Crowdfunding Now And What Was Supposed To Be

by Gray Reed & McGraw

BREAKING NEWS:  Crowdfunding is legal.  Sort of.  Before you start soliciting for investors on Facebook, you need to know that general solicitations to sell equity to your company not listed on the stock exchange or otherwise registered is still illegal.  That doesn’t mean you can’t engage in some form of what is considered crowdfunding.

I recently took part in a UHSBDC presentation called “Crowdfunding for Small Business” with the founder of Buffalo Bayou Brewing Company, Rassul Zarinfar.  I was supposed to talk about the JOBS Act and he was assigned to discuss how he raised his needed capital to start his craft brewery from about 50 different people.  He had a lot to talk about.  I got to discuss Reg D.  You can check out the informative slides from the presentation here:  UHSBDC Crowd Funding Power Point.

Last April’s JOBS (or Jump-Start Our Business Start-Ups) Act was supposed to make it easier for entrepreneurs to raise money using Kickstarter-like campaigns so start-ups could raise small chunks of money from many investors via the internet without worrying so much about Reg D.  I wrote this post about it on the day it was signed into law.

The SEC was supposed to issue specific regulations for crowdfunding to strike the balance between easier access to capital and preventing widespread fraud against unsophisticated investors.  Their deadline was originally December 2012.  The December 2012 deadline came and went.  Alas, the brewery founder was the star of the show.  Side note: he probably would have been the star anyway because he founded a craft brewery and I was going to discuss detailed securities regulations.

Crowdfunding Now

So, we spent most of our time at the presentation discussing how to “crowdfund” under existing laws.  Much of Buffalo Bayou Brewing Company’s story is revealed in the Power Point presentation we used.  In short, Rassul convinced his friends and friends of friends to invest without making a general solicitation for investors.  Technically, he used Rule 505 of Regulation D which allowed him to raise up to $5 million (he raised about 10% of that), from as many accredited investors and up to 35 non-accredited investors.  You can read more specifics about the various rules and what it means to be an “accredited” or “sophisticated” investor on the presentation.  The SEC also does a good job of explaining Rules 504, 505 and 506 which are exceptions to the general rule that requires you to register with the SEC.

He had to invest some of his own money to pay lawyers (another reason to love him besides his great beer) to put together a Private Placement Memorandum, or PPM, that disclosed to his investors all of the risks.  He also had to be careful and document exactly how he shared his PPM and who he targeted to comply with existing laws because you cannot make a general solicitation for unregistered equity.  Have I said this enough.  While it sounds like rainbows and unicorns, he now answers to 50 shareholders.  He also concluded his second round of funding which came with its own set of headaches dealing with his original investors and their redemption rights.

Crowdfunding in the Future

The current expectation is that the SEC may have the new JOBS Act crowdfunding rules in place by the end of this year.  Had they been in place, Rassul could have simply posted a video on a website, made some disclosures and asked the general public to invest in his brewery and sat back and watched the money come in from hundreds of investors each pitching in a few thousand dollars each.  Because of the special relationship between founders and shareholders, Rassul still has reservations about this proposed process from the entrepreneur’s perspective.

Nevertheless, the new rules are supposed to allow companies to raise up to $1 million.   Investors with a net worth of less than $100,000 will be allowed to invest 5% of their yearly income or $2,000, whichever is higher.  People with more money will be allowed to invest more, up to 10% of their income.  Under the proposal, a company with $1o million in assets would not have to register with the SEC until they obtain 2,000 investors (500 of whom can be non-accredited).   The SEC will also allow a five-year phase in plan for companies with less than $1 billion in annual revenues.

Many people have seen this as an opportunity to easily create a website, a la Kickstarter,  taking a small cut as easy money.  This is not a technology or web play because that is the easy part.  This is an opportunity for those into compliance and accounting because the devil will be in the the details.

Full time securities lawyers, of which I am most certainly not one, have voiced great skepticism to me that this will ever come to fruition.  They wonder:

  • What disclosures will be required on these websites?
  • What prevents an investor from investing his maximum on one website and then going to next site and investing more?
  • Same thing with companies using more than one site?
  • How do you confirm the investor is accredited or sophisticated?
  • How do you enforce transfer restrictions?
  • What happens when the accredited investor transfers his stock and how do you keep track of the numbers?
  • What do you do about rights of redemptions?
  • How do you protect unsophisticated investors from being diluted?
  • Can bundlers or finders take people’s money and then invest on these sites and what rules will apply to them?

The questions are numerous which is one reason it is taking more time to promulgate the rules.

Rassul and I will do an encore performance for the UHSBDC on Crowdfunding for Small Business on March 26, 2013.


DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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