A New Type of Fundraising
November 04, 2014
By Marilyn Yang, W’17
As the Micro 3D Printer project demonstrates, crowdfunding can be a powerful tool for fledgling small businesses, allowing them to tap into social media networks and “viral” trends. Entrepreneur Magazine aptly describes crowdfunding as “the social media version of fundraising” (“The Basics of Crowdfunding”). Crowdfunding shifts influence toward the common consumer; by making a donation, the consumer helps turn concepts into reality.
What if instead of receiving gifts, donors received equity of the business running the fundraiser? Such a form of crowdfunding, securities-based crowdfunding, involves general solicitation or advertising; therefore, it is currently only legal for accredited investors, or investors who have a net worth of more than $1 million or who have an annual income that exceeds $200,000 in the two most recently completed years, with the expectation that the annual income would exceed that amount in the current year. Now, the Jumpstart Our Business Startups Act of 2012, commonly referred to as the “JOBS Act,” creates a new exemption that will permit securities to be sold to the general public via crowdfunding intermediaries without first having to register with the Securities and Exchange Commission (SEC) the offer and sale of those securities. But first, the SEC must create rules to implement the requirements of the new exemption, including rules designed to protect crowdfunding investors from fraud. (“The Basics of Crowdfunding”).
The SEC’s proposed rules were released in October 2013, initiating a 90-day public comment period. Key highlights of the JOBS Act and the proposed rules include investment limits and disclosure requirements: the amount individuals could invest through securities-based crowdfunding would be capped depending on the investors’ annual income or net worth, and companies would be required to disclose their primary officers, directors, and any investors owning more than 20% equity (Clifford). In addition, generally any equity purchased through crowdfunding must be held for at least one year, transactions must take place through an SEC-registered intermediary, and only U.S.-based companies with a specific business plan would be eligible to use the exemption (Clifford). Crowdfunding intermediaries could come in the form of either a registered broker or a funding portal, which is a completely new type of SEC-registered entity.
In testimony to the Senate in May, SEC Chair Mary Jo White described the equity crowdfunding rules as remaining a “top priority” in the agency’s agenda (White). Following the release of the proposed rules and throughout the public comment period, the SEC has received much feedback from a wide spectrum of market participants.
During the public comment period, the Investor Advisory Committee, established by Section 911 of the Dodd-Frank Act to advise the SEC and composed of law professors, lawyers, members of consumer protection groups, and other stakeholders, published several recommendations regarding these proposed rules, many of which concern equity funding “portals,” – the securities-based crowdfunding counterpart of sites such as Kickstarter. The Committee recommended that the SEC revise its proposal to require collaboration by portals so that an investor would not be able to “portal-hop” to bypass net worth and income requirements and to force portals to provide disclosures and educational materials directly to investors rather than simply referring to links on their websites (Dunn). It also proposed that portals be allowed to reject investors and offerings “that they believe could pose an undue compliance or fraud risk” (Dunn). This recommendation is actually echoed in the crowdfunding portal community; in the proposed rules, the SEC stated that it appears likely that crowdfunding intermediaries would be considered issuers for purposes of the liability provision (Clifford). The Financial Industry Regulatory Authority (FINRA) is currently in the process of creating a regulatory system for funding portals (Say).
In the realm of securities-based crowdfunding, how serious of a concern is fraud? Alon Hillel-Tuch, co-founder and CFO of crowdfunding platform RocketHub, argues that because of the social nature of crowdfunding, social buzz correlates with money raised, allowing fraudsters to be easily discovered (Clifford). The red herring is when a crowdfunding campaign “raises a significant amount of money without a corresponding amount of social activity” (Clifford). In Australia and the United Kingdom, where different forms of equity crowdfunding have already been legal for eight and three years, respectively, no complaints of fraud have yet been raised, according to Kim Wales, founder of Wales Capital, a management consulting firm that focuses on the implementation of the JOBS Act (Clifford). From an investor’s perspective, however, the more safeguards against fraud, the better.
There has been ample buzz surrounding the JOBS Act and its potential impact. Crowdfunding could offer new opportunities similar to those developing under registration exemptions such as Regulation A, an existing exemption from registration for small offerings of securities up to $5 million within a 12-month period, and Regulation D, which contains three rules providing exemptions from the registration requirements, allowing some companies to offer and sell their securities without having to register the offer and sale with the SEC although they must file “Form D” after they first sell their securities (“Registration under the Securities”). For example, start-up Fundrise, which facilitates offerings relying on such exemptions, raised $31 million from major Chinese tech firm Renren and real estate giants Ackman-Ziff and Silverstein Properties (Say). Where entry into the real estate market was previously limited to large, established players, real-estate-focused websites such as Fundrise are shaking up that business model by allowing more types of investors to participate in deals involving hotels, apartment blocks, and other commercial developments (Say).
Small businesses employ roughly half of all private sector workers and create about 75% of net new jobs in the U.S. (“Crowdfunding Infographic”). Through securities-based crowdfunding, the JOBS Act provides entrepreneurs with yet another channel to acquire the funds they need to get started. The JOBS Act’s focus on promoting small businesses demonstrates the prevailing importance of entrepreneurship to the U.S. economy.
The Securities and Exchange Commission, as a matter of policy, disclaims responsibility for any private publication or statement by any of its employees or former employees. The views expressed herein are those of the author and do not necessarily reflect the views of the Commission or other members of the staff of the Commission.
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