the final regulations end up similar to the proposed regulations then Title III crowdfunding will permit issuers to raise up to $1 million from the public through a broker-dealer or registered funding portal. The issuer will need to make disclosures to the SEC at least 21 days prior to the first sale and audited financial statements will be required for issuances above $500,000. Neither the issuer, nor the broker-dealer/funding portal, will be able to solicit investments and there will be caps on how much individual investors can invest in a given year. In their current form, the proposed regulations look a lot like Rule 506(b) but without the 35-person limit on non-accredited investors.
The start-up community has been waiting a long time for the SEC to finalize the rules on equity crowdfunding, however if the proposed regulations are anything to go by the end result will be underwhelming.
Donation-based crowdfunding is a relatively straight-forward way for businesses to raise money from the public without giving away any of their equity. The downside is that the amounts raised tend to be more modest (usually under $50,000). Equity crowdfunding is still in its infancy, but if the SEC develops appropriate regulations then this could promptly become the go-to model for businesses looking to raise six-figure amounts or more.