Traditionally, entrepreneurs and small businesses turn to family and friends for early rounds of start-up capital after exhausting their own funds. It is thus difficult for entrepreneurs without wealthy friends and family to find vital seed capital. The Jumpstart Our Business Startups (JOBS) Act, signed into law in April 2012, contains provisions that may make fundraising easier, at the seed and later stage levels, by deregulating the use of equity-based “crowdfunding.” These provisions have the potential to dramatically shift the venture landscape by vastly simplifying access to early round funding.
“Kickstarting” Your Business
Crowdfunding is a fundraising strategy whereby capital is raised from a large group of individuals who invest relatively small amounts through a platform, often online, through websites such as Kickstarter.com. The strategy was popularized by charities, artists, musicians, and filmmakers looking to fund their creative endeavors and has evolved into a popular way for obtaining early funding for start-ups, particularly in the technology sector. Until now, crowdfunding has existed in the United States solely as a reward-based system. Due to the pre-existing regulatory framework, individuals and entities have been unable to offer equity positions to more than a de minimis number of non-accredited investors without prior registration with the SEC. Thus, those attempting to raise money for their projects on existing crowdfunding sites have resorted to providing investors with certain rewards, ranging from tickets for the new movie that will be produced with the funding proceeds to pre-sales of products that the funding is being used to develop. This reward-based system has been very successful for raising seed capital. In 2011, the crowdfunding industry reportedly raised $1.5 billion for over 1 million projects.
The JOBS Act’s Expansion of Crowdfunding
The JOBS Act significantly changes the regulatory framework surrounding crowdfunding, primarily by exempting from SEC registration certain issuers utilizing crowdfunding platforms to raise equity-based funds. The significance of this exemption is that it allows start-ups and small companies to offer equity to both accredited and non-accredited investors without going though the financially and administratively burdensome process of registering with the SEC. By simplifying access to a wide investor base, this exemption has the potential to truly improve an entrepreneur’s chance of finding early stage capital. While the impact is potentially significant in all industries, the greatest potential is for technology innovators, with typically less capital-intensive businesses than traditional brick-and-mortar companies. Even with the annual limitations explained below, crowdfunding might be sufficient to launch a technology company into revenue-positive territory, a significant achievement, especially without the participation of a venture capital fund.
Qualifying for the Registration Exemption
To be exempt from registration, the following three requirements must be satisfied:
- Issuers must sell only on “authorized” crowdfunding platforms, also known as funding portals (the exact requirements for what makes a platform “authorized” have yet to be published by the SEC),
- Issuers can only raise a total of $1 million from crowd-funding during any 12-month period, and
- An individual investor’s maximum crowdfunding investment is limited, in any 12-month period, to the greater of $2,000 or 5% of the investor’s net worth or annual income (if the investor’s net worth or annual income is less than $100,000) and 10% of the investor’s net worth or annual income, up to a maximum of $100,000 (if the investor’s net worth or annual income is $100,000 or greater.)
In addition, the funding portals are required to meet specific conditions, including obtaining background and securities enforcement regulatory history checks on every officer, director, and person holding more than 20% of the outstanding equity of the issuer. The JOBS Act provides the SEC with the authority to oversee this new investment sector and has mandated that the SEC provide further regulations, the scope of which will ultimately determine the impact of crowdfunding on the start-up industry.
Further Crowdfunding Compliance Requirements
The JOBS Act only provides an exemption from registering with the SEC, not an exemption from the financial disclosure requirements. The specific disclosure requirements, to which entities engaged in public offerings are subject, depend upon the financial size of the offering:
- Entities attempting to raise $100,000 or less must have the executive officers certify the veracity of the financial statements as well as provide prior year tax returns.
- Entities attempting to raise between $100,000 and $500,000 must have an independent CPA review the financials.
- Entities attempting to raise more than $500,000 must have an independent audit of the company’s financials.
These remaining disclosure requirements are, however, a small price to pay for the potentially significant expansion of capital access promised by the JOBS Act.
Financing’s “Wild West”
While seemingly a blessing for many entrepreneurs, the JOBS Act clearly creates material risks for investors, especially inexperienced investors for whom the “accredited investor” protections were so carefully crafted. With the virtual elimination of the protective regulatory framework for traditional public offerings, Issuers are held to a much lower standard of disclosure. While the maximum investment threshold of $100,000 provides a loss ceiling and thus some protection, it would seem that the opportunity for fraud is significant.
True Impact of Crowdfunding
Beyond regulatory unknowns, there are some commentators who question the impact that equity-based crowdfunding will have on the venture industry. Some believe that crowdfunding will in fact disincentivize later rounds of investment by traditional venture capital firms who, commentators suggest, will be unwilling to invest significant sums of money into entities that already have unwieldy capital structures with hundreds of small investors. Conversely, there are many who believe that equity-based crowdfunding will allow for increased amounts of early stage funding that will get start-ups to a size where they are more appealing to traditional venture capital firms.
The true impact that the crowdfunding provisions of the JOBS Act is yet unknown, but the initial enthusiasm is present, evidenced in the emergence of new crowdfunding platforms catering specifically towards equity-based funding, such as: wefunder.com, peoplesvc.com, and fundable.com. The extent of the impact will likely depend upon the dampening effect of the SEC regulations and market enthusiasm for this new form of investment. Regardless, the crowdfunding provisions of the JOB Act have opened up a completely new funding sector and will potentially allow entrepreneurs, who previously had little or no opportunities to obtain seed funding, the opportunity to reach out beyond their circle of friends and family to access a limitless amount of capital.
Chadbourne Summer Associate David Lamb assisted with the research for this article.