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Crowdfunding for Capital? Know the Rules.

Crowdfunding for Capital? Know the Rules.

Consider the traditional approach to securing business financing: Armed with your valuable idea, a sound business plan, and some marketing research, you strive to get an audience with some wealthy investors, perhaps angel funds, a venture capital firm, and a few investment banks. You spend a great deal of time and effort pitching to this very limited pool of capital investors, with uncertain success. 

Now consider a current popular approach called crowdfunding: You pitch your valuable idea and supporting business plan and research out into the world via social platforms and media. 

Crowdfunding is a method of raising capital through the collective effort of friends, family, customers, individual investors, even complete strangers. The method taps into expansive pools of potential investors primarily through social media and other crowdfunding platforms, letting business owners, in essence, make their pitch to the world.

It’s the complete opposite of the traditional approach to raising capital, and it’s certainly not Shark Tank. Among the most popular crowdfunding platforms are Fundable, Kickstarter, Indiegogo, Crowdfunder, and RocketHub.

The benefits of crowdfunding are many. The first is the obvious reach it offers. Using a crowdfunding platform allows a business or idea to get in front of a significantly larger number of potential investors. That also spells efficiency. With a centralized and streamlined approach, businesses and entrepreneurs can reach large numbers of potential investors, thereby eliminating the time-intensive need to pursue investors on an individual basis.

Another benefit is developing a polished presentation. Many of the crowdfunding platforms provide professional assistance to help business owners and entrepreneurs put together a business case in a well-thought-out, digestible package. 

Lastly, crowdfunding helps to validate new concepts. When the masses provide feedback, a business or entrepreneur can quickly determine whether something is missing from the business case or offering and can address those needs in a timely fashion.

It’s important to note that there are three basic types of crowdfunding: donation-based, rewards-based, and equity-based.

With donation-based crowdfunding, there are no financial returns to investors or contributors. In rewards-based crowdfunding, individuals contribute capital in exchange for a “reward.” Rewards are typically in the form of the products or services the business provides.

With equity-based crowdfunding, individuals contribute capital in exchange for an equity interest in the business. As you might imagine, this option is rife with rules.

Key Rules and Regulations

Under the Securities Act of 1933, the offer and sale of securities must be registered unless an exemption from registration is available. Title III of the Jumpstart Our Business Startups (JOBS) Act of 2012 added Securities Act Section 4(a)(6), which provides an exemption from registration for certain crowdfunding transactions. 

Then in 2015, the U.S. Securities and Exchange Commission (SEC) adopted Regulation Crowdfunding to implement the requirements of Title III. Under the rules, eligible companies can use crowdfunding to offer and sell securities to the investing public starting May 16, 2016. However, a company issuing securities in reliance on Regulation Crowdfunding is permitted to raise a maximum aggregate amount of $1 million in a 12-month period.

On the flipside, anyone can invest in a crowdfunding securities offering; however, other SEC rules are in place to protect investors, namely, limitations on the amounts individual investors are allowed to invest in all Regulation Crowdfunding offerings over the course of a 12-month period. Such limitations depend on an individual’s net worth and annual income.

The rule states that if either a person’s annual income or his net worth is less than $100,000, then during any 12-month period, he can invest up to the greater of either $2,000 or 5% of the lesser of his annual income or net worth.

If both his annual income and his net worth are equal to or more than $100,000, then during any 12-month period he can invest up to 10% of annual income or net worth, whichever is lesser, but not to exceed $100,000.

The following table from the SEC offers a few examples:

Investor Annual Income

Investor Net Worth

Calculation

Investment Limit

$30,000

$105,000

Greater of $2,000 or 5% of $30,000 ($1,500)

$2,000

$150,000

$80,000

Greater of $2,000 or 5% of $80,000 ($4,000)

$4,000

$150,000

$100,000

10% of $100,000 ($10,000)

$10,000

$200,000

$900,000

10% of $200,000 ($20,000)

$20,000

$1,200,000

$2,000,000

10% of $1,200,000 ($120,000), subject to $100,000 cap

$100,000

 

Another rule requires that transactions be conducted through a broker or funding portal which complies with the requirements of the Securities Act Section 4A(a) and that each offering can be conducted through only one online platform.

There are other rules regarding companies not eligible to use crowdfunding, as well as limits on advertising, restrictions on resale, and other regulations. Refer to the U.S. Securities and Exchange Commission for all rules and details.

Responsibility and Connectivity

The final important element of the SEC’s crowdfunding rules is the need for disclosure. Companies raising money through crowdfunding must file a Form C with the SEC, provide offering statement disclosure and amendments to the offering statement, provide progress updates, and file annual reports.

In the end, crowdfunding may not be for every startup, entrepreneur, or investor, but it is certainly a dynamic way to find capital or uncover unique investment opportunities in 2016’s dynamic, digital marketplace…as long as you follow the rules.

This article summarizes the rules adopted by the SEC, but is not a substitute for any rule itself. Only the rule itself can provide complete and definitive information regarding its requirements.

Author(s)

Paul Ouweneel
Paul D. Ouweneel, CPA, CFP, CFA
Manager
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