Crowdfunding Could Spur Startups

The Great Depression led to the adoption of a series of laws designed to prevent individual investors from being fleeced by unscrupulous and fraudulent ‘businessmen.’ These laws provided the framework of securities laws that have been navigated by countless entrepreneurs since the 1930s seeking legitimate investment in their fledgling businesses. Conversely, the Great Recession has pushed Congress to adopt the Jumpstart Our Business Startups (JOBS) Act, signed into law by President Obama on April 5, which fundamentally changes the rules of the investment game for businesses of all sizes.
Perhaps the most significant change is allowing startups to use ‘crowdfunding” to raise capital. There is significant potential for a flourishing of startups as this new flavor of capital comes online. There is also the opportunity for regular Americans to get the same opportunity angel investors have had for decades — the small chance to make a lot of money and a much larger chance of losing every penny — investing in startups.
Crowdfunding is the modernization of an old process — raising small amounts of money from a large number of people — using the power and scope of the Internet. Crowdfunding via the Internet already exists in many different forms. Independent journalists fund investigative journalism not funded by the mainstream media via Spot.us; Kickstarter.com allows inventors and artists to raise funding directly from (and sell to) people passionate about the product; and Kiva.org assists developing-world entrepreneurs to connect directly to individual philanthropists to secure microloans.
Here’s how it usually works. Entrepreneurs create a ‘pitch’ profile on a crowdfunding Web site. The crowdfunding site reviews the profile to be sure it is appropriate and not fraudulent (with varying levels of success). The crowdfunding sites have an incentive to list only honest, worthy companies — otherwise, the ‘crowd’ will migrate to an alternate crowdfunding Web site. If the application is approved, the entrepreneurs use social media to promote their pitch to communities of people likely to be receptive to the idea. People who take interest review the profile, often engage in an online discussion with the entrepreneurs, and may make a financial contribution through the crowdfunding site.
The SEC will be finalizing the rules and restrictions on crowdfunding over the next 270 days; however, the JOBS Act already contains significant limitations on both the investor and the company seeking investments through crowdfunding. Companies can raise only $1 million every 12 months through crowdfunding (however, these companies still can — and many will — raise additional funds pursuant to the current, more traditional private-placement rules). Depending on the predefined target that the company establishes for its fund-raising round, the company will need to prepare detailed financial statements (audited if the target is more than $500,000) and deliver these to any prospective investor. The company must also provide both the SEC and prospective investors indepth information about the company and the offering, including the company’s business plan, the risks of the investment, and information about the officers, directors, or managers of the company.
Although any American can participate in crowdfunding as an investor, each crowdfunder will be able to invest only a limited percentage of their annual income (5% for individuals with income under $100,000, 10% for those over this threshold) in any 12-month period. Additionally, the equity that these crowdfunders receive will be restricted stock — it cannot be transferred for 12 months, with few exceptions.
The legalization of crowdfunding will also lead to the launch of a new kind of company — the fund-raising portal — as any company raising funds through crowdfunding must use these portals to act as the conduit between the company and the investors. These portals will exist only on the Internet — there will be no bricks-and-mortar storefront for these portals. The portal will need to register with the SEC and take reasonable steps to ensure that all participating in crowdfunding have followed all of the SEC’s rules — essentially the SEC will be ‘deputizing’ the portals to enforce the SEC’s rules. Companies using a portal should expect to pay 6% to 10% of the total funds raised as a service fee.
Congress and the president hope crowdfunding will lead to more startups obtaining critical funding early in their development, which should lead to more small businesses getting off the ground. However, the individuals investing in these early-stage companies need to be aware of the risks of these investments and remember the golden rule of investing: “if it sounds too good to be true, it probably is.”

Attorney Scott Foster, Esq. and Paul Silva are co-founders of Valley Venture Mentors.

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