Those who are committed to the notable insights of Milton Friedman and the obvious tenets of dining out know there is no such thing as a free lunch. But on April 5, 2012, economists and aphorisms alike were suddenly confronted by a complimentary new law that many entrepreneurs and commentators are calling a “game changer” for raising capital and investing online.
Conveniently dubbed the Capital Raising Online While Deterring Fraud and Unethical Non-Disclosure (CROW DFUND) Act of 2012, the law provides an official avenue for entrepreneurs to raise capital online by “crowdfunding,” the term coined to refer to the concept of raising money by soliciting small amounts of money from a large pool of investors.
Passed in an attempt to give small and emerging businesses easier access to capital, the act brings venture capital and private equity investing from Wall Street to Main Street. Opportunities for small businesses and entrepreneurs abound. Are you a developer in need of seed money to take your product to market? A film director looking to get your project financed? A community organizer hoping to rehabilitate a neighborhood riddled by blight? Don’t have significant collateral for a traditional bank loan? Don’t have access to a trust fund or connections to wealthy angel investors or venture capitalists? The CROWDFUND Act was written for you.
Fellow entrepreneurs and creative-minded individuals are already riding the crowdfunding zeitgeist. Indie film directors and musicians and product developers have raised millions of dollars over the past few years using websites like Kickstarter and IndieGoGo. One independent product developer raised more than $1.4 million on Kickstarter (mainly through individual donations of less than $200) to develop a new iPhone dock. Locally, Arizona film producer Nicholas Holthaus recently raised more than $15,000 on Kickstarter to produce an independent film about the 1990’s Tempe, Ariz., music scene. In all, online contributors pledged nearly $100 million in 2011 through Kickstarter alone, representing a nearly four-fold increase over 2010.
The CROWDFUND Act takes crowdfunding to the next level. Until now, online fundraisers like Holthaus have been forced to rely solely on donations from simpatico online contributors, in exchange for various “rewards” that correspond with different levels of financial support. For example, a $19.91 donation to Holthaus’s film project Stuck Outside of Phoenix could have earned the donor a spot as an extra in the film (for $8,000, he and his musician friends would have flown to the donor’s house where they would have played a musical set, given guitar lessons and cooked dinner for the donor, among other things). The reason for these elaborate, and often creative, donation-reward schemes is simple: Thanks to federal securities laws written during the Great Depression, would-be entrepreneurs are prohibited from incentivizing online investors by simply offering them a cut of potential profits or even from asking them for a loan.
The CROWDFUND Act removes this restriction and makes it legal to raise money online (up to $1 million in a 12-month period) by borrowing money from investors or from issuing stock or other securities in the proposed venture. By posting the offering on a “funding portal” website that is registered with the Securities and Exchange Commission, an entrepreneur can solicit online investors to loan money or even purchase stock in the company. Potential investors who register with the funding portal website will be able to evaluate the potential risks and rewards of an offering and choose whether or not to invest. Individuals with annual incomes of $100,000 or less can invest up to the greater of 5 percent of their income or $2,000 per year in crowdfunding offerings. Those with annual income or net worth of more than $100,000 are capped at 10 percent of their income or net worth, or $10,000, whichever is greater (up to a maximum of $100,000) per year.
At this point, those wondering how to cash in on this new law and bring their great new business idea to the masses might want to hold that thought, at least for a moment. First, because the SEC is still working out the details, the CROWDFUND Act will not take effect likely until the end of this year. Second, remember Uncle Milton’s advice about that free lunch. To start, the law imposes some pretty significant disclosure and compliance requirements in order to be able to take advantage of the crowdfunding exemption. For example, soliciting businesses will need to disclose their detailed business plan and tax records, and provide financial statements that are reviewed by an independent accountant (or audited financial statements for those raising $500,000 or more). Any material misstatement or omission in the disclosures could result in the soliciting party being subject to a lawsuit from offended investors.
Not to mention those who do successfully raise money in a crowdfunding offering but don’t structure the offering carefully could be faced with an investor relations nightmare, significant tax reporting costs and other headaches. One small misstep could also make it difficult if not impossible to raise additional money in the future from traditional sources such as venture capital or institutional investors. The moral of the story? Entrepreneurs looking to take advantage of the new crowdfunding exemption should indulge in this admittedly self-serving advice: Get a lawyer.
In addition, before eschewing venture capital in favor of the online masses, entrepreneurs should also consider that experienced angel investors and VC firms bring more than money to the table. An early-stage venture could likely benefit from the wisdom, experience and corporate connections that these traditional investors contribute along with their funds.
Investors looking to invest in crowdfunding offerings, hoping to get in on the ground floor of the next Facebook or Instagram, should know this: For every Facebook there are a thousand failed ventures. In fact, the simple truth is that most startups fail. While the CROWDFUND Act puts several restrictions on both issuers and funding portals in order to lessen instances of fraud, even an investment in an honest and well-meaning crowdfunding venture puts an investor at risk of losing his or her entire investment. In the end, it may be better for the investor to accept a “reward” in exchange for his or her “donation.”
For entrepreneurs and investors alike, only time will tell if crowdfunding will make a lasting beneficial impact on small businesses, jobs and the economy. Some dismiss crowdfunding as not very useful or simply a fad. Still others lament the removal of longstanding rules and regulations designed to protect investors. Yet there are more than a few who see crowdfunding as a potentially revolutionary tool for democratizing access to capital in the digital age, utilizing the Internet and the free market as a platform to create jobs and new technologies.
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