CHAPTER 2

The Evolution of Crowdfunding

In the seventeenth and eighteenth centuries, many book publishers sold their offerings by means of subscriptions, what the industry today calls advance-sale copies. The publisher would solicit advance purchases from subscribers, print the exact number of books for which it received subscriptions, and mention the subscribers on the title page of the book. Many companies today use similar crowdfunding methods to test the market for new product and service offerings.

According to Wikipedia, the American Committee for the Statue of Liberty in New York Harbor ran out of funds for the statue’s pedestal in 1884. Incensed that the statue might not be completed, newspaper publisher Joseph Pulitzer urged the American public to donate money toward the pedestal in his newspaper the New York World. Pulitzer raised over $100,000 in six months. More than one hundred twenty-five thousand people contributed to the cause; most donations were one dollar or less.

These are early examples of crowdfunding.

The Friends-and-Family Offering

In a way, companies looking to raise capital have always relied to some extent on a form of crowdfunding: hitting up friends, family members, neighbors, old college roommates, and people they know for loans, gifts, or contributions to help get their businesses (or their lives) off the ground. The reward for such investors was frequently intangible (love, affection, helping your slacker kid buy his way into a job, or the right to reserve a restaurant table on New Year’s Eve).

What made such friends-and-family offerings difficult, of course, was that most people’s networks were relatively small and tightly confined. Also, you had to approach each person one on one and establish a personal rapport with each of them. To network successfully in the pre-Internet world, you had to take time to get to know someone before you asked him for a favor or for money. If your network was rich and well connected, life was good. If it wasn’t, well . . .

Intermediate Steps: Microlending and Peer-to-Peer Lending

That began to change in the early 2000s with the concept of microlending, pioneered by Dr. Mohammed Yunus in Bangladesh. In 1976, Yunus launched a research project with his graduate students in Bangladesh. His goal was to give banking opportunities to low-income people, eliminate the exploitation of the poor, and create opportunities for self-employment. His initial loan was $27 to forty-two women who lived in a village sustained by bamboo production. After this successful loan, Yunus was able to secure a loan from the government to lend small amounts to the poor. Within five years, the program had more than thirty thousand members, and in 1983, the program transformed into Grameen Bank. The bank now has more than eight million borrowers; 97 percent of the money goes to women-operated businesses.

Yunus and Grameen Bank (www.muhammadyunus.org and www.grameenfoundation.org) were awarded the Nobel Peace Prize in 2006 for their efforts in economic and social development, and they have been the inspiration for a number of microlending sites in the United States.

In 2005, Kiva.org (unaffiliated with Grameen Bank) became the first microlending website. It gave individuals the ability to lend small amounts of money to entrepreneurs in poor, rural areas across the globe. What makes Kiva so attractive is that lenders are given pictures and a profile for each loan. They see whom the loan is going to, what it will be used for, and the terms of repayment.

Kiva has field partners in various world regions that help document the stories and distribute the loans to individuals. This unique system personalizes the process and gives investors not only more information about their borrowers but confirmation that their investment is having a meaningful impact on the borrower and his or her community.

In 2006, Prosper.com launched the first peer-to-peer lending site in the United States. The concept was similar to Yunus’s microfinance vision and Kiva’s microlending model. On the website, an individual submits a request for funding, which includes a story, a picture, and his or her credit score. You might find people who are trying to refinance debt, fund a vacation, or start a business.

The difference between Prosper and earlier forms of microfinance is that this was the first time the process existed outside of developing countries. U.S. entrepreneurs looking for funding typically have had more financial options than developing nations. What makes Prosper’s concept attractive to borrowers is that the interest rates are generally less than those a bank might offer. Additionally, it gives credit-strapped consumers alternatives to traditional bank loans.

In 2007, LendingClub.com launched the second peer-to-peer lending site in the United States. In line with its goal of creating an alternative to banks, it offered borrowers and investors great rates. The concept of the site is similar to that of Prosper.com. Recently, Lending Club surpassed Prosper in loan funding ($353 million versus $255 million).

Microlending has proven extremely successful in traditional societies, where people tend to live in the same tightly knit communities their entire lives. In such communities, everyone knows everyone else, and there is a culture of shame for any individual who does not live by the rules and pay back debts promptly. Someone who takes the money and runs is likely to become a pariah in her village or town.

In highly mobile America, where people change jobs and residences frequently—often so quickly that they seem never to set down roots anywhere—the microlending concept has had greater difficulty taking off. In a culture that tolerates and forgives bankruptcy and other indiscretions, worships risk taking, and believes that success often results from lessons learned from multiple failures, the idea that you should suffer for not paying your debts on time seems—well, a bit antiquated. And as for feeling shame about anything—as they used to say in Brooklyn, fuhgeddaboudit (today the denizens of Brooklyn would say “chill, dude,” which amounts to much the same thing).

The Social Media Revolution

What really made crowdfunding (and crowdlending, for that matter) more viable, of course, was the introduction of social media networks, such as Facebook and Twitter, in the mid-2000s. Originally viewed as online Rolodexes that would help people keep track of business contacts and far-flung family members, social media platforms have revolutionized the concept of a personal network.

Today it is not uncommon for even relatively unknown entrepreneurs to have hundreds of friends on Facebook or thousands of followers on Twitter. Social media has, in fact, changed the concept of a personal network from a group of people one knows and stays in frequent contact with to something more akin to a fan club, a “posse,” or—to use a marketing term—an affinity group.

Your social media contacts are not necessarily friends or family; they are just people who, for one reason or another, are interested in you and want to keep up with what you’re doing. But in large enough numbers they can be a rich source for financing projects of all types.

Here’s a mantra I will be repeating throughout this book: success in crowdfunding (of any kind) depends on your ability to develop, manage, grow, and leverage a large following on social media. Because that’s where your crowd will come from.

Kickstarter.com and Project Crowdfunding

In 2009, Kickstarter launched as a new way to fund creativity. The company also helped bring a new term to the forefront—crowdfunding—which allows a large group of people to pool their money to help fund an idea. Kickstarter took this concept and built a model that helps creative minds get funding from their peers. Projects range from documentaries to smart watches.

As I pointed out in Chapter 1, most crowdfunding activity involving social media networks has so far been limited to either project crowdfunding or gift crowdfunding.

In project crowdfunding, an individual or company solicits money from the crowd for a project of some kind and gives investors something either tangible or intangible in return but not securities in a company. For example, a rock band might solicit contributions to record its next CD.

In gift crowdfunding, an individual or company makes a donation or gift without any expectation of return, except perhaps for a charitable deduction if the crowdfunding is being done by a charitable organization registered with the IRS under Section 501(c)(3) of the U.S. Internal Revenue Code. For example, a church might use crowdfunding to raise money for a mission overseas.

Today there are numerous crowdfunding platforms in the United States, dominated by the big ten:

1.Kickstarter.com (the industry pioneer, accepts creative projects only)

2.IndieGoGo.com (accepts creative, personal, and charitable projects)

3.Gofundme.com (the largest, with more than three hundred thousand campaigns since its inception, accepts personal and charitable projects and local fund-raising efforts)

4.YouCaring.com (personal projects only)

5.Kiva.org (international microloans only)

6.Causes.com (not-for-profit fund-raiser for grassroots campaigns only)

7.GiveForward.com (medical expenses only)

8.CrowdRise.com (charitable projects only)

9.DonorsChoose.org (school donations only)

10.FirstGiving.com (charitable projects only)

Angel Investor Social Media Websites

Independent from project and gift crowdfunding, a number of social media sites have cropped up in recent years to help identify angel investor communities and put them in touch with start-up and early-stage companies. These sites, emboldened by Title II of the JOBS Act and the SEC’s July 2013 release removing the prohibition on “general solicitation” and “general advertising” from offerings to accredited investors, have given life to a new type of venture financing vehicle, called an online syndicate, which allows angel investors (virtually all of whom are accredited investors under the SEC rules) to quickly assemble a group of investors over the Internet for a targeted start-up company.

Currently, the most prominent website in this field is AngelList (http://angel.co), with 159 investor syndicates and 4,865 early-stage companies looking for capital online.

Such websites are ideally positioned to become portals for the facilitation of accredited investor crowdfunding offerings under Title II of the JOBS Act (described in detail in Chapter 13).

Intrastate Crowdfunding Under State Law

It took a long time (from October 2013 to October 2015) for the SEC to finalize its crowdfunding regulations under Title III of the JOBS Act. During that time, a number of U.S. states decided they didn’t want to wait for the final SEC regulations.

Just about every state has some sort of intrastate exemption for securities offerings by local companies. Generally, if your company is organized and located in the state, makes offers and sales only to people who reside in the same state, and complies with other restrictions (which vary from state to state; for example, limiting the number of purchasers or the dollar amount of the offering), your offering is exempt from federal and state securities laws.

In the two years before final passage of the SEC’s crowdfunding regulations, no less than 29 states—including Alabama, Georgia, Idaho, Indiana, Kansas, Maine, Maryland, Massachusetts, Michigan, Oregon, Texas, Vermont, Washington, and Wisconsin—and the District of Columbia amended their intrastate offering exemptions to allow crowdfunding for offerings of securities that take place within their borders.

In all these states, an intrastate crowdfunded offering would need to comply with all restrictions imposed by the SEC’s Rule 147 relating to intrastate offerings (the text of which can be found at www.law.cornell.edu/cfr/text/17/230.147). For example:

The issuer must be organized and located in the state (in Wisconsin, the majority of the issuer’s full-time workers must also work in Wisconsin).

All prospective purchasers must reside in the state (in Texas, the offering must also be completed in Texas).

The issuer must file an offering notice with the state securities regulator on a prescribed form.

In some states (including Texas and Wisconsin), the offering must also comply with all restrictions in the SEC’s Regulation Crowdfunding.

Small businesses with social media followings that are largely limited to a single state should consider making a crowdfunded offering under their state’s intrastate rules rather than following the cumbersome procedures involved in launching an interstate offering under the SEC’s Regulation Crowdfunding.

The downside? Even one out-of-state purchaser in an intrastate offering can blow the exemption, so issuers will need to make 100 percent sure that all purchasers in the offering are residents of the same state and that all purchases take place within the state. Making offerings in person at state fairs, chamber of commerce meetings, and other local venues, and making photocopies of people’s driver’s licenses before they buy, may end up being more cumbersome than registering with a funding portal under Regulation Crowdfunding.

Social Media Crowdfunding (Title III Crowdfunding)

The use of crowdfunding platforms to raise money for companies and business projects goes by a number of names, including equity crowdfunding, crowdfunded investing, and social media crowdfunding.

U.S. securities laws (discussed in Chapter 12) closely regulate offerings of securities by privately owned companies. Because those laws traditionally prohibited private offerings made by “general solicitation” or “general advertising” (public offerings of securities registered with the SEC can always be made via “general solicitation” and “general advertising”), the laws had to be changed to expressly permit crowdfunded offerings of securities.

The federal JOBS Act of 2012 came about because of two things: a major recession and an entrepreneurial effort by three dedicated individuals.

The 2008 financial collapse gave way to the Great Recession, which began to turn around only in 2012. After past recessions, small businesses got the country back on track, but this time around they couldn’t do so because all the typical ways small businesses had traditionally gained access to capital had dried up. Banks weren’t lending, credit card companies slashed credit limits and hiked interest rates, and private equity and venture capital firms were investing money in fewer than 2 percent of companies that approached them. Many people and organizations still had cash after the 2008 collapse, but that money wasn’t flowing to the entrepreneurs who could use it to start businesses and to small businesses that could create jobs.

But then three entrepreneurs—Sherwood Neiss, Jason W. Best, and Zak Cassady-Dorion—got creative. Recognizing the potential of crowdfunding to provide capital not available from traditional sources, the three developed their Start-up Exemption Regulatory Framework (www.start-upexemption.com) and lobbied Congress extensively for what eventually emerged from the legislative process as Title III of the JOBS Act of 2012.

The Start-up Exemption Regulatory Framework contained the following basic elements:

A funding window of up to $1 million for entrepreneurs and small businesses (defined as businesses with average annual gross revenue of less than $5 million during each of the last three years or since incorporation)

Investment from nonaccredited investors capped at $10,000 or 10 percent of their prior year’s adjusted gross income

Elimination of the investor-sophistication requirement in SEC Rule 506 (discussed in Chapter 12 of this book) to reflect the fact that average investors are a lot smarter today than they were in 1933

Elimination of the five-hundred-investor limit for companies that use crowdfunded investments (this refers to a requirement in the federal Securities and Exchange Act of 1934 that companies with more than five-hundred owners must register with the SEC as “public companies” and file annual and quarterly reports)

Preemption of state securities laws called blue-sky laws that contain contrary requirements

Allowance for “general solicitation” and “general advertising” on registered funding platforms where individuals, companies, and investors can meet virtually and where ideas can be vetted by the community as a sort of peer review

Standardization of the filing process using generic term sheets and subscription agreements based on venture capital industry practices

Neiss, Best, and Cassady-Dorion have gone on to become the founders and principals of Crowdfund Capital Advisors (CCA) (www.crowdfundcapitaladvisors.com), a crowdfunding think tank that, as this book went to press, was poised to become one of the first SEC-approved funding platforms under Title III.

A number of companies are positioning themselves to play a significant role in Title III crowdfunding. Leading the pack (as of December 2015) was SeedInvest.com, an equity-based crowdfunding platform that connects accredited investors to leading start-ups seeking funding.

Other potential crowdfunded offering platforms (or funding portals), most of which are in the very early stages of development, include:

EquityNet.com (billed as the “original equity crowdfunding platform,” EquityNet boasts a patented software system that streamlines the business planning process)

GrowVC.com (with offices in New York, London, and Hong Kong, it is positioning itself to be a player in international crowdfunded offerings)

Crowdfunder.com (based in Los Angeles, bills itself as “the leading equity crowfunding platform” as this book goes to press)

iFunding.com (specializes in crowdfunding of real estate offerings, investments and syndications)

IPOVillage.com (helped launch Crowdfunding-Website-Reviews.com, one of the Internet’s top sites for getting information on crowdfunding platform websites)

TruCrowd.com (focuses on serving nonaccredited investors)

Sprigster.com (focuses on providing crowdfunded financing for franchised businesses)

SyndicateRoom.com (the United Kingdom’s first crowdfunded offering platform that focuses on the investors and investor returns requires that issuing companies first have a lead investor, or group of lead investors, on board providing a minimum of 25 percent of the funding round out of pocket)

Lest anyone still think that crowdfunding is a passing fancy, there are already established in the United States alone are:

The National Crowdfunding Association (www.nlcfa.org)

The Crowdfunding Professional Association (www.cfpa.org)

The Crowdfunding Accreditation for Platform Standards program to promote the adoption of best practices for the operation of crowdfunding platforms globally (www.crowdsourcing.org/caps)

A Brief Overview of Crowdfunding Under Title III of the JOBS Act and Regulation Crowdfunding

Regulation Crowdfunding contains almost seven hundred pages of rules and regulations for companies that want to raise capital via crowdfunding. Here’s an overview of how crowdfunding will work under this regulation.

Rules for Issuers

A company looking to raise money through crowdfunding (called an “issuer” in the securities laws) is limited to raising $1 million through crowdfunded offerings over a rolling twelve-month period. This limit includes an issuer’s predecessors and affiliates of the issuer (such as any other company run by the same founders as the issuer). Certain companies cannot use crowdfunding, including:

Companies that have committed certain securities law violations

Investment companies such as hedge funds

Publicly traded companies

Companies outside the United States (although their U.S.-based subsidiaries can use crowdfunding)

Crowdfunded issuers who fail to file their annual reports with the SEC on Form C-AR

Issuers cannot offer their securities to the public directly but only through a funding portal registered with the SEC. The funding portal must be a website or similar electronic medium, and the issuer is limited to only one funding portal per offering.

Before launching a crowdfunded offering, the issuer must file electronically with the SEC and post on the funding portal an “offering statement” on the SEC’s new Form C (Appendix 1, described in Chapter 5), containing much the same information as has always been required of companies in private offerings. During the offering, the issuer is required to file progress updates five business days after the offering has reached 50 percent and 100 percent of the targeted amount, as well as a final Form C-U to disclose the total amount of securities issued as part of the offering.

These offering documents may be viewed by the general public—anyone who visits the site—but investments and communications with issuers may be made only by people who open accounts with the funding portal.

As part of its offering documents, the issuer must include financial statements covering the shorter of the two most recently completed fiscal years or the period since the issuer’s inception, the nature of which will depend on the amount the issuer is trying to raise:

If the offering amount is $100,000 or less, disclosure of the amount of total income, taxable income, total tax as reflected in the issuer’s federal income tax returns certified by the principal executive officer to reflect accurately the information in the issuer’s federal income tax returns (in lieu of filing a copy of the tax returns), and financial statements certified by the principal executive officer to be true and complete in all material respects; if, however, financial statements of the issuer are available that have either been reviewed or audited by a public accountant that is independent of the issuer, the issuer must provide those financial statements instead and need not include the information reported on the federal income tax returns or the certification of the principal executive officer.

If the offering amount is more than $100,000 but less than $500,000, the financial statements must be reviewed by an independent certified public accountant (CPA), using the Statements on Standards for Accounting and Review Services issued by the Accounting and Review Services Committee of the American Institute of CPAS (AICPA); if, however, financial statements of the issuer are available that have been audited by a public accountant that is independent of the issuer, the issuer must provide those financial statements instead and need not include the reviewed financial statements.

If the offering amount is more than $500,000 but not more than $1 million of securities in reliance on Regulation Crowdfunding for the first time: financial statements must be reviewed by a public accountant that is independent of the issuer; if, however, financial statements of the issuer are available that have been audited by a public accountant that is independent of the issuer, the issuer must provide those financial statements instead and need not include the reviewed financial statements.

If the offering amount is more than $500,000 and the issuer has previously sold securities in reliance on Regulation Crowdfunding, the financial statements must be audited by an independent CPA using generally accepted U.S. auditing standards (GAAS) or any other standard adopted by the Public Company Accounting Oversight Board (pcaob.org). Any unaudited financial statements submitted as part of a Regulation Crowdfunding offering must be labeled as such. Issuers seeking to raise up to $100,000 are not required to submit copies of their actual tax returns, due to the risk of disclosing private or personally identifiable information about the company’s founders and early investors.

During the offering, the issuer cannot advertise the terms of the offering except for a short public notice (similar in form and content to the “tombstone ads” used by underwriters in public offerings) directing readers to the funding portal where the offering is conducted. These notices may, however, be disseminated broadly through general solicitation in all media channels, online and off-line, and the issuer is allowed to communicate directly with investors using communications media (such as chat rooms) furnished by the funding portal.

An offering must be posted for at least twenty-one days, but after that the offering can last as long as an issuer likes, provided the offering documents are kept up to date. If the issuer raises the targeted amount before the offering ends, the issuer can terminate the offering early (but not until twenty-one days after the offering commences) as long as it gives investors five business days’ notice of the new closing date, it allows investors to cancel their investments up to forty-eight hours before the new closing dates, it notifies investors whether or not the issuer will accept investments during the final forty-eight hours, and the issuer continues to exceed the target on the new closing date.

If the issuer fails to raise the targeted minimum amount of capital before the offering expires, any investments made during the offering are returned to the investors. If the issuer raises the targeted minimum amount of capital, the offering closes—investors’ funds are released to the issuer, and the issuer delivers securities to the investors.

After an offering is completed, the issuer must file annual reports with the SEC on Form C-AR; failure to do so on time disqualifies the issuer from future crowdfunded offerings.

Issuers, including their directors and officers, are liable to investors for “untrue or materially misleading statements” in their offering documents unless they can prove they did not know, and in the exercise of reasonable care could not have known, of the untruth or omission.

Rules for Investors

An individual investor is limited in the amount he or she can invest in crowdfunded offerings each year. If the investor’s net worth or annual income (whichever is greater) is $100,000 or less, the investor cannot purchase more than $2,000 or 5 percent of the net worth or annual income (whichever is greater) in crowdfunded securities.

If the investor’s net worth or annual income (whichever is greater) is more than $100,000, the investor may purchase up to 10 percent of the net worth or annual income (whichever is lesser).

Purchases of other types of securities are not included when calculating these limits.

An investor may cancel an investment up to forty-eight hours before the offering closes but is barred from doing so after that time.

Investors are entitled to progress reports while the offering is pending and to certain statements when an offering closes. Investors may communicate directly with issuers and other investors during the offering process but only through the communications channels maintained by the funding portal. These communications can be viewed publicly only by participants in the offering.

After an offering closes, crowdfunded securities cannot be resold by anyone for a period of one year except to the issuer, as part of a registered public offering of the issuer’s securities (an IPO), or for estate planning or divorce purposes. After the one-year period, crowdfunded securities can be freely sold—if, of course, the investor can find a buyer for them.

Rules for Funding Portals

All crowdfunded offerings must take place through an intermediary, called a funding portal, which must be a website or other electronic medium.

Unless it is operated by broker-dealers who are already registered with the SEC, a funding portal must be registered with the SEC, be a member of FINRA, and maintain in place a $100,000 fidelity bond (the FINRA rules for crowdfunding portals can be found at www.finra.org/industry/rule-filings/sr-finra-2015-040).

A funding portal is required to review all offering documents submitted to it by issuers and may deny access to the portal if it believes there is the potential for fraud or the issuer is not eligible for crowdfunding under Regulation Crowdfunding. It is also required to make a reasonable effort to vet investors to make sure they haven’t exceeded their investment limits in crowdfunded securities.

In operating its business, a funding portal must operate by numerous rules, including:

It cannot offer investment advice or recommendations, or solicit purchases, sales, or offers (although it can advertise its services generally).

It cannot be compensated based on the amount of sales it achieves or charge a contingency fee.

It cannot hold, manage, possess, or otherwise handle investor funds or securities (it must establish accounts with banks and securities depositories to hold these).

It can limit companies from accessing its portal using objective criteria (for example, a portal can limit offerings to just one industry or a certain type of security) but cannot deny access based on “the advisability of investing in the issuer” (that is, the portal cannot pick favorites).

It can highlight offerings using objective criteria, but cannot highlight offerings based on “the advisability of investing in the issuer” and cannot be compensated for highlighting an offering.

It can provide search functions to sort by objective criteria.

It can provide communication channels by which investors can communicate with one another and with issuers but cannot participate in discussions except as a moderator.

It can advise issuers about the structure or content of the issuer’s offering, including assisting the issuer in preparing the offering documents.

It can compensate a third party for referring people to the funding portal as long as no personally identifiable information is given.

It can cancel an offering if the portal believes there is a potential for fraud.

The funding portal must preserve records of all offerings and communications for five years.

A funding portal, including its directors and officers, has the same liability as an issuer if fraud occurs, although it has a defense if it can prove that it used reasonable care in reviewing an issuer’s offering documents and established a reasonable policy for avoiding misstatements and untruths in crowdfunded offerings.