As a part of the Jumpstart Our Business Startups (JOBS) Act (H.R. 3606), passed by Congress on March 27, 2012 and signed into law by President Obama on April 5, 2012, the Federal government has created legislative authority for the social media phenomenon of crowdfunding. The JOBS Act addresses various issues relating to financing businesses, with the stated intent of easing restrictions on entrepreneurs. Title III of the JOBS Act transports the world of start up investing from the silicon valley venture fund and wealthy investor down to the street level and less affluent investor.
Crowdfunding can take many forms: micro loans, pre-orders, donations and equity investments. Crowdfunding often relates to a specific project or product and allows the public to vote with their dollars on whether the project moves forward. A project that appeals to the crowd funder’s identity and values get their backing. The JOBS Act only deals with equity crowdfunding, that is many people investing small sums of money in a venture. Other types of crowdfunding are considered loans, sales or charity, which do not create the securities law concerns addressed by the JOBS Act. Equity crowdfunding explicitly contains the possibility of a financial reward and is primarily driven by financial return. The vast majority of active crowdfunding activities, however, are based on the crowd funders making a statement that the effort, project or cause matches their values. Whatever its form, crowdfunding pools money from individuals with a shared interest who are willing to provide small contributions toward a goal. When the goal provides an opportunity for the crowd funders to share in profits of the venture, as opposed to receiving a product or feeling good about the venture, federal and state securities laws generally apply.
Crowdfunding is promoted by a multitude of websites as “an explosive combination of democracy and free market capitalism”. Crowd funders are able to “vote” on the business they want to succeed, by using their dollars to promote causes or products they believe in. The enthusiasm that many of these sites create for crowdfunding can blind the funder to the dangers of fraud and mismanagement. Into this combination, steps the JOBS Act to try and harness the power of crowdfunding while mitigating the dangers. As with all securities, the double lawyer of regulation in the United States applies and ventures raising funds through crowdfunding, in addition to complying with federal law, have had to comply with state securities laws, which include varying requirements and exemptions. The State of California has been active in enforcing its securities laws as they relate to crowdfunding, most notably ordering the website ProFounder to stop its activities supporting the sale of crowdfunding securities in California and refrain from operating any website that induces securities to be sold over the Internet, without obtaining authorization to act as a securities broker-dealer in the State of California.
Crowdfunding by its nature, as a form of social media, is intended to be conducted electronically over the Internet. Traditional fundraising was done face to face through the use of written materials and involved a venture or its broker obtaining information about an investor and then providing information about the venture to a limited number of suitable investors. By using the Internet, crowdfunding flips this dynamic around and uses information about the benefits of the venture to attract investors from a pool of investors that is seemingly without limits. A crowdfunding venture can be exposed to potential liability at the federal level, in all 50 states, and in foreign countries. In the United States, a security must either be registered with the Securities and Exchange Commission (SEC) at the federal level and at the state level, or take advantage of an exemption from registration. The terms of available exemptions from registration at the federal level do not match the dynamic of raising capital through crowdfunding. Exemptions variously require a filing with the SEC, disclosure in the form of an offering circular, limit the number of individuals that may be contracted, restrict the use of widely distributed information or place a high threshold on the net worth of the investor, all of which make conducting a crowdfunding offering difficult or too cumbersome. Perhaps most importantly, the private offering approach of these exemptions is inconsistent with widespread use of the Internet. Title III of the JOBS Act addresses these problems on the federal level, but not without restrictions. The ability of ventures to equity crowdfund after the passage of the JOBS Act is not immediate, as the SEC must issue regulations to implement its provisions. The SEC has 270 days following enactment of the JOBS Act to issue such rules.
Differing provisions of state securities laws have been touted as possible state exemptions from registration authorizing crowdfunding. In California, Section 25102(n) of the California Corporations Code might provide a possible exemption, in that it permits a general announcement of an offering (this is still well short of the general distribution of information that crowdfunding envisions) without qualification in California and there is at a corresponding exemption at the federal level. However, any such state exemption by its nature is limited to a single state and, because of this inherent limit, does not meet the description of what is generally thought of as crowdfunding. Websites that purport to indicate that California already has a crowdfunding exemption, also may rely on offerings with respect to which a permit has been issued by the California Commissioner of Corporations, but this approach again has restrictions, entails delay, requires a fairness review and contains minimum net worth requirements. Crowdfunding, as envisioned by Title III of the JOBS Act, will not require states to enact new state securities exemptions as state securities laws will be preempted crowdfunding securities were made exempt as “covered securities.” Covered securities are already exempt from state securities laws, but states are expected under the SEC regulations to retain some enforcement authority and the ability to require notice filing with respect to crowdfunding securities.
Various versions of the JOBS Act, as it made its way through the House and Senate, have contained a variety of proposals, including allowing individuals to raise funds using Facebook and other social media websites. The more flexible of these proposals, such as the Facebook approach, have fallen by the wayside and while SEC implementation can have a dramatic impact on the eventual impact of securities laws, the general outline of equity crowdfunding under the Title III of the JOBS Act is as follows:
- Up to $1 million per year may be raised through an SEC-registered crowdfunding broker or funding portal.
- Intermediaries (brokers or funding portals) helping to raise funds through crowdfunding must (i) register with the SEC, (ii) make sure investors are advised of the risks of the offering, and (iii) take measures to prevent fraud.
- Individuals with an income of less than $100,000 per year may invest the greater of $2,000 or five percent of their income.
- Individuals with an income of more than $100,000 per year may invest up to ten percent of their income, but no more than $100,000.
- Companies that use crowdfunding must provide financial statements to investors. Companies seeking to raise: (i) $100,000 or less, must provide tax returns and company certified financial statements, (ii) between $100,000 and $500,000, must have independent accountants reviewed financial statements; and (iii) more than $500,000, must have audited financial statements.
As with many fundraising initiatives, there is a great deal of excitement and anticipation about the coming benefits to new ventures of using equity crowdfunding. Good counsel and caution are appropriate before investors or ventures start to utilize the new crowdfunding authorization after the SEC issues its regulations. While crowdfunding will provide another source of equity funding for small businesses, there may be potential drawbacks for entrepreneurs. Unlike other forms of crowdfunding, where contributions to or purchases from one-off projects give the participants no say in the operation of the project, even small equity investors want, and will have as a group, some influence in the direction a business takes. With hundreds of equity investors a venture may be answering to hundreds of bosses. At the very least, providing information to numerous investors can be time-consuming and costly to administer. Startup ventures that accept equity crowdfunding may also have difficulty raising additional funds in the future from venture capital firms and other sophisticated investors, because of their hundreds of small, less knowledgeable backers. Small investors’ expectations can be more difficult to manage and create a much higher level of sympathy in any securities litigation or dispute.
Another problem will be the general perception that the use of crowdfunding may create over time. As industry observers have noted, given the relatively limited amount that can be raised by crowdfunding, many of the ventures that use crowdfunding will be start-ups just trying to get off the ground. Based on history, many, if not most, of these ventures will fail creating investor losses. Over time, using crowdfunding may be seen as a bad bet because of this taint. Industry professionals are also worried that scammers will descend on the fledgling market and mire it in fraud. If the SEC becomes enmeshed in chasing fraudulent activities down, the entire exemption may be tainted and shunned by legitimate ventures.
Using crowdfunding will not somehow relieve a venture from securities litigation concerns. If there are material misstatements or omissions in the information provided in crowdfundig process, Title III of the JOBS Act provides an express cause of action against the venture. Moreover, any person who is a director, partner, principal executive or financial officer, or controller may be similarly liable. Because the crowdfunding exemption requires the use of an intermediary, they may prove to be another source of potential recovery.
Crowdfunding may provide an alternative to current offering exemptions because of its ability to raise funds over the Internet with lower costs and expansive potential sources of funds. Any plans to raise funds through crowdfunding must evaluate the final SEC regulations and consider the various costs and benefits including the annual reporting requirement and fees charged by brokers and funding portals.