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What Entrepreneurs and Business Owners Need to Know About Crowdfunding
Crowdfunding – a strategy for raising money from large numbers of people, usually via the Internet, to support a project or cause – has received much attention lately. Not all of it positive. The crowdfunding strategy was initially developed and used in the early days of the Internet to fund political causes, social or charitable causes, or artistic endeavors such as films, books, music recordings, or music events. More recently, however, its use in the business context has been growing. Supporters of the concept praise the freedom it allows creative persons and businesses to secure financial backing directly from interested persons; freedom from having to pitch ideas to risk-averse commercial lenders or overbearing venture capitalists. What entrepreneurs and business owners must realize, however, is that while crowdfunding has the potential to be a game changer for raising capital, the rules of the game, particularly those under federal and state securities law haven’t changed. At least not yet.
Forms of Crowdfunding and Their Legal Risks…
Crowdfunding efforts come in essentially three forms, which vary by what is promised to the funder or “backer” in return. The first, the donation format, essentially promises nothing in return. Here the backer simply pledges money for an idea or cause with no agreement or expectation of anything in return except the satisfaction of providing money to some endeavor he or she feels is worthwhile. Because the funder has no expectation of profits, the promoter assumes no liability under federal or state securities laws. Common law principals of fraud still apply in this context, however, and promoters may still be held liable if their intention is not to use the funds as promised.
The third form of crowdfunding promises some form of profit sharing or interest in return for a contribution. Under well-settled law, any investment of money in a common enterprise, with an expectation of profit arising from the efforts of a promoter or third party, constitutes an “investment contract”. An investment contract, in turn, is a security. Therefore, in this third scenario, the funder is, by law, an investor, seeking financial return for the funds he or she provides for the project. As a result, a promoter under this scenario must be cognizant of various securities law requirements before seeking contributions from potential funders.
Securities must be registered with federal and/or state regulators unless an exemption applies. Registration is prohibitively costly and time consuming for persons with a product to promote and develop, so most try to qualify for exemption. The most widely- used federal exemption is Rule 506 of SEC Regulation D. Under Rule 506, a promoter can raise an unlimited amount of money by satisfying certain standards. Chief among these is the private-placement requirement; that is, the avoidance of any form of general solicitation or advertising to market the securities. Rule 506, while useful, runs contrary to the concept of crowdfunding, which depends upon general solicitation.
New Rules Expected to Facilitate Crowdfunding…
In an attempt, in part, to preserve the Rule 506 exemption and still make it available to use for crowdfunding, Congress passed the Jumpstart Our Business Startups Act (“JOBS Act”). Under the JOBS Act, the SEC is required to adopt rules to allow an exemption to Rule 506’s prohibition of general solicitation or advertising; in other words, to allow for crowdfunding. To meet the conditions of the JOBS Act, the SEC’s new rules must contain two significant requirements. First, in order to qualify for the solicitation or advertising exemptions, all purchasers must be “accredited investors”. Accredited investors include various institutional investors, as well as individuals who meet income or net worth tests under Regulation D. Secondly, promoters and others relying upon the exemption must take reasonable steps, using methods to be determined by the SEC rule, to verify that purchasers are, in fact, accredited investors.
Rules proposed in August 2012, but not yet adopted, state that the SEC will use an objective standard to determine whether the verification steps are reasonable, based on the facts and circumstances of each transaction. The SEC made it clear in the proposed rules that it expects promoters to use verification methods beyond just having the person check a box or make a statement that he or she is an accredited investor. Some of the methods suggested by SEC include: (1) a review of public filings (primarily in the case of an institutional investor); (2) a review of a person’s W-2 or other tax information; and/or (3) verification through a reliable third party such as an attorney, accountant, broker-dealer, or a reliable third-party verification site.
Companies using the exemption will likely still have to satisfy remaining Rule 506 requirements such as financial statement requirements and the requirement that purchasers receive "restricted" securities, meaning that the securities cannot be sold for at least a year without registering them. Companies using the Rule 506 exemption will also still be required to file what is known as a "Form D" after they first sell their securities. Form D is a brief notice that includes the names and addresses of the company’s owners and promoters, along with basic information about the offering. For Rule 506 offerings using the crowdfunding exemption, there will be a checkbox added to Form D to indicate that the company making the offering is relying on the exemption. The revised form is expected to be released with final rules.
While crowdfunding has the potential to be a game changer for raising capital, the rules of the game, particularly those under federal and state securities laws haven’t changed.
New SEC rules, expected later this year, will provide parameters for the use of crowdfunding to raise business capital.
Business owners and others considering the use of some form of crowdfunding should consult with legal counsel at the outset.
This article is intended to provide general information only and is not intended to provide solutions to individual problems. Readers are cautioned not to attempt to solve individual problems solely on the basis of information contained in the article. Date of publication: January 22, 2013.
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