When people mention crowdfunding, the most common response is, “oh yeah, like that Kickstarter thing.” Rewards-based crowdfunding is now just the tip of the iceberg; there is also peer-to-peer lending, equity crowdfunding (for accredited investors and soon to be available for unaccredited investors as well), donations-based crowdfunding, debt crowdfunding, and intrastate crowdfunding. The average person may be unfamiliar with the number of options and opportunities available. Set in motion in the US by the JOBS Act in 2012, crowdfunding has taken off. Below are some facts and write ups to delve a bit deeper into this new fintech space.
-Risks associated with investing in startups – this is a high risk area to invest in and thus has both a large potential upside, but also a large potential downside; the risk of loss of investment (the greatest risk of this investment class). High risk offers the chance at high rewards, but at the price of larger outcome variance – anything from loss of investment, to backing the next Facebook, or so called “unicorn,” is potentially possible.
–Diversification Risk – only 10% – 20% of startups succeed (“The Major Reasons Startups Fail”), so, it is recommended that you diversify your startup investment portfolio to increase your chances for investment success.
–Fraud Risk – maybe part of the reason it has taken the SEC so long to finalize the JOBS Act is to try to find a systemic way to deter fraud from this investment sector. It is predicted that some of the deals on crowdfunding entities may end up being frauds, and it is recommended that investors do as much due diligence on the startups they want to fund as possible before investing.
–Liquidity Risk – many startup investment opportunities require investment periods of up to 6 or 8 years before there is a chance for an exit through an IPO or an acquisition; sellers have to wait a year before being able to sell privatized securities.
–Loss of Investment Risk – possibly the largest risk associated with startup investing is that the company doesn’t make it and goes bankrupt; you then lose the amount invested. It is important to work with a crowdfunding entity that does a good job carrying out the proper due diligence alongside your own due diligence to ensure the best possible outcome.
-Opinions on Models & Perceived New Opportunities-
-Rewards/Donations-Based; Equity-Based (Accredited – Title II); Equity-Based (Non-accredited – Title III); Peer-to-Peer Lending; and Intrastate
-There seems to be a positive correlation between the stage of growth a business is in and the type of crowdfunding that fits best. There is also an observed positive correlation between the growth stage a company is in and the amount of SEC filings and oversight required. Earlier stage businesses seeking to raise up to $1M might be best off raising money through either a rewards/donations based model; a peer to peer lending campaign model; or a Title III crowdfunding model once the SEC releases their final rulings. The next step in growth might be for those companies looking to raise somewhere from $1M to $50M. These companies could benefit from the previously listed forms of crowdfunding, but could also have the added benefit of crowdfunding from a possibly larger pool of Regulation A+ investors. These fundraising campaigns allow investors to fundraise up to $20M (in Tier 1 of Regulation A+) or $50M in Tier 2. Lastly, companies seeking to fundraise more than $50M could use the previously listed crowdfunding models, but might be best off with a Title II type offering for accredited investors’ which does not have an investment cap. This may be the last step for some, but for others, the next logical step could be to seek additional funding from the public market if your company next released an IPO.
-Title III investment minimums should be kept as low as possible to encourage risk diversification.
-America should consider incentivizing startup investing like they are doing in the UK. There they have tax incentives called the Enterprise Investment Scheme (EIS) and the Seed Enterprise Investment Scheme (SEIS). Benefactors of these tax incentives can gain from tax relief of up to 50% of the cost of the shares invested. This is a huge stimulus to invest in startups and could help take some of the sting away for investors scared to lose their investment capital if implemented in America.
-Crowdfunding can be seen as a needed supplement to municipal bonds. Municipal bonds will not be replaced by crowdfunding for the big ticket items, but can help speed up the process to get smaller projects – the community is pushing for – funded.
-Complicated fee structures are a nuisance. I like it when sites have a simple 5% – 10% rate or at least keeping the quantity of fees down; people are looking for ease of use.
–Opportunities – Secondary market for Title II’s that have already been on the market for one year to
address liquidity risk. This will encourage both investors and more small businesses to enter the space. PeerRealty (with their CFX platform to be implemented in September) and France’s Alternativa are already implementing secondary markets and New Zealand’s Snowball Effect is working on one as well.
-Investment fund where investors could choose certain startup types they are interesting in investing in to address the diversification risk issue; like a mutual fund for pre-IPO securities.
-Investors Security Fraud Bond – an insurance product by John Vassiliw of Walnut Street Brokerage, could help bring some investors that would otherwise be more skeptical about investing into the market
-One word everyone seems to be talking about in this industry; transparency. This is the one thing that makes the crowdfunding movement especially appealing when compared to more traditional forms of finance. Transparency, ease of use and quickness are all key draws into this new fintech space.
-Types of Crowdfunding –
- Rewards / Donations-Based – incentivized investing; receive early prototype (or cheaper than retail pricing) of a product in exchange for a small investment; for donations one may receive a personalized thank you note in exchange for support of nonprofit or cause; no sales of securities
-State level anti-fraud regulations (not SEC regulated)
- Securities to Accredited Investors (Title II) – companies using this crowdfunding method sell a certain percentage of their equity for larger investments in hopes of quickening the growth process of their business ; these companies are typically larger and further along the growth spectrum than those seeking rewards-based crowdfunding; these are sale of securities to accredited investors (through deal specific special purpose vehicles)
-SEC regulated (no action letters protect websites from being public offerings)
-Bad actor disqualifications applies for all issuers & crowdfunding sites themselves
- Securities to the Public (Title III) – sales of securities to the general public; awaiting SEC final rulings on this title of the jobs act
-Extensive SEC regulation; currently illegal until SEC rules are finalized
- Peer-to-Peer Lending – registered borrower payments dependent notes to the general public (25 states only) or private placement; typically to consolidate debt or refinance
-SEC registered securities; not really crowdfunding
-Bank regulations; not legal in several states due to blue sky restrictions. Private placement have blue sky preemptions
- Intrastate Crowdfunding – public offerings to residents of a single state-exempt from SEC rules under Securities Act 3(a)(11) exemption/rule 147; can sell securities within a certain state to residents of said state
-Regulated by the state
-Now allowed in Alabama, Arizona, Colorado, Florida, Georgia, Idaho, Indiana, Kansas, Kentucky, Maine, Maryland, Massachusetts, Michigan, Mississippi, Nebraska, Oregon, Tennessee, Vermont, Virginia, Washington, and Wisconsin
–Rewards/Donations based – Kickstarter, Indiegogo, SellABand, PledgeMusic, RocketHub, YouCaring
–Securities to Accredited Investors (Title II) – MicroVentures, OurCrowd, RealtyMogul, CrowdCube, FoundersClub, AngelList, RealtyShares, PatchofLand, Seedrs, SharesPost, WeFunder, and iBankersDirect
–Securities to the Public (Title III) – No examples in the US so far – pending SEC ruling; SnowballEffect is selling Title III type investments but is unavailable for investors outside of New Zealand
–Peer-to-Peer Lending – Kabbage, LendingCluib, Prosper, FundingCircle, Kiva, Zopa (UK), RateSetter (UK), AuxMoney (Germany)
–Intrastate Crowdfunding – CraftFund, LocalStake, and Michigan Invests Locally Exemption (MILE)
-Important Legislation –
–506(b) – (preceded 506(c)) companies can sell securities to any number of accredited investors and a handful of other buyers
-don’t have to verify investors’ accredited status themselves
-Cannot advertise the offering publicly (or whats called general solicitation)
–Dodd Frank Act of 2010 – gives the SEC statutory authority over security-based swap transactions
to make the financial systems more transparent and accountable; to end government bailouts funded by tax payers; to prevent risky and abusive financial services practices
-New SEC Office of Credit Rating established to improve accuracy of ratings provided by agencies that
evaluate the financial strength of businesses and governments
–Volcker Rule – restricts the ways banks can invest and regulates trading in derivatives
– Consumer Financial Protection Bureau (CFPB) – is tasked with preventing predatory mortgage lending, improving the clarity of mortgage paperwork for consumers and reducing incentives for mortgage brokers to push home buyers into more expensive loans. The CFPB has also changed the way credit card companies and other consumer lenders disclose their terms to consumers. It requires loan terms to be presented in a new, easy-to-read-and-understand format.
–House Bill 3429 – Illonois Intrastate crowdfunding bill lead by Sponsor Representative Carol A.
– Lower max offering cap, and lower per investor cap
-No longer includes experienced investor concept
–JOBS Act – “Jumpstart Our Business Startup Act,” Sept. 23, 2013 which really got the ball of crowdfunding rolling in the United States
-Cost effective access to capital without overly burdensome regulation
-Inteded to encourage funding of small businesses
–Title I – reopening American capital markets to emerging growth companies
*Title II – access to capital for job creation; equity crowdfunding for accredited investors
–506(c) – allows issuers to advertise offerings; need not have prior relationship with investor; can publicly promote the fact that their raising capital to anyone that will listen; BUT, they have to verify that anyone who actually invests is an accredited investor, and investors must prove they are accredited
-no cap on amount raised
-1 year transfer restriction
*Title III – equity crowdfunding for non-accredited investors
-Required to go through a broker-dealer or funding portal
-Pre-filing with the SEC required before any offer
-1 year transfer restriction
–Title IV – small company capital formation
–Regulation A+ – (AKA mini IPO) new way for private companies to raise money without the headaches of going public or restrictions on private offerings (provision of the JOBS Act)
–Tier 1 – offerings of securities up to $20M in 12 months (with not more than $6M in offers by selling security-holders that are affiliates of the issuer)
-Must pass a state review
-Reviewed financials required
–Tier 2 – offerings of securities up to $50M in 12 month period (with not more than $15M in offers by selling security-holders that are affiliates of the issuer)
-Non accredited investors can invest no more than 10% of their income or new worth / annual income
-Audited financial statements required
–Title V – capital expansion
–Title VI – outreach on changes to the law
–Sarbanes-Oxley Act – new or expanded requirements for all US public company’s boards, management and public accounting firms
-in wake of ENRON & Worldcom
–SEC Rule 147(17 CFR 230.147) – safe harbor rule allowing intrastate offerings
-80% of revenue must be funded and used within the state
-any resales during offering period of 9 months must be within the state
-needs update to allow for internet funding since this conflicts with the intrastate wording as rule is currently stated
–506(c) vs. 506(b) –
-506(b) – cannot use general solicitation; financial statements required; up to 35 non-accredited investors
-506(c) – can advertise and solicit the offering; accredited investors only
–Broker-Dealer Vs. Funding Portal – “although not all “Portals” are Broker-Dealers (“BD”), BDs are – by definition under the JOBS Act in Title III, Section 304.(a)(h)(2) – already considered to be Portals. Thus these Best Practices are for the operation of a platform (as defined in c. below) regardless of whether it is operated by a Broker-Dealer or by a Registered (non-BD) Portal (“RP”). BDs may offer both Title II and Title III offerings on their platforms, whereas RPs are limited to Title III offerings only.” – SEC.gov
–Equity-Based Crowdfunding Vs. Debt-Based Crowdfunding –
-Equity-Based Crowdfunding – offers investors to buy a percentage of the company
-Debt-Based Crowdfunding – offers investors the chance to lend money to a company in the form of debt in exchange for a set amount of interest on that loan
–Tier I Vs. Tier II (Within Reg A+) – no transfer restrictions or holding minimums
-Tier I – $20M cap; reviewed financials; no ongoing disclosure / filing
-Tier II – $50M cap; audited financials; annual, semi-annual, current reports including audited financials
–Title II Vs. Title III (Within JOBS Act) – minimum 1 year holding period
-Title II – limited to accredited investors; no caps on raising funds; no intermediary required
-Title III – investors don’t have to be accredited to invest; capped at $1M of funding; advertising limited to notices and all must be done on the internet
Additional Reading –
-Current Crowdfunding legislation – http://crowdfundinglegalhub.com/
-The JOBS Act – http://www.gpo.gov/fdsys/pkg/BILLS-112hr3606enr/pdf/BILLS-112hr3606enr.pdf
-“4 Tips to Set You Up for Crowdfunding Success” – http://www.entrepreneur.com/article/248473
– “Crowdfunding Grows Up: Co-Investing With The Professionals” –
-“New regulations could dramatically change entrepreneurship in America” –
– “States endorse crowdfunding investors for mom and pop shops” –
-“Why Debt-Based Real Estate Crowdfunding is the Favorite Among Leading Platforms” – http://www.equities.com/editors-desk/personal-finance/real-estate/why-debt-based-real-estate-crowdfunding-is-the-favorite-among-leading-platforms
Terms (Definitions) –
–accredited investor – “has a net worth over $1 million, either alone or together with a spouse (excluding the value of the person’s primary residence) OR
-earned income that exceeded $200,000 (or $300,000 together with a spouse) in each of the prior two years, and reasonably expects the same for the current year” – investor.gov
–Broker-Dealer – “A broker-dealer is a person or company that is in the business of buying and selling securities – stocks, bonds, mutual funds and certain other investment products – on behalf of its customers (as broker), for its own account (as dealer), or both. Individuals who work for broker-dealers – the sales personnel whom most people call brokers – are technically known as registered representatives.” – FINRA
–CFIRA (Crowdfund Intermediary Regulatory Advocates) -non profit (501(c)(6)) that works alongside SEC and FINRA to help establish rules, industry standards & best practices
–CFPA (The Center for Placement Advancement) – tech training & accredited consulting education which has trained nearly 500,000 professionals since its 1967 inception
–Crowdfunding – “the practice of soliciting financial contributions from a large number of people especially from the online community” – Miriam Webster
-“The use of small amounts of capital from a large number of individuals to finance a new business venture. Crowdfunding has the potential to increase entrepreneurship by expanding the pool of investors from whom funds can be raised beyond the traditional circle of owners, relatives and venture capitalists.” – Investopedia
-“the practice of getting a large number of people to each give small amounts of money in order to provide the finance for a business project, typically using the internet” – Cambridge Dictionary
-“Crowdfunding is a method of financing that allows individuals to utilize their personal networks to raise funding for their cause or business. Crowdfunding campaigns can be used to fund non-profit creative projects and causes as well as for-profit businesses. Because crowdfunding is such a vast industry, there are approximately 500 crowdfunding platforms currently in existence focusing on different niches.” – Fundable.com
–FINRA (Financial Industry Regulatory Authority) – “A regulatory body created after the merger of the National Association of Securities Dealers and the New York Stock Exchange’s regulation committee. The Financial Industry Regulatory Authority is responsible for governing business between brokers, dealers and the investing public. By consolidating these two regulators, FINRA aims to eliminate regulatory overlap and cost inefficiencies.” – Investopedia
–Fintech – contraction of the words financial and technology seen a lot in crowdfunding literature
–NASAA (North America Securities Administrators Association) – “A voluntary organization, established in 1919, of securities regulators whose aim is to protect investors who buy securities or investment advice by educating the public, investigating violations of state and provincial law and filing enforcement actions. Membership includes securities regulators from all 50 U.S. states, the District of Columbia, Puerto Rico, the U.S. Virgin Islands, Canada and Mexico.” – Investopedia
–NASD (National Association of Securities Dealers) – “The NASD was a self-regulatory organization of the securities industry responsible for the operation and regulation of the Nasdaq stock market and over-the-counter markets. It also administrated exams for investment professionals, such as the Series 7 exam.” – Investopedia
–SaaS (Software as a Service) – “A software licensing model in which access to the software is provided on a subscription basis, with the software being located on external servers rather than on servers located in-house. Software-as-a-Service (SaaS) is typically accessed through a web browser, with users logging into the system using a username and password. Instead of each user having to install the software on his computer, the user is able to access the program via the internet. Businesses commonly use software as a service (SaaS) in customer retention management, human resources and procurement. Technology companies, financial services companies and utilities have lead the business world in adopting SaaS technology.” – Investopedia
–SEC (Securities and Exchange Commission) – “A government commission created by Congress to regulate the securities markets and protect investors. In addition to regulation and protection, it also monitors the corporate takeovers in the U.S. The SEC is composed of five commissioners appointed by the U.S. President and approved by the Senate. The statutes administered by the SEC are designed to promote full public disclosure and to protect the investing public against fraudulent and manipulative practices in the securities markets. Generally, most issues of securities offered in interstate commerce, through the mail or on the internet must be registered with the SEC.” – Investopedia
–SIPC (Securities Investor Protection Corporation) – “A nonprofit corporation created by an act of Congress to protect the clients of brokerage firms that are forced into bankruptcy. Members to the SIPC include all brokers and dealers registered under the Securities Exchange Act of 1934, all members of securities exchanges and most NASD members.” – Investopedia
–SMEs (Small Medium-Sized Enterprises) – label can be applied to all companies seeking crowdfunding
–Unicorn – common fintech word for private companies worth more than one billion dollars (such as Snapchat, Uber, Airbnb and SpaceX)