Financing a Startup Company Series: Crowdfunding 2.0 – Equity Based
This post continues our Financing a Startup Company Series and focuses on equity-based crowdfunding.
A relatively new model for crowdfunding (Crowdfunding 2.0) involves issuing equity to members of the general public in exchange for money. In the past, companies were prohibited from advertising to the general public when attempting to sell stock (think posting on Facebook that you are accepting investors, or offering stock for Kickstarter donations). Further, the types of people who could invest in startups were also limited. The only options for startups to sell to the general public were to issue stock through an IPO (expensive and limited to later stage startups), or by navigating the complex rules governing private stock offerings. The private stock offering rules are complex and among their numerous restrictions prohibit advertising the offering to the public, limit the number and wealth of investors. For example, Rule 506 allows raising up to $5MM from the sale of stock to an unlimited number of Accredited Investors, but only 35 non-Accredited Investors. Accredited Investors are generally people with $1MM in net worth excluding their home, or $200K annual income. Because of the complexity of the SEC regulations involved with the raising money from investors (whether through public or private offerings) make sure that you consult first with an attorney who has experience assisting startups with these issues.
Because of the ban on general advertising, raising money through equity-based crowdfunding was exceptionally difficult. A few crowdfunding portals, such as Crowdfunder, legally offer equity-based crowdfunding by only allowing carefully vetted Accredited Investors to participate.
In the near future, however, the process of selling to the public should become somewhat less restricted: in 2012, Congress passed the JOBS Act, instructing the SEC to write regulations to enable wider use of equity based crowdfunding. When finalized, the regulations will likely allow companies to reach out to the public at large for cash in exchange for equity. While this potentially opens the door to selling stock in an early stage startup to the general public, there will be regulatory strings attached. The proposed rules issued by the SEC this fall (2013) impose the following regulations:
- Equity based crowdfunding will only be allowed through regulated funding portals.
- The maximum amount of funds a startup may raise using equity based crowd funding will be capped at $1MM per year.
- Over a 12-month period, individual investors with incomes below $100,000 may only invest up to 10% of their annual income or $2,000. Investors with incomes greater than $100,000 may invest 10% of their annual income, up to a maximum of $100,000.
- Companies that pursue this model may have to provide an annual report to the SEC and audited financial statements (an expensive undertaking) to their investors.
- The securities that are sold will likely have resale restrictions imposed by the SEC.
These are only some of the regulations, and the SEC has not yet finalized the rules. Thus, reaching out to the general public to offer equity for cash remains off limits. Once the regulations are finalized, before attempting to use equity based crowdfunding, consult with a knowledgeable attorney to avoid running afoul of the SEC rules.
Even when equity-based crowdfunding is allowed, the following potential issues will still exist:
- Materially misleading statements in advertising materials can still lead to §10b-5 antifraud liability. Antifraud violations are much more serious than false advertising claims and can be ruinous for a company and its executives. Consult with a lawyer before posting what your marketing person creates.
- State securities laws still cover the investors in their territory and can require a filing notice and payment of a fee.
- In order to raise funds, you will need to pitch your business to the public. This may mean that your company has to disclose to competitors information about sensitive, confidential, technology or business plans.
- There will likely be ongoing responsibilities to report to the shareholders on the financial and business performance of the company. These can be expensive, time consuming, and open the door for antifraud liability.
- Even if equity-based crowd funding becomes legal, and common, one should also consider whether other sources of financing, such as sophisticated angels and VC’s, will invest in a company that has raised equity-based crowd funding. It might be the case that VC’s will not want to get involved with a company that has so many shareholders.