CHAPTER 1
What Is Crowdfunding?
Most business start-ups have relied at some point on the friends-and-family offering to raise the capital needed to create new businesses—to make the products, provide the services, and launch the innovations that make the global economy exciting and dynamic and provide the foundation for human progress.
Since historically few other people (to say nothing of reluctant banks after the 2008 financial crisis) have been willing to risk their hard-earned money on speculative start-ups, most entrepreneurs and company founders, having exhausted their credit cards and personal savings, have been forced to borrow money or seek investment from their friends, college roommates, family members, teachers, mentors, and anyone else who would listen to their pitch. The near-universal popularity of friends-and-family offerings can be explained by two basic facts of human nature:
1.Friends and family members will frequently offer you money out of love and affection (or, less charitably, to get you out of their hair), not necessarily for the purely economic motive of seeking a return on their investment.
2.Friends and family members are less likely than other people to sue you and force you into bankruptcy if the you-know-what hits the fan and the start-up fails to achieve liftoff.
Historically, the pool of available capital from friends and family has been extremely limited for most entrepreneurs, and the success of these offerings often depended on who your friends and family were. If they were rich or well connected, you were more likely than not to get the capital you needed to launch your business. If your friends and family were poor, well . . .
But that is about to change. In a big way.
Taking the Friends-and-Family Offering to the Next Level
The past decade has seen an explosive growth in Internet-based social media platforms, such as Facebook, Twitter, Instagram, Pinterest, Snapchat, Google+, and LinkedIn. While these platforms are significantly different from each other, all have one basic thing in common: they are designed to help people exponentially expand their network of friends and family by building a personal network of followers, fans, hangers-on, groupies, posses, and significant others so that it becomes larger than the friends and family who share entrepreneurs’ DNA or who actually know them in the flesh.
Thanks to these platforms, millions of people throughout the world have discovered that they have more in common with someone in a remote foreign country than they do with their next-door neighbors. The author himself, a relative novice on social media, has about four hundred friends on Facebook and almost two hundred on Twitter. I admit to knowing personally only a handful of them. Each week I receive invitations to friend other people on Facebook, and I wonder how in the devil these people found me, and why they care about my “friendship.” I sometimes wonder whether the people who use cartoon caricatures or famous artwork as their Facebook photos are real people or computer algorithms.
It was only a matter of time before entrepreneurs, visionaries, and dreamers started thinking about tapping into these expanded social media networks to raise capital for their projects, their businesses, and other aspects of their lives.
But there was a problem.
Since the 1930s, the U.S. Securities and Exchange Commission (SEC) had imposed severe restrictions on an entrepreneur’s ability to raise capital using “general solicitation” or “general advertising.” The idea was that you had to actually know people, and know them fairly well, before you hit them up for money.
I have had personal experience with these limitations. Back in the early 1990s, I and a couple of partners decided to produce a television show based on a novel idea: entrepreneurs from around the country would pitch their ideas before a panel of venture capitalists, lawyers, and industry experts and have their business plans critiqued before a live television audience.
Sound familiar? Fans of the popular network television show Shark Tank might be surprised to know that my show, MoneyHunt, ran on PBS for seven years before it folded when the Internet bubble burst in 2001 (to see some old episodes, search on YouTube for “Cliff Ennico” or “MoneyHunt television show”).
Because I was not only the host of the show but the legal expert on the management team, I spent countless hours speaking to securities lawyers, SEC staffers, and others trying to get the answer to a simple question: what can entrepreneurs say, and not say, on television about their efforts to raise capital? In the early 1990s, the answer was “nothing,” and each guest on MoneyHunt was instructed in no uncertain terms not to say anything about raising money in order to avoid a cease-and-desist order from the SEC and other securities regulators. If a guest blurted out “we are looking to raise $1 million for 20 percent of our company,” we had to stop taping and rerecord that segment to avoid being sued by the government. Not a happy outcome for a show devoted to the entrepreneurial life.
Enter crowdfunding.
The term crowdfunding, in its most general sense, means raising money for something from a group of people that is large and relatively undefined: the crowd. Crowdfunding has been around in one form or another since the mid-2000s, but only in late 2015 have crowdfunding techniques been legally approved for companies looking to raise capital.
Crowdfunding offers entrepreneurs who are not yet ready to exploit more traditional avenues of capital raising—such as venture capitalists and angel investors—to tap into their ever-expanding social networks on Facebook, LinkedIn, Twitter, and elsewhere to raise money for their businesses. It also gives them the limited ability to advertise and promote their offerings, even on television, without violating SEC rules and regulations.
Even more significant, crowdfunding offers investors chances to tap into start-up and early-stage companies that aren’t yet on the radar screens of larger and better- informed investors, and (perhaps) get a piece of the next Facebook before the marketplace finds out about it and media attention drives up the price of the company’s shares.
Of course, whenever the U.S. government loosens the rules in one area of the law, it tightens them somewhere else, and crowdfunding is no exception. As a condition for allowing entrepreneurs freer access to the capital markets, the SEC has imposed lots of conditions designed to ensure that unsophisticated investors do not lose their shirts buying into companies that aren’t ready for prime time. Some of these conditions may pose insurmountable barriers to many companies and investors who want to take full advantage of crowdfunded investments.
This book is a guide for entrepreneurs, investors, and others to the new crowdfunding rules, with tips and advice on how to best take advantage of them.
The Different Types of Crowdfunding
There are three basic types of crowdfunding for companies looking to raise capital. With project crowdfunding, those who contribute invest in a specific project (such as a new book or film) but do not receive securities in a company. Accredited-investor crowdfunding allows high-net-worth individuals and organizations to invest in a company and receive securities (usually but not always preferred stock or convertible debt) in return. Title III of the JOBS Act, and the SEC regulations adopted in October 2015, have opened social media crowdfunding or equity crowdfunding to the general public, enabling them to participate in offerings of securities by start-up and early-stage companies as long as their total investments in such securities do not exceed specified amounts.
This book focuses on social media crowdfunding, but first a few words to explain the three types.
Project Crowdfunding, Including Gift Crowdfunding
Until now, most crowdfunding activity has been limited to project crowdfunding and gift crowdfunding.
In project crowdfunding, an individual or company solicits money from the crowd for a project of some kind and gives investors something tangible or intangible in return but not securities in a company.
Let’s say I decided to write a book—a novel, for example, with vampires and zombies competing to have sex with remaining live humans on a reality television show after a nuclear holocaust (yes, yes, I know it’s been done to death, but it’s just an example—please go with it). I submit it to several traditional publishers, but no one is interested.
I get a brilliant idea: I decide to seek crowdfunding for my new book. I create a crowdfunding campaign on Kickstarter, IndieGoGo, RocketHub, or another crowdfunding platform, describe the book in detail (perhaps with a sample chapter and other information that would be included in a book proposal), and ask for money. For $25, an investor would get an autographed copy of the book on its release. For $100, an investor gets to participate in a webinar in which I will discuss the book and my inspiration for it, answer questions, and so forth. For $1,000, an investor gets an invitation to my book-launch party at an exclusive New York City restaurant or nightclub. You get the idea.
As part of the campaign, I would set a minimum total amount I will accept for the project, for example, $25,000. If I raise the $25,000 through the crowdfunding campaign, then I accept the investments, write and publish the book (either in print format or as an e-book), and fulfill my promises to the investors (send the autographed copies, host the webinar and the launch party). If my campaign doesn’t reach $25,000 by a certain date, then the investors get their money back (without interest), and I turn to my next project.
This is an example of project crowdfunding. Authors, inventors, other creative types, and companies looking to test-market products have been using this method of crowdfunding for almost a decade. Because project crowdfunding does not involve investment in a company, or in securities as defined by federal and state securities laws, it has not been regulated by the SEC.
A variation on project crowdfunding is gift crowdfunding, in which the investor doesn’t expect anything in return except the opportunity to have a positive impact on the world in some way. Examples of gift crowdfunding include:
People without health insurance looking to finance a much-needed surgical procedure
Infertile couples looking to finance in vitro fertilization procedures (in a recent crowdfunding campaign, a couple asked for money to help conceive a baby and gave investors the opportunity to participate in naming the baby by voting from a list developed by the couple and their parents)
Not-for-profit or charitable organizations looking to raise tax-deductible donations for specific projects
In most gift crowdfunding campaigns, investors do not expect to receive anything in return for their money except the opportunity to feel good about themselves and the world in general. If a gift crowdfunding investor is looking to deduct her investment on her taxes as a charitable contribution, however, she needs to invest in a bona fide public charity registered with the Internal Revenue Service (IRS) under Section 501(c) (3) of the federal Internal Revenue Code. My vampire/zombie novel wouldn’t qualify, nor would the infertile couple seeking to have a baby.
Like project crowdfunding, gift crowdfunding does not involve an investment in a company or securities and accordingly is not regulated (except perhaps by the IRS and state attorneys general, which to some extent regulate fund-raising activities by charitable organizations).
In April 2012, Congress passed the Jumpstart Our Business Startups (JOBS) Act of 2012, which was signed into law by President Barack Obama later in the year.
The overall purpose of the JOBS Act was to ease restrictions on capital raising for early-stage companies. The JOBS Act contained six sections, or titles, making significant changes to the federal securities laws. All six titles are summarized in Chapter 13 of this book, but two titles of the JOBS Act are of particular interest for this book.
Accredited-Investor Crowdfunding (Title II Crowdfunding)
Title II of the JOBS Act created a new exemption for private offerings of securities (those not required to be registered with the SEC) in the United States. Prior to the JOBS Act, companies were not allowed to advertise or promote private offerings of securities at all, with certain very narrow exceptions. Under Title II (and a follow-up SEC release issued in July 2013), companies were allowed to do so as long as:
They weren’t raising more than $1 million over a twelve-month period
They allowed only accredited investors (extremely sophisticated or rich people who could afford to lose their entire investments in the company) to buy securities in the company
The concept of an accredited investor is discussed in more detail in Chapter 10. Title II offerings are discussed at length in Chapter13.
Social Media or Equity Crowdfunding (Title III Crowdfunding)
Title III of the JOBS Act, the primary subject of this book, allows entrepreneurs and start-up companies to sell securities in their companies using crowdfunding techniques, even if investors who participate in the offering are not accredited investors.
Title III is the heart of the JOBS Act, containing the provisions that will allow crowdfunded offerings of securities on the Internet. On October 23, 2013, the SEC issued a lengthy release (nearly seven hundred pages) spelling out the rules for how Title III crowdfunded investments can and cannot be accomplished: the proposed Regulation Crowdfunding. After two years of public comment and debate, the SEC approved the final version of Regulation Crowdfunding on October 30, 2015. The new rules will become effective May 16, 2016.
Under the regulations, it doesn’t matter how many people invest in a Title III crowdfunded offering, or who they are, as long as:
If the investor’s net worth and annual income are both less than $100,000, he or she does not invest more than $2,000 or 5 percent of his or her net worth or income (whichever is greater) in crowdfunded offerings of securities during a rolling twelve-month period
If the investor’s net worth or annual income is $100,000 or more, he or she does not invest more than 10 percent of his or her net worth or income (whichever is less) in crowdfunded offerings of securities during a rolling twelve-month period
The SEC’s goal in drafting this limitation is to ensure that investors in crowdfunded offerings can afford to lose their entire investments if the company they’re investing in collapses, files for bankruptcy, or otherwise fails to live up to its promise. As a practical matter, this means that most ordinary folks will be legally allowed to participate in only a handful of crowdfunded investments under Title III of the JOBS Act. As has always been the case, wealthy people will be allowed to invest more in these types of offerings.
The regulations also require that Title III crowdfunded offerings be made through a funding portal, not to the securities-issuing companies directly. A funding portal is a financing intermediary that registers with the SEC for the sole purpose of facilitating crowdfunded offerings of securities. It can be a free-standing company or a division or affiliate of a registered broker-dealer exchanging in a full range of securities-related activities. Brief profiles of several companies that are expected to register as funding portals under Title III appear in the section “Suggestions for Further Reading” near the end of this book.
The regulations put the burden squarely on the funding portals to ensure that crowdfunded offerings go smoothly and comply with all federal laws and regulations. Among other things (discussed in Chapter 11), a funding portal must:
Be registered with the SEC and be a member of the Financial Industry Regulatory Authority (FINRA)
Handle all documents for each crowdfunded offering and make them available to investors online
Scrutinize all offering statements and other documents submitted by companies to ensure legal compliance
Determine whether investors in crowdfunded offerings are either accredited investors or have satisfied the SEC’s limits on investment in private offerings
Handle all funds received from investors in crowdfunded offerings and make sure the investors get their money back if an offering fails to raise the desired amount of capital
Additionally, a funding portal is liable to investors (along with the portal’s directors, officers, and employees) if it fails to use “reasonable care” in reviewing a company’s offering documents or fails to adopt a “reasonable policy” to avoid false or misleading statements made by companies in those documents.
Who Should Be Reading This Book?
There are three key groups of players in a crowdfunded offering of securities: the companies seeking financing (called issuers), the investors, and the funding portals that connect the two. While I have included some information for investors in Chapter 10, and some information for people looking to start funding portals in Chapter 11, this book is primarily for the kinds of people I have served as a lawyer and consultant for more than thirty-five years: entrepreneurs looking to start new companies, entrepreneurs with existing companies that need capital to grow to the next level, and the accountants, financial advisers, business development consultants, and other professionals who work with them.
Despite my profession, I have attempted to write this book in plain English. No prior knowledge of accounting, entrepreneurial finance, or securities law is required. If you are planning to launch a crowdfunded offering, however, you will need to read a few additional books about business and financial planning, accounting, cash-flow management, maintaining good relations with investors, and other relevant topics. A number of excellent ones are listed in the “Suggestions for Further Reading” section near the end of the book (and no, I have not written all of them).
Social media crowdfunding under Title III of the JOBS Act is not for everyone.
While theoretically any start-up or early-stage company can register with a funding portal to solicit crowdfunded investments, as a practical matter many companies will not be able to do so because the funding portals will be programmed to screen out companies that are not ready to offer their securities to the public.
In order to launch a Title III crowdfunded offering, a company must:
Have a written business plan, with clearly defined strategies for developing and marketing the company’s products and services, dealing with competition, and financing its operations
Have access to (and the ability to afford) lawyers, accountants, and other professionals who can transform the company’s business plan into an “offering document” meeting the requirements of the SEC’s Regulation Crowdfunding and in the form of the SEC’s new Form C (a copy of which appears as Appendix 1 at the end of this book; these so-called “Form C Disclosures” are discussed in Chapter 5)
Have incorporated either as a corporation or limited liability company (LLC) in the state where the company has its principal place of business (the different forms of legal organization, and the advantages and disadvantages of each for crowdfunded offerings, are discussed in Chapter 4)
Have built its management team to the point where investors will have confidence in them
(Preferably) have accepted loans or investments from one or two angel investors
(Most important) have strategies or procedures in place to communicate with a large crowd of investors on an ongoing basis if the company’s offering is successful (this is discussed in Chapter 8)
In this book, readers will be neither encouraged to seek nor discouraged from seeking crowdfunded investment for their companies. Crowdfunded offerings of securities have advantages and disadvantages, but they require a certain amount of discipline and attention to detail, more so than traditional private offerings of securities. If managed properly, they can be a wonderful way to raise capital that wouldn’t be available from any other source and can introduce your company to talent and networking opportunities that would not otherwise be possible.
If managed poorly, they can lead to disgruntled investors, class-action lawsuits against your company and its founders (including you), and other unpleasantness. I have tried throughout this book to balance the positive and the negative aspects of crowdfunded investments with a focus on teaching readers how to handle them the right way—that is, in such a way as to maximize the chance your company will reap the benefits while doing as much as possible to avoid the pitfalls and dangers.
Where This Book Will Take You
This book is organized into five parts:
Chapters 1 and 2 explain what crowdfunding is and how it evolved.
Chapters 3 through 7 lay out the steps necessary to launch a successful Title III crowdfunded offering.
Chapters 8 and 9 discuss how to deal with a crowd of investors if your Title III crowdfunded offering is successful.
Chapters 10 and 11 present pros and cons for individuals considering investing in such an offering and/or setting up a funding portal.
Chapters 12 and 13 summarize the federal laws and SEC regulations relating to private offerings of securities and explain how the two collided in the federal JOBS Act and the SEC’s regulation of Title II and Title III crowdfunded offerings.
Several appendices appear at the end of this book, including form documents and term sheets for different types of crowdfunded offerings.
A Word About Legal and Tax Information
There is a big difference between legal information and legal advice.
While this book will discuss at length the federal laws and regulations governing crowdfunded offerings of securities, any legal and tax information in this book is for educational purposes only and is not to be relied on as legal or tax advice, which can only be given by a lawyer or tax professional who is licensed to practice in your state.
A Few Words Before We Launch
The author is an attorney in private practice who has spent most of his career representing business start-ups, early-stage companies, and the people who invest in them. While I have helped hundreds of clients put together friends-and-family offerings over the years, I have never worked for the SEC or any other government agency and therefore was not privy to any inside information regarding the discussions and debates leading up to the JOBS Act, Regulation Crowdfunding, or any other law governing crowdfunded offerings of securities. I also confess that I have never launched a funding campaign on Kickstarter, IndieGoGo, RocketHub, or any other crowdfunding website. Although, boy, am I tempted.
The SEC’s Regulation Crowdfunding was finalized in October 2015, shortly before this book was going into print, and it is possible there have been subsequent developments that are not covered in these pages. The reader is encouraged to subscribe to some of the websites listed in the “Suggestions for Further Reading” section near the end of this book to keep track of current developments in this fast-evolving field of entrepreneurial finance.
Subject to the foregoing, as we lawyers say, The Crowdfunding Handbook is entirely my doing, and I am solely responsible for its contents.