Crowdfunding Gets an Equity Boost: BB&K's James Harper Examines What the Proposed Rules by The U.S. Securities and Exchange Commission Mean for Entrepreneurs

by Best Best & Krieger LLP
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The Press-Enterprise - November 13, 2013.

Crowdfunding, or crowd-sourced fundraising, allows small businesses and artists without access to traditional bank loans or wealthy private investors to raise money for projects through a large network of contributors who each make a relatively small contribution. Currently, most all crowdfunding is donation-based and individual donors are rewarded by knowing they helped the project get started and may receive T-shirts or other prizes for making a larger donation. But this is about to change.

The U.S. Securities and Exchange Commission on Oct. 23 issued proposed regulations that will allow businesses to sell shares of stock to the general public through equity crowdfunding.

The website Kickstarter.com, and others like it, already allow entrepreneurs and artists to post a project on the Internet and promote it to potential donors through a short video. Potential donors then pledge funds to meet the funding goal and, if enough funds are pledged, the donations are collected and the project is funded. Kickstarter.com asserts 44 percent of the projects on its website reach the funding target and the average project raises around $5,000. The website has also facilitated funding for a few big ticket projects, such as Zach Braff’s movie project “Wish I Was Here,” which raised more than $2 million in just three days.

Passed in April 2012, the federal Jumpstart Our Business Startups Act, known as the JOBS Act, directed the SEC to create rules allowing businesses to issue shares of stock through large networks of small investors. Once the proposed regulations are finalized, entrepreneurs and artists will not only be able to solicit donations on websites like Kickstarter.com but appeal directly to the public via equity crowdfunding websites to find investors who want to buy actual shares in their business or project. Each individual investment must be relatively small, around 5 percent to 10 percent of an investor’s annual income or net worth, but through the powers of social networking and Internet promotion, these small investments could add up quickly.

Back in the 1930’s the SEC and numerous state laws were created to prevent charlatans from selling “stock” in worthless businesses or investments backed by swamp land. Today these securities laws still prevent businesses from selling stock to everyday people without disclosing copious amounts of audited financial information and investment risks. The required disclosures help ensure that an investor has enough information to make a wise investment decision. This process is often called “going public,” and involves significant costs for the business to hire accountants, lawyers and bankers. Although there are exceptions to the required disclosures, such as seeking investments only from high-net worth individuals, many of the exceptions have not been a good fit for small businesses, artists and social projects. With equity crowdfunding, small businesses are excused from making these burdensome financial disclosures and are permitted to provide just the basic financial information about the business.

In anticipation of equity crowdfunding, more than 6,800 domain names with the word “crowdfunding” have been registered since the JOBS Act passed. Along with the potential benefits of equity crowdfunding, there are some significant risks for investors.

According to the Small Business Administration, only one-half of new small businesses survive five years and only one-third survive ten years. For businesses that use crowdfunding but do not survive, the small investors will lose their money. Equity crowdfunding brings back some of the concerns in the 1930’s when stock peddlers appealed directly to regular everyday people who may be easily deceived or who may not be able to afford the risk of a bad investment.

Along with the limits on how much money an individual may invest, each business will only be allowed to raise up to $1 million through crowdfunding in any 12-month period. The public has an opportunity to comment on the SEC’s proposed rules during a 90-day period after they are published in the federal register. After that, the SEC will finalize the regulations that will attempt to make crowdfunding easily available to small businesses while at the same time protecting individuals from investing their life savings in a high-risk business.

* This article was originally published in The Press-Enterprise on Nov. 3, 2013. Republished with permission.

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