Gallet Dreyer & Berkey, LLP | Crowdfunding: Can I Use it to Raise Money?
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Crowdfunding: Can I Use it to Raise Money?

6/27/2016 | By: Jay L. Hack, Esq. | GDB 2016 Summer Newsletter
“Crowdfunding” is the flavor of the month when it comes to raising money. You read about it on the Internet, you see stories on television, and your broker tells you it’s a source of funds to buy real estate or open a restaurant. Unfortunately, Crowdfunding may be the most misunderstood term in finance because four different transactions all take the same moniker. We’d like to take the mystery out of the term.
 
In Crowdfunding, a group (the crowd) is solicited, usually on the Internet, to contribute or invest money in exchange for something. Which rules apply to a Crowdfunding offer depends on what the “investor” gets in exchange for the money.

If the investor gets a warm and fuzzy feeling (Gofundme: Help pay for my kidney transplant) then the law has minimal impact. If the investor gets a product for the money (Kickstarter: Fund my children’s book so you can get a copy) then it may look like an investment, but it isn’t. This type of Crowdfunding is more like the charitable contribution and is just a high risk way to buy a product. The up side is getting the product and the down side is getting nothing. Not a lot of legal implications.
 
The first modern Crowdfunding was this type — US fans solicited contributions through the Internet so that their favorite rock band from London could come to the United States. The fans got tickets to enjoy the concerts but they did not have an interest in the profits of the concert tour.

If the fans had gotten an interest in the profits of the tour, then the Crowdfunding would have involved the sale of a security. An interest in the profits of an entity from the activities of others is the law school definition of a “security,” and if someone offers a security in exchange for money, federal securities laws are in play. The offer of a security means we must turn the page to the chapter on using Crowdfunding to raise money for a business activity from investors who expect to earn a profit from the activities of others.

The most common form of a security is common stock, but preferred stock, bonds, debentures and many other arrangements are also securities. If a company (known as the “issuer”) wants to offer its securities to the public, then it must either register the offering with the Securities and Exchange Commission or take advantage of an exemption. Registration with the SEC takes a lot of time and costs a lot of money, so avoiding registration by taking advantage of two Crowdfunding exemptions may provide cost-effective alternatives.

We will call the first exemption “Small Crowdfunding.” We call it “small” because issuers can sell only $1 million of securities per year under the “small” Crowdfunding rules. Independent Internet portals offer the securities to the general public. The maximum that one person may invest in all Small Crowdfunding is limited to between $2,000 and $100,000 per year, based upon a percentage of the lower of the investor’s annual income or net worth.

The rules require the issuer to provide offering information and financial statements on the Internet portal. Financial statements need not be audited for an issuer’s first Small Crowdfunding. There will be costs to prepare the disclosures and for the Internet portal to conduct the offering. For issuers, the $1 million annual limit may be too small and the costs of making the offering may be relatively high as a percentage of the amount raised. However, if an issuer needs less than $1 million to get off the ground and has no other acceptable source of funds, Small Crowdfunding may be the best route because the issuer can offer whatever creative type of security it thinks people will buy.
There is a lot of flexibility to structure a Small Crowdfunding to the issuer’s specific needs.

We will call the second exemption “Big Crowdfunding,” which allows issuers to solicit “accredited investors” to invest in their securities, with no dollar limit. Defining an “accredited investor” is complicated, but if we simplify it and say that the term includes people whose incomes or net worth exceed minimums that the SEC has established, we will cover most accredited investors.

An issuer can engage in a “general solicitation” of accredited investors in a Big Crowdfunding. A general solicitation is not quite a public offering, but it is close. There are fewer rules, but the issuer must collect meaningful evidence that the investor qualifies as accredited. There are Internet sites that specialize in Big Crowdfunding and they tend to have relationships with accredited investors who are looking to make significant investments in major projects. Those sites also obtain verification that the investors qualify as accredited.

When you use Crowdfunding properly, it can be an important tool in providing necessary capital to allow you to fund or grow your business. If you would like to discuss using Crowdfunding to raise capital for your business, contact Jay L. Hack at jlh@gdblaw.com.