Crowdfunding: What It Is and What It Isn’t

You’ve probably heard of “Crowdfunding” by now, but you may not be sure exactly what it is.  You likely have the general impression that crowdfunding is a way for companies to raise money without many of the costs and compliance burdens associated with more traditional financing methods.  And if you’re a business owner, you may very well be excited about the prospect of bringing badly needed capital into your company without having to pay a small army of bankers and lawyers to help you do that.

But before you take another step in the direction of crowdfunding “nirvana,” there are some things you’ll need to understand, starting with a better understanding of what crowdfunding is and what it isn’t.

“Crowdfunding” Defined:

Put simply, crowdfunding is a way for a privately held company [1] to raise up to $1 million within any 12-month period, [2] by selling small amounts of stock to a virtually unlimited number of individuals, [3] without having to register the shares with the U.S. Securities and Exchange Commission (SEC).  It’s permitted by virtue of an amendment to the Securities Act of 1933 that exempts “eligible” crowdfunding from the costly process of an SEC registration.  That amendment was made as part of the “Jumpstart our Business Startups” Act (the JOBS Act) signed into law in April 2012.

In order for a crowdfunding to be “eligible” for the registration exemption, it must meet a number of requirements imposed under the JOBS Act and SEC regulations.  Among others, (i) no more than $1 million of securities may be sold in any 12-month period; (ii) the amount of money received from any one investor may not exceed a maximum amount described in the JOBS Act; (iii) the crowdfunding may be undertaken only through a regulated broker-dealer or “funding portal;” (iv) the company issuing the stock must file a notice with the SEC that provides certain specific information such as financial information about the company and a description of how the investment proceeds will be used; and (v) the company must comply with the requirement to make ongoing reports to the SEC.

But “Crowdfunding” is Not:

1. A legal way to raise an unlimited amount of money without SEC registration.  As mentioned above, a crowdfunding will not be exempt from costly SEC registration if the amount raised exceeds $1 million in any 12-month period.  In addition, the crowdfunding company is limited to seeking a maximum investment per investor of (a) the greater of $2,000 or 5% of the investor’s annual income or net worth within any 12-month period (if either the investor’s annual income or net worth is less than $100,000); and (b) 10% of the investor’s annual income or net worth, not to exceed a maximum amount of $100,000 (if either the investor’s annual income or net worth is equal to or more than $100,000).
2. A legal way to raise money on your own over the internet.  The crowdfunding rules require that the fundraising be done through a regulated broker-dealer or “funding portal,” so don’t think the JOBS Act permits you to go to all your Facebook friends or your favorite list-serve to ask for investments in your company.  In fact, the JOBS Act forbids you to advertise for investors in any manner, except for the purpose of directing potential investors to the broker-dealer or funding portal being used for purposes of the crowdfunding.
3. A way to avoid disclosing information to investors or the SEC.  As has always been the case, most companies seeking capital will be well-served in providing potential investors with a written description of material information they should know before making an investment in the company.  On top of that, though, the crowdfunding rules require that companies provide the SEC with certain information about the company doing the crowdfunding, including (a) background about the company’s ownership and capital structure relevant to the value of the offered securities, (b) a description of how the crowdfunding proceeds will be used, and (c) tax returns, reviewed financial statements, or audited financial statements, depending on the total value of the funds being raised.  In addition, the company will be required to make annual filings with the SEC.
4. A way to avoid professional advisory fees in your fundraising efforts.  Lest you think crowdfunding is the long-awaited means by which your company can raise money without legal assistance, think again.  The compliance burdens, some of which are described above, are not insignificant; and the price for noncompliance could be significant.

While crowdfunding may give you access to a new pool of investors that you couldn’t access prior to the passage of the JOBS Act of 2012, you will need to weigh the compliance costs against the amount of capital being raised before deciding that crowdfunding is the best way for you to raise money for your company.  Consult your legal or business advisor to help you make that cost-benefit analysis, and consider also whether other more traditional means of corporate fundraising make more sense for your company.