Crowdfunding: Three New Variations
Anne Wallace, Esq.

Crowdfunding: Three New Variations

There is simultaneously a lot of media buzz and some continuing popular confusion about crowdfunding. Very often, enthusiastic proponents discover that they’re not really talking about the same thing. Nonetheless, there is reason to be excited. As a source of alternative financing, crowdfunding offers considerable potential, especially with three new models emerging.

There are interesting developments, especially with regard to equity and debt crowdfunding, but it is important, first of all, to review  the basics and define some terms.

Crowdfunding 101

There are essentially four different models of crowdfunding: donations, rewards-based, equity and debt. The difference is in what donors get in return in each situation.

  • GoFundMe and Crowdrise.com epitomize donation crowdfunding. It’s popular with many kinds of charitable and humanitarian causes. It’s essentially like passing the hat via internet to accomplish some worthy goal, like funding the marching band’s trip to band camp. Funders get a warm, fuzzy feeling.
  • Rewards based crowdfunding is used by individuals and companies seeking contributions in order to develop and launch a new product. Funders receive a token reward of a tee shirt or a DVD in addition to that warm glow.
  • With equity crowdfunding, companies raise money from investors who receive shares in the company in exchange.
  • With debt crowdfunding, lenders provide needed debt financing in exchange for a debt instrument that pays interest.

The latest developments have been in in the latter two models.

Federal Changes that Affect Equity Financing

The Securities Act of 1933 was enacted to protect investors from fraud and misrepresentation by requiring that entities issuing securities to the public disclose extensive financial information and register with the Securities and Exchange Commission.

Traditionally, non-accredited investors (investors earning an income of less than $200,000 and with less than $1 million dollars in assets) were not able to purchase shares from private companies but had to wait for a public offering. Recently, smaller investors have chafed at their inability to jump into the next big Google or Facebook at the earliest, riskiest and potentially most profitable stage.

The Jumpstart our  Business Startups (JOBS) Act was intended, in part, to address this concern. Implementing the law required changes to securities regulations, including a rule known as Regulation A. The process has taken more than three years and has been the source of much speculation and frustration.

An expanded version of Regulation A (or Regulation A+) lets people of more modest means invest in the kinds of companies typically backed by venture capitalists and angel investors. However, the startup community has reacted coolly because the disclosure requirements are still fairly extensive.

The latest changes, effective on June 19, provide a somewhat broader, but still limited exemption to the registration and disclosure requirements imposed by the Securities Act.  Many commenters still distinguish this from full-fledged equity crowdfunding.

The latest iteration of Regulation A+ allows for small public offerings of securities that do not exceed $5 million in a 12-month period. There are no reporting requirements until the company has more than $10 million in assets and more than 500 shareholders.

  • Alcoholic Employees: What are an Employers' Rights and Responsibilities?

    April 14, 2016

    If Mad Men taught us anything, it's that corporate America has come a long way since the 1960's with regard to its treatment of alcohol in the workplace. Some viewers of the show may envy that …

  • How Ambassadors Can Ruin Your Brand and How to Deal With Disasters

    January 21, 2016

    The name brand ambassador says it all. Similar to an ambassador for a foreign country, the goal of that person is to represent the brand in a positive light and bring consumers closer to the …

  • How to Protect Trade Secrets

    January 26, 2016

    Coca-Cola’s recipe for its soda is supposed to be one of the best kept secrets ever. The original recipe is said to be kept in a vault in the company’s Atlanta home where visitors to …

  • Must-Reads if You Are Thinking About Buying a Business

    September 18, 2014

    If you are thinking about buying a business, you must have lots of questions. Of course, you should get some help with this process -- from your banker, your attorney, your accountant, and possibly a …

  • Employee Monitoring and Wearable Technology [e258]

    March 09, 2016

    Nasir and Matt discuss the new iPhone update that employees should pay attention to. They also talk about the pitfalls of employers issuing wearable technology to their employees. Transcript: NASIR: Welcome to our podcast where we cover business …

  • How to Avoid Age Discrimination

    November 05, 2015

    Employee Performance Evaluation If you scan through the national newspapers you will find article after article about managers and supervisors who are agonizing over the behavior of employees. Sometimes this agony is brought about by the …

  • The Cost of Converting Independent Contractors to Employees

    October 06, 2015

    While Uber may be receiving the lion’s share of the attention on the topic, there has been no shortage of court rulings, IRS audits, and labor decisions on the issue of workforce misclassification. With a …

  • Is PTO Enough When Paid Sick Leave Is Required?

    January 19, 2016

    Look around your office. Is anyone out sick today? (Alternatively, is someone who is in the office clearly too sick to be there?) According to Bloomberg BNA, sick leave will be a big issue for …

  • Can Employers Still Use Credit History in Hiring?

    June 18, 2015

    Job seekers hate credit checks. They see it as invasive data collection with only remote relevance to job performance. It has also been argued that credit checks unfairly burden those who have or have had …

  • Product Liability 101 for Small Importers

    September 16, 2014

    Global sourcing has lots of exciting potential. The recent entry of Alibaba.com onto the global stage along with others such as the FITA Buy/Sell Exchange, Euro Pages and Global Sources seems to presage a new …

Regulation A+ permits two tiers of exempted filings:

  • Tier 1 – Securities offerings of $20 million or less making these offerings available to both accredited and nonaccredited investors. The annual offering limit of $20 million includes $6 million on behalf of selling security holders that are affiliates of the issuer.
  • Tier 2 – Exempts securities offerings of $50 million or less. Nonaccredited investors may purchase securities in Tier 2; however, they are limited to 10 percent of the greater of their annual income or net assets.

As with a registered IPO, a disclosure statement (called an “offering statement,” to distinguish it from a prospectus for a fully registered IPO or other securities offering) must be filed and cleared with the SEC.  While the level of disclosure is somewhat less complicated and detailed than that for a registered offering, it is still substantial.  Tier 2 offerings require audited financial statements, while Tier 1 offerings generally do not.

Advocates note that businesses will be able to advertise their offerings, sometimes described as “mini I.P.O.s,” on websites and through social media, giving fans and customers an opportunity to buy shares in private companies.

Critics reply that the newest rules are still so costly and complicated that few high-quality companies will bother to use them. They make the point that the true crowdfunding rules, which focus on internet portals, are still not fully in effect.

Meanwhile, a number of states have become restive and established their own genuine equity crowdfunding rules, complete with internet portals. The hitch is that these permit only intrastate investment.

State Equity Crowdfunding Rules

Twenty-two states and the District of Columbia have enacted equity crowdfunding rules, nine of them in the last six months. Eleven states are considering creating such laws and procedures, and three more states, Florida, Illinois and New Mexico, have rules or legislation awaiting the governor’s signature.

The intrastate restriction makes this option attractive for more populous states. In Texas, for example, that means a pool of 20 million potential investors. In Vermont, with a population of only approximately 500,000, intrastate investment means less.

In Texas, the in-state requirement is not easy to meet. Eligible companies must be organized and doing business in Texas and have their principal office there. In addition, they must have 80 percent of their gross operations in the state, at least 80 percent of their assets in the state and plan to use at least 80 percent of the revenues raised within the state.

Companies that meet these threshold requirements may raise up to $1 million within each 12-month period (including offerings by control persons). Three key points apply:

  • Nonaccredited investors, who are Texas residents, may contribute up to $5,000 per offering.
  • Offerings must be carried out online through a registered dealer or crowdfunding portal, and
  • Issuers must submit limited disclosure to the state Securities Board

Two available portals are Crudefunders, though which Texas investors may buy their own particular piece of an oil well, and MassVenture, through which investors may speculate in real estate.

The sites are somewhat spare and, depending on your appetite for risk, may either spark enthusiastic capitalism or the urge to check for your wallet.

Debt Crowdfunding

A number of peer-to-peer debt crowdfunding sites exist, including Lending Club, Prosper, Funding Circle and Upstart. All offer relatively low interest loans to qualified small businesses unable to borrow from banks.

For investors, debt crowdfunding may be attractive because of the promise of a fixed return with relatively little risk especially if debt investments are secured by company assets. The portals must still do the same level of due diligence as they would for equity type investments. They will also have to assess the company’s ability to meet the repayment schedule to the investors.

ZipCap, a San Diego startup, offers a new and different lending model that allows loyal customers, rather than investors to participate in debt financing.

The aim is to offer small retailers like restaurants, boutiques and service providers access to low-interest loans financed by investors with a vested interest in supporting a local economy. Their pilot project targets a few carefully selected businesses in California and Michigan.

ZipCap’s borrowers start by establishing a showcase and then rallying an “Inner Circle” of customers who pledge to spend a set amount of money in a fixed period of time. ZipCap then tallies up those pledges and allows businesses to borrow against a portion of it.

To be eligible for loans, companies must have been in business for at least two years in the same location and must enroll at least 100 Inner Circle members. Participants pay ZipCap a monthly fee of either $99 or 2.5 percent of their Inner Circle transactions, whichever is lower.

Crowdfunding, in all its varieties, can open up new opportunities for small businesses on the move. The latest developments in federal equity financing rules, state equity crowdfunding laws and consumer based debt crowdfunding add to the possibilities.

None are likely to replace more traditional debt and equity models. but they add new tools that may be right for emerging entrepreneurs.

Read More