“Crowdfunding” is one of the most recent concepts in obtaining funding for private companies. Prior to the enactment of the Jumpstart Our Business Startups Act (called the JOBS Act), private companies were not allowed to solicit investments from prospective investors unless they had a “substantial preexisting relationship” with the investor or registered the offering with the SEC. The JOBS Act allows companies to sell securities to a large number of investors, whether or not the company knows the investors prior to the sale. However, until the SEC issues guidance on how the crowdfunding offerings have to be conducted, crowdfunding will not be available as a means of financing your company except in limited contexts.
What is crowdfunding? Crowdfunding is intended to allow private companies to cast a very wide net when seeking investors. It has been conducted on a limited basis for some time but it has typically been structured in a manner that allows the company raising funds to fall outside of securities regulations. Kickstarter (www.kickstarter.com) is a website sometimes used to fund creative projects such as films and video games, usually as a donation, and one filmmaker recently raised $5.7 million on Kickstarter with contributors receiving benefits ranging from updates on the movie for a $1 contribution to a speaking role in the movie for a $10,000 contribution. It may also facilitate pre-sales of products by offering customer rewards. Crowdfunding has also been used to provide micro-loans through companies like Kiva (www.kiva.com). Typically the loans are interest free and Kiva doesn’t take a commission. Since no profit is involved, Kiva takes the position that these loans are not “securities.” Something akin to crowdfunding is also being used with solicitations for investments given to people with whom there is already a “substantial pre-existing relationship” and who meet the “accredited investor” criteria. However, as a general rule, crowdfunding has not been available as a source of capital for start-up companies.
What does crowdfunding involve? Crowdfunding rules are tough. Among other rules, companies using crowdfunding are required to make a significant amount of financial and other information available to the SEC and to their investors prior to the sale. This information has to be updated annually. Also, the intermediaries (which will likely be the websites through which crowdfunding is accomplished) are required to comply with a host of requirements, including conducting background checks and ensuring that the offering proceeds are provided to the company only when the minimum offering is achieved.
The bottom line: Despite all of the “buzz” about crowdfunding, other than the limited uses described above, it is not yet legal and won’t be legal until the SEC issues regulations. Even when it becomes legal, it will come with a heavy compliance cost. While the concept sounds enticing, it may not provide the benefits to start-up companies that Congress intended.