One of the things we are asked about from time to time is “what is this crowdfunding thing I keep hearing about?” And of course the related question, “how can I use it to raise money for my business?” As it turns out, there is a lot of misinformation out there about this whole “crowdfunding” phenomenon. We will try to dispel some of the misconceptions surrounding this topic and guide you to what might or might not be realistic for entrepreneurs seeking to use this newfangled financing vehicle (which is actually not that new and can refer to a wide range of related concepts).
All forms of modern crowdfunding (sometimes thought of as a subset of the broader concept of crowdsourcing but sometimes used synonymously) refer to the same general concept: raising money from a relatively large number of people, each in relatively small amounts, that is used to finance a business, project or cause. There are, however, different approaches to crowdfunding, each of which involve different structures and involve different legal concepts. Here are some of the different methodologies that people may be referring to when they talk about “crowdfunding.”
- “Reward-Based” Crowdfunding. Although crowdfunding traces its roots back to concepts like arts patronage, early book publishing and even the financing for the Statue of Liberty, modern crowdfunding most often means “reward-based” fundraising for businesses or creative projects, typically via an online funding portal. This is the sort of fundraising made popular by Kickstarter, Indiegogo, RocketHub and others. By some accounts there are more 500 of these platforms worldwide, with many of them focusing specific activities, from books and music to porn films. These platforms, also called “crowdsourcing” or “token crowdfunding” sites, do not sell equity in the projects being funded and do not allow “investors” to participate financially in the success of the project. Instead, they offer tangible rewards and special experiences in exchange for pledges, such as free product samples, CDs, signed photos and posters, dinner with the company founders, etc. These platforms avoid becoming entangled in existing securities laws because supporters have no expectation of sharing in the profits of the enterprise.
- “Donation-Based” Crowdfunding. A variant of this model is “donation-based” crowdfunding, which funds a variety of social causes and charitable activities like disaster relief. Crowdrise is a good example of this sort of model.
- “Regulation D” or “Accredited” Crowdfunding. “Title II” of the JOBS Act, signed by President Obama on April 2012, created a new type of capital raising mechanism by removing the Securities and Exchange Commission’s traditional prohibition on “general solicitation” for offers and sales made under the SEC’s Regulation D, as long as all purchasers of the securities are “accredited investors,” which for individuals means that they meet a net worth or annual income test. The SEC requires companies to “take reasonable steps” to verify that purchasers are accredited investors, using methods such as asking for personal tax returns, which has created a fair amount of backlash in the angel investor community. The final SEC rules were adopted in July 2013 and this type of crowdfunding is now being used in the marketplace. Organizations such as AngelList have adopted this model, while others like CircleUp have opted to stick with traditional Regulation D private placements, eschewing general solicitation.
- “Title III” Crowdfunding. This is the JOBS Act version of equity crowdfunding for unaccredited investors that will, if it is ever implemented by the SEC, allow the use of the internet and social media to raise capital from a large number of people in relatively small amounts. In October, the SEC issued a 585-page release with proposed rules and forms that would implement the details of this sort of crowdfunding. These offerings must be conducted through a registered broker-dealer or a “funding portal” that meets certain conditions. Companies are limited to raising $1 million in any 12 month period, with additional limits on the amounts that individuals can invest depending on their income and net worth. There is also a sliding scale for the level of review (or audit) of the company’s financial statements and a series of filings with the SEC, including a post-offering annual report requirement. This exemption is not available until the SEC adopts final rules and no one can predict when that will occur.
- “Intrastate” Crowdfunding. Unable or unwilling to wait for the protracted SEC rulemaking process to unfold, nearly a dozen states, including Georgia, Alabama, Kansas and Wisconsin, have enacted or proposed new laws—or tweaked existing policies—to make it possible for resident entrepreneurs to secure financing from everyday, i.e., non-accredited, local investors. This type of crowdfunding flies under the federal radar because of the “intrastate offering” exemption from the federal securities laws.
So there you have it. Next time someone asks you about crowdfunding, you’ll be able to ask “which kind?”