Crowdfunding is an online money-raising strategy used as an alternative for inventors to bypass traditional investing vehicles in order to fund new ventures. Through online funding platforms, entrepreneurs are able to “pitch” their business ideas to the public in an effort to attract investors. There are four crowdfunding segments—equity, lending, rewards and donations. Equity crowdfunding is the fastest growing of the four and the focus of this article. Through equity crowdfunding entrepreneurs are able to raise capital in exchange for equity in their startup company.
This alternative method is attractive for smaller companies, as the majority of the loans received from banks go to companies with revenues from $3 to $50 million, leaving the smaller companies with nothing. This has left small business entrepreneurs to rely on credit cards and home equity loans, which have been affected negatively due to the struggling economy. Therefore, crowdfunding is playing a critical role in jump-starting the entrepreneurial activities.
Based on the Crowdfunding Industry Report released in April 2012, an estimated 452-crowdfunding platforms raised almost $1.5 billion in 2011. That number is expected to increase to $2.8 billion in 2012. Despite the fact that crowdfunding has been gaining momentum there are a slew of concerns surrounding this method.
The first set of concerns has to do with intellectual property rights. First, the creators risk having their ideas being stolen when posting their pitches online for the world to see prior to having those ideas patented. Meanwhile, entrepreneurs risk having their ideas stolen by those better able to get funding. Additionally, publicly posting ideas gets the clock running on when a person can file a patent in the United States and completely kills the ability to file a foreign patent.
Equity crowdfunding, also, raises some federal securities law. Based on regulations of the U.S. Securities and Exchange Commission (SEC), in order to solicit investments from the public, an inventor must first file with the SEC. This was the case until the Jumpstart Our Business Startup Act (JOBS), was signed into a law by President Obama on April 5, 2012. Part of the JOBS act was the CROWDFUND Act, which made significant changes in current federal and state securities laws in order to allow entrepreneurs to raise capital through the Internet. The purpose of the act was to make it easier for startups for fund their projects by carving out an exemption for some small businesses and entrepreneurs from the SEC registration requirements. The act made funding more accessible to startups by allowing non-accredited investors, those investors with a net worth of $1,000,000 or an annual income of $200,000 or more, to participate.
The Act reduced the solicitation restrictions. However, the signing of the Act into law did not immediately make crowdfunding legal. Instead, the SEC is given until 2014 to come up with their own set of rules. The specifics of the act allow entrepreneurs to collect up to $1 million from investors in a 12 month period, with no more than $10,000 from each investor or 10% of their incomes, which is less. If the entrepreneur furnishes financial statements to the public, they are awarded by being allowed to collect up to $2 million. Under the previous SEC rules, disclosures of financial statements were required when a company had 500 or more shareholders. Under the JOBS act, those who qualify did not have to disclose until they reached 1000 shareholders.
As equity crowdfunding falls under the regulations of the SEC, concerns about failing to comply with the state and federal disclosure regulations can lead to significant issues such as securities fraud, private lawsuits and administrative enforcements. Furthermore, as the crowdfunding exemption is targeting smaller and less sophisticated business models, the concern of improper disclosers and the legal circumstances, which pursue are legitimate.
There are also those skeptics of crowdfunding who believe that it could become a tool for financial fraud and abuse as it allows those who fall within the exemption to not have to comply with the SEC’s full disclosure for a certain period of time. By its nature, crowdfunding attracts inexperienced investors, meaning they won’t have the ability to spot whether a project is real or fraudulent.
The Ortega Business Law Firm