What is Crowdfunding? And, How Can it Help My Business?

by John Rake and Lee Lashway


Crowdfunding is a means of raising capital, typically by a large number of smaller contributions, from individuals via the Internet and social networking platforms. The use of crowdfunding as an alternative to traditional business financing – bank lending, credit cards, venture capital, angel investors – has proliferated in recent years, coupled with an increase of crowdfunding platforms. Business owners should become familiar with crowdfunding platforms currently available and possible application of federal and state securities laws to determine whether they present a viable fundraising option. Business owners should also be aware of potential opportunities under Title III of the JOBS Act, which, if implemented by the SEC, may offer another fundraising tool.

Current Crowdfunding Platforms

Donation-based platforms

Some of the better known platforms are rewards-based platforms designed to raise funds for creative projects (e.g., Kickstarter), product development (e.g., Quirky), and charity projects (e.g., IndieGoGo). In Oregon, a Portland-based rewards platform, Crowd Supply, offers retail support for product launches in addition to crowdfunding. These platforms do not fall under securities laws and regulations, because they do not involve an offer or sale of securities, as the term “securities” is currently defined under the Securities Act. Rather, the rewards-based platforms typically provide a pre-determined reward in exchange for a donation, which amounts to a “pre-sale” of goods or services. As such, the rewards-based platforms do not require any exemption from the registration requirements of the Securities Act. These donation-based platforms are a great tool for businesses that offer consumer goods and services.

Peer-to-peer lending platforms

Other platforms, such as Lending Club and Prosper, fall into the category of “peer-to-peer lending.” Peer-to-peer lenders assemble funds through a registered offering of promissory notes to investors who are seeking the high yields typically associated with making higher risk loans. Proceeds of the offering then form the basis for unsecured, interest-bearing loans that business owners may use to fund small business initiatives in amounts up to $35,000. Peer-to-peer lending may be a good tool for business owners with good credit history looking for smaller loans, but some states restrict the use of these platforms in their jurisdictions. Oregon currently permits resident borrowers to apply for loans through Lending Club and Prosper, but Oregonians interested in lending money can only use Prosper; at this time, Lending Club is not an option for Oregon investors; thus, it may not be a good option for Oregon business owners looking to raise funds from Oregonians.

Accredited crowdfunding platforms

There are also crowdfunding platforms that facilitate equity investments (as opposed to loans or donations) in companies. FundersClub and AngelList are two popular examples of “accredited” crowdfunding platforms that have adopted an investment fund model. They do so by forming investment funds through sales of equity securities to accredited investors in unregistered offerings under the Rule 506 of Regulation D. Proceeds of those offerings are used by the investment funds to invest in startups or other worthy high-growth businesses.

Another model of an accredited platform is that of a broker-dealer engaged in direct sales of growth company securities to pre-qualified accredited investors. In this model, exemplified by CircleUp, an affiliate of the platform registered as a broker-dealer sells securities of the startup itself directly to accredited investors under Rule 506 of Regulation D, rather than creating a separate investment fund. Both models of “accredited” platforms may be a useful tool for high-growth companies looking to raise a significant amount of money (more than is available by peer-to-peer lending). However, the platforms are highly selective in accepting businesses as potential investment targets for the platforms’ investor members.

Looking Ahead.  The Potential Implementation of a Larger Crowdfunding Exemption

The JOBS Act of 2012, signed into law by President Obama on April 5, 2012, promised several significant changes to the crowdfunding scene. In particular, Title III of the JOBS Act, entitled ”Capital Raising Online While Deterring Fraud and Unethical Non-Disclosure Act of 2012” or the ”CROWDFUND Act,” creates a registration exemption for securities offerings of up to $1 million to be sold in small amounts to a large number of investors through intermediaries. Subject to SEC rulemaking, Title III will allow participation by accredited and non-accredited investors alike. The SEC missed its rulemaking deadline of December 31, 2012, and recently told the U.S. House of Representatives during a hearing on April 11, 2013, that they don’t know when the agency will be able to issue the rules. Consequently, crowdfunding under Title III remains unlawful. Critics charge that Title III will impose onerous burdens and expenses out of proportion to the amount of money that could be raised. For example, businesses looking to raise $500,000 or more will have to file audited financial statements, and all businesses seeking funds will have to use an intermediary portal, which could make the process more costly and difficult relative to other funding possibilities.

Takeaways

Regardless of the form of crowdfunding explored, business owners can do a few simple things to optimize the likelihood of others “investing” in their enterprise, whether by donation, loan, or buying securities. First, business owners should ensure their entity is properly formed for the type of crowdfunding they are interested in, and that the organizational documents appropriately address the number of shares, voting rights, board composition, and management structure. Second, business owners should polish their business plan, which will form the basis for required and appropriate disclosures to interested investors. Finally, business owners should make sure their accounting records are updated and transparent. For each of the above steps, business owners are advised to consult with a qualified attorney and accountant.