Crowdfunding Under the JOBS Act

So, you’ve got an idea. It’s the Next Big Thing, but bigger. It’s a bread slicer that slices bread in ways previously unimagined. Of course it also has built-in web and video capabilities. After all, who would want to slice bread without being able to watch the game? Or a soap opera? Or the new reality show? Surf Twitter?

Whatever it is, you’re the only one with the best idea since, well, you know – an internet-tv-bread-slicing appliance that will soon be in every kitchen. Your family and friends are supportive, share your vision, and are eager to see you become rich and famous as the re-inventor of the small kitchen appliance. Steve Jobs of the canteen. You know exactly how you would design the thing, where it’ll be manufactured (is labor still cheap in China?), even how it’ll be marketed (“But wait! If you call now, we’ll send you TWO video-bread-slicers for the price of one…”).

There’s just one problem. To make this dream a reality, you’ll need money. A lot of money. A couple hundred grand, or maybe a whopping million, and that’s just for starters.

But money shouldn’t be a problem, should it? Who could resist investing in a company that’ll be worth a few hundred million within three years, and within five years will put so much heat on Cuisinart, Google, and Apple, that they’ll have no choice but to get out of the kitchen business?

The problem is that venture capitalists are too conservative to share your revolutionary vision; and angel investors don’t have money on the scale you need. The solution: crowdfunding! You can build a skyscraper of pennies if you have enough. An ocean of singles. A fortune of $10 bills. Collect the cushion change of a billion internet users, and you could fund NASA.

You just need somebody to herd the kittens. Crowdfunding portals, such as Kickstarter, do exactly this. You present your brilliant idea to them; and if they believe in it and in you, they help you to solicit donations from their subscribers. In return, you will have to give your sponsors something material: say, a free video-bread-slicer once it is designed and manufactured.

Anyway, that’s how it worked until recently: crowdfunders were prohibited from asking for equity in exchange for their investments. Enter the JOBS Act, and the rules change.

Now, let’s get a bit more serious. In recent years crowdfunding became a lucrative business. According to Deloitte TMT Predictions 2013, “crowdfunding portals will raise $3 billion in 2013, double the $1.5 billion raised in 2011.” That’s a sizable amount of money.

According to the report, there are four major categories of crowdfunding portals. The first and largest category is consumer lending, whereby investors can lend relatively small amounts of money through an internet portal. The second category is reward-based portals like Kickstarter, where investors get a copy of the product in exchange to their investment. The third largest category is donation portals. This category is mostly used by charitable organizations to raise money for their cause. The last category, and the only one regulated by the SEC, is the more traditional equity-in-exchange-for-funds model.

In other words, despite all the recent media hype surrounding it, VC-like crowdfunded investments constitute the smallest part of this industry.

Title III of the JOBS Act governs operations of crowdfunding intermediaries (portals and platforms) that can offer financing in exchange for equity stakes in the company. While the original deadline for the SEC rule was January 2013, the final regulation is still pending.

The May 2012 JOBS Act FAQ works as an interim guideline on the matter. According to this document, crowdfunding securities issuers are required to “use the services of an intermediary that is either a broker registered with the SEC or a ‘funding portal’ registered with the SEC”. Funding portals will also have to become members of FINRA. FINRA currently “invites prospective crowdfunding portals to voluntarily file an interim funding portal form”.

According to Section 4(6) of the ’33 Act, equity-based crowdfunding is subject to certain restrictions.

  • The total amount raised cannot exceed $1 million in any 12-month period.
  • Second, while the number of investors is unlimited, there is a restriction on how much each individual may invest. The amount is limited to a percentage of the investor’s net income, and capped at a total of $100,000.
  • Any company financed through crowdfunding is also obligated to file a financial report at least annually. A company that raises over $500,000 must have its reports audited.
  • Finally, while the SEC has lifted its ban on advertisements of private placements (normally subject to the Form D filing requirement), the advertisement of crowdfunded offerings is explicitly prohibited.

So, is crowdfunding good for your Next Big Thing? The answer, as always, is: it depends. A number of factors have to be taken into consideration.

  • What if your total investment needs are higher than a million? In the January-May of 2013, average Form D placement was above $7.5 million.
  • What about investors’ voting and appraisal rights under state laws — laws that differ from state to state?
  • If you are planning more than one round of fundraising, how will your future investors will deal with ten to fifteen (or even more) seed investors that are already on board? Will they even want to? What would your decision-making process look like?
  • Then there’s the question of intellectual property protection. In many cases, investors that seek seed funding do not have any patent applications filed yet. How will the crowdfunding portals enforce confidentiality of their ideas?
  • Who and how will determine your goals and milestones? Your crowd investors are not necessarily going to be experts in your problem area, nor even familiar with industry standard process and best practices. You might find yourself constantly educating your investors instead of moving forward your business.

In short, crowdfunding is the perfect solution for certain very limited situations, but it is by no means a silver bullet.