Primer on Crowdfunding for Small Businesses
The startup or small business faces daunting challenges in attracting funding. Simply, startup funding isn’t simple. The Jumpstart Our Business Startups Act of 2012 (the JOBS Act) added another arrow in the quiver of those looking for funding sources for their startup or small business. Crowdfunding has been around for a while, but the JOBS Act added an entirely new dimension to crowdfunding. This blog post discusses innovations recently introduced to allow the small business to attract investment through crowdfunding.
Related article: Investors for Startups: Terms of Engagement
Before the JOBS Act, you could sell equity in your small business generally only to a small class of investors, those who qualify as “accredited investors” under the securities laws. Basically accredited investors are those who have money to lose. They must have an annual income of more than $200,000 or a net worth of more than $1 million.
The JOBS Act added an exemption to the Securities Act of 1933 to allow crowdfunding. It took a while for the Securities and Exchange Commission (SEC) to approve new rules to permit companies to offer and sell securities through crowdfunding. Late in 2015 the new crowdfunding rules were approved and when the new rules become effective, which should be in early May 2016, crowdfunding will become part of the small business funding landscape. The new crowdfunding rules are “designed to assist smaller companies with capital formation and provide investors with additional protections,” according to the SEC. Crowdfunding may not be for every small business, but you should at least familiarize yourself with the contours of the JOBS Act crowdfunding and decide whether it is an avenue that your small business may want to pursue.
Different kinds of crowdfunding
Let’s clarify what kind of crowdfunding we are talking about. Crowdfunding refers to a number of different kinds of ways to raise funding for companies. Crowdfunding has reportedly been around since 1997 and is a way for your business or organization to get funding by raising small amounts of money from a large group of people. From the perspective of the business or organization, they get money. From the perspective of the people giving the money, what they get in return for parting with their money is what all of the fuss is about.
There are have been crowdfunding platforms around for several years and it is important to distinguish between crowdfunding campaigns under those platforms and the crowdfunding now authorized under the JOBS Act. There are at least four different kinds of crowdfunding.
1. Donations. Non-profit organizations raise money from donations over an Internet platform. The donor gets a tax donation. You may have seen gofundme.com or Indiegogo.com.
2. Lending crowdfunding. Small companies raise money from loans. The company receiving the money gets debt financing and the person lending the money gets a return based on the interest rate of the loan. Take a look at LendingClub.com and FundingCircle.com for examples of lending crowdfunding.
3. Rewards crowdfunding. This kind of crowdfunding has fueled the explosion in crowdfunding and when you heard of crowdfunding, this is what most people thought of. You probably have heard of Kickstarter which has facilitated over $1.5 billion (that is billion) since 2009. The company sets a crowdfunding campaign and offers various rewards usually in the form of products to those people who give money. The company sets varying levels of rewards that correspond to pledge amounts. The company gets money and the person giving the money gets whatever reward is promised.
4. Equity crowdfunding. This is the motherlode of crowdfunding opportunities and was specifically authorized by the JOBS Act. The company gets money and the person giving the money is an investor who receives equity in the company.
Equity crowdfunding is what is specifically authorized under the JOBS Act and is the subject of this article. Remember crowdfunding is simply another method to attract funding. Equity crowdfunding changes the rules in a big way, but you need to be ready for equity crowdfunding. This primer introduces some of the restrictions on equity crowdfunding. Remember that this is entirely new territory.
In equity crowdfunding, your investors get a piece of the action and the SEC adopted rules and regulations to protect the investors from overly aggressive small businesses owners, risky investments and most of all, from the investors themselves (we are not going to argue about governmental parochialism in this blog post). There are four major requirements in equity crowdfunding: eligible companies; investment caps; eligible investors; and intermediaries.
Eligible companies are eligible; bad actors are not
The small business seeking investors is the issuer. Those who are ineligible are various “bad actors.” Bad actors include those have been convicted of a crime related to securities. If you have committed securities fraud, you may have better luck raising money from your family than in equity crowdfunding.
The issuing company does not need to file a registration statement but will still need to disclose extensive financial information, the nature of the company’s business, the securities being offered and the amount to be raised. It needs to disclose who are the officers, directors and any owners with 20% or more equity stake in the company. The company needs to file an annual report with the SEC and provide the annual report to investors.
Under the regulations, you will not need an audit at least for first time crowdfunding issuers. If you are raising less than $500,000, you are permitted to provide specific information from your company’s tax returns that have been reviewed by an accountant. If you are raising $500,000 or more up to the limit of $1 million, you can submit financial statements that have been reviewed (lower level of scrutiny than an audit) by a CPA.
Any legal entity may be an issuer but if your company is organized as a LLC, you may have some challenges particularly in terms of admitting new members and other standard requirements for LLCs. Those corporations that have elected to be treated as S corps are limited to 100 shareholders. Consequently, most of the issuing companies in equity crowdfunding will likely be C corporations. If you are preparing for crowdfunding, there are certainly implications in the form of business organization.
How much moolah do you want?
Your startup is allowed to raise as much as $1 million through crowdfunding from unaccredited investors in any 12-month period without filing a registration statement with the SEC. But unaccredited does not mean that every destitute person can throw his or her money at you. There are still limits on the financial profile of your investor. You can set a minimum and maximum amount of funding that you are trying to raise. When some startups hear this amount, they think that this is easy money. It is not and it will not be every small business that can raise any amount of money through crowdfunding. And if the startup fails to meet its target capital raise then it has to terminate the offering and return all of the money that it raised.
Investor profile: everyone gets to invest at least $2,000
The government imposes numerous restrictions on those who want to invest in small companies through crowdfunding. Investors are only allowed to invest a set amount of money in any 12-month period based on their net worth and income.
If an investor’s annual income or net worth is less than $100,000 then the investor can invest the greater of five percent of the investor’s annual income or net worth or a maximum of $2,000 in a 12-month period. If the income and net worth are equal to or more than $100,000 then the individual can invest no more than 10 percent of the lesser of the annual income or net worth.
For any investor, accredited or unaccredited, rich or poor, the maximum amount any investor can put into a business throughout online equity crowdfunding in any 12-month period is $100,000. And the investor may not resell the investor’s stock for one year after the purchase date.
The small business issuer needs to go through an intermediary, either or broker regulated with the SEC or an online funding portal. These intermediaries are heavily regulated about what they must do. They must produce educational materials and disclosures. They have to enumerate the risks. They are required to qualify the investors, including by gathering questionnaires and assure that the investors meet the requirements.
Equity crowdfunding opens new avenue for raising money
Crowdfunding to allow equity purchases of your company is now a viable option. It is not for every startup or small business. There are advantages and also considerable risks for the small business and you should discuss with your startup lawyer or small business attorney. Knowing some of the constraints on crowdfunding may enable you to make an informed decision about whether crowdfunding is an avenue that you want to explore for raising funding for your small business.