Friendly Funding

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Smart Reno business owners and entrepreneurs, like their counterparts across the country, are always on the lookout for new sources of capital. Recently, Congress passed a new law - the Jumpstart Our Business Startups Act (the JOBS Act) - which creates new opportunities for small and emerging businesses to raise funds. Historically, small business owners and entrepreneurs without significant collateral for a bank loan and with no connections to Wall Street investment bankers or wealthy venture capitalists have looked to a small circle of family and friends for sources of equity. Outside that circle, raising money becomes complicated not only by a lack of connections, but because of a tangled web of securities laws and SEC regulations that can make it difficult, if not impossible, for many startups to, well, start up.

The JOBS Act, and one component of the law in particular, the CROWDFUND Act, aims to shake things up by bringing securities laws and regulations into the Facebook Age. Aspiring entrepreneurs will still be able to ask family members for help with their new idea. However, with the implementation of the CROWDFUND Act, which authorizes raising capital through “crowdfunding,” they can also attempt to raise money by harnessing the power of their social networks and the hundreds of “friends” that they may have or meet online. For the right entrepreneur, crowdfunding could prove to be a creative way to generate funds for their ventures.

What is Crowdfunding?

Crowdfunding, as the term implies, is a way of funding projects using a crowd of people. Originally, the crowds that would fund projects were composed of the devoted fans of a particular music group or artist. For example, in 1997, American fans of the British rock band Marillion joined together and paid for the band’s first U.S. tour after they learned that the band’s record label wasn’t going to. On their own, the fans collected $60,000 in donations over the Internet and underwrote the tour. Marillion subsequently used crowdfunding a number of times over the years as a way to raise money for new projects. The band essentially got thousands of fans to act as small-scale venture capitalists who would underwrite new projects by pre-ordering albums that had yet to be written in exchange for the promise of special editions or other exclusive offers.

This approach to funding proved so successful for the band that Marillion eventually dumped its record label. Other musicians and artists, and even bloggers and non-profits also started using crowdfunding for their projects and the strategy went viral.

Now, through websites such as Kickstarter and IndieGoGo, creative types are raising hundreds of millions of dollars each year by soliciting donations online. Limitations on crowd funding as an investment model even though the concept was first introduced in the creative community, the applicability of the funding model for business endeavors quickly became evident.

One major obstacle to using this model to fund business ventures, however, is a series of Depression-era securities laws that regulate how and to whom equity stakes in new ventures may be offered. Current crowdfunding models avoid this issue by soliciting donations in return for various “rewards.” But investors who are looking to make money by investing in crowdfunding ventures, either by purchasing stock in the venture or making a loan to the venture, are prohibited from doing so.

Under current law, an entrepreneur looking to raise capital for a project by offering equity in their venture must either register with the SEC and conduct an initial public offering or qualify for an exemption from registration, typically under Rule 506. However, crowdfunding offerings are generally unable to utilize Rule 506 for two reasons. First, Rule 506 does not allow general solicitation or mass advertising (although another part of the JOBS Act requires this restriction to be removed), and offering securities to a crowd of unrelated investors over the Internet clearly violates this rule. Second, Rule 506 is limited only to so-called accredited investors, who are typically either corporations and other entities with at least $5 million in assets or individuals with more than $1 million in assets (not including their personal residence) or who make over $200,000 in annual income (or $300,000 combined between spouses). Obviously, these are not your typical Facebook friends.

The CROWDFUND Act

All of these SEC rules and regulations were originally proposed after the Great Depression as a way to protect investors. Critics of the JOBS Act fear that lifting these restrictions exposes investors to exploitation from scam artists and hucksters. Supporters of the JOBS Act claim that the CROWDFUND Act sufficiently balances investor protections for crowdfunding offerings to justify the widespread use of crowdfunding as a means of generating capital that will in turn create jobs and stimulate the economy.

Is Crowdfunding right for you?

Crowdfunding would potentially let average investors invest like accredited investors, in smaller, alternative ventures. If your business idea has the potential to be the next YouTube, but risks becoming the next Betamax, crowdfunding may be a good way to attract investors who are willing to take those chances. If your venture appeals to the interests of a particular market segment, such as green investors, “local first” advocates, or people who would be willing to invest $100 in a venture that will help rehabilitate a blighted neighborhood, crowdfunding may be a good fit.

But, before diving in, there are several things to consider. First, the CROWDFUND Act will not actually take effect until the SEC has had time to implement its rules and regulations under the law (its deadline is Dec. 31 of this year). Second, for entrepreneurs, the CROWDFUND Act reduces the barrier to raising capital but does not eliminate it. The law imposes several disclosure requirements on ventures thats want to raise capital through crowdfunding, and creates a private right of action for bereaved investors who lose money on the venture due to a material misrepresentation or omission in any required disclosure.

Conclusion

Crowdfunding is a great way to take advantage of social media and the power of word-of-mouth advertising. The inherently democratic nature of the model makes it a great way to discover market interest in a project before huge amounts of money are spent in development. Small business owners interested in employing this innovative way of raising capital should seek sound legal counsel from a knowledgeable lawyer in order to help structure the offering and comply with SEC rules.