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Finding Capital in the Crowd

In today’s world, technology often innovates faster than lawmakers can legislate. Fast internet speeds, increased mobile internet access, and the popularity of crowd-connectivity websites have created new opportunities for entrepreneurs to raise funds and capital for their business ventures via crowdfunding.

Crowdfunding is the use of a website or other online platform to raise money for a project. Websites like IndieGoGo or Kickstarter allow anyone to upload a project to their site and ask the internet ‘crowd’ to fund it via small donations of $5 to $1,000 or more. Many of these projects offer perks to contributors for donating a set amount, such as recognition in the credits of a film or advance copies of a book. Even stars like Zach Braff of the television show Scrubs have turned to crowdfunding to help them realize their projects. In light of the successes of these projects, the potential upside for entrepreneurs is enormous. Instead of bringing on investors for a share of a business or making costly interest payments to financial institutions, an entrepreneur could solve his expansion needs simply by posting his capital request on an internet website and waiting for people across the world to fund the expansion. However, entrepreneurs should be careful to avoid running afoul of federal and state securities laws.

Entrepreneurs generally can offer discounts, special promotions, or “sneak peaks” in exchange for a contribution to the venture. However, they should avoid offering anything that might resemble debt or an equity interest in their business. If the business must pay it back or provide a share of the profit or income from the business, such a scheme will likely be considered a sale of a security and fall under the reach of federal securities laws.

Currently, entrepreneurs utilizing crowdfunding must comply with the Securities Act of 1933, Securities Exchange Act of 1934, and their accompanying regulations, promulgated by the Securities and Exchange Commission, which impose stringent filing and disclosure requirements prior to an entrepreneur offering his investment to the masses. Failure to comply with these laws can subject an entrepreneur to harsh penalties, including million dollar fines or even jail time. As it stands now, offering an equity or debt interest via an internet site is illegal under federal and Illinois law unless another securities exemption applies.

If entrepreneurs are looking to generate start-up capital using crowdfunding, they should be aware of proposed Securities and Exchange Commission (SEC) crowdfunding rules, which are contained in SEC Commission Release No. 33-9470. The SEC’s proposed rules have been released for a comment period with the final rules expected in late Summer or Fall of this year. Once finalized, the SEC’s crowdfunding rules would allow for simplified disclosures prior to a crowdfunding offering. Note that the crowdfunding rules still require some disclosures, but once made, the entrepreneur is allowed to rely on the internet portal to otherwise comply with securities rules and regulations. The proposed rules also limit the proposed offering to $1,000,000, with participation limits of approximately $2,000 per participant. While the low ceiling on these offerings will dissuade some capital-intensive business ventures, a crowdfunding offering may provide a suitable alternative for some entrepreneurs worried about the onerous control requirements for venture capital investors. For those entrepreneurs requiring larger or faster infusions of capital, Rule 506(c) of SEC Regulation D continues to provide an attractive safe harbor, provided the entrepreneur has the right connections to reach the high income individuals that Rule 506(c) limits offerings to. In any case, from a consumer side and from an entrepreneur’s perspective, crowdfunding bears some consideration in both structuring investments and for raising the business capital necessary to start and grow a business.

In Brief

  • Entrepreneurs can offer discounts, special promotions, or ‘sneak peaks’ via crowdfunding sites.
  • Entrepreneurs cannot offer equity or repayable debt via crowdfunding sites.
  • The SEC is finalizing rules for entrepreneurs to offer equity or debt via crowdfunding sites, but those rules still require disclosures with the SEC.
  • The proposed rules would permit entrepreneurs to raise up to $1,000,000 via crowdfunding websites.
  • The SEC’s rules are expected to be finalized in late Summer or Fall of 2014.