Democratizing Entrepreneurship: An Overview Of the Past, Present, and Future of Crowdfunding
By Heather L. Traeger, Theodore W. Kassinger, and Zachary D. Kaufman, O’Melveny & Myers LLP
Entrepreneurs face challenges raising capital to fund the development of new ideas in the United States because of regulatory constraints,
primarily those imposed by the Securities Act of 1933 (“Securities Act”). Although avenues exist for entrepreneurs to seek financing, funders typically hold the purse strings tightly and release them selectively. Crowdfunding is a promising method of raising capital that allows an entrepreneur to shop his or her idea to a greater audience of potential investors without running afoul of the Securities Act‘s constraints.
Traditional funders, such as venture capitalists, refused to finance an idea by Eric Migicovsky and his colleagues at Pebble Technology to develop Internet-connected, customizable wristwatches.1 These watches could link via Bluetooth to, and display information from, smartphones and could also function as cycling or running computers or remote controls for playing music.2 So, on April 11, 2012, the Pebble team turned to Kickstarter, a crowdfunding platform, through which they asked the public to pledge a total of $100,000 to the team’s idea. Just 37 days later, Pebble had attracted 68,929 “backers”3 of its watch and had raised over 100 times its request: $10,266,845.4
Six days before Pebble launched its Kickstarter venture, President Obama signed into law the Jumpstart Our Business Startups Act (“JOBS Act”).5 The White House stated that the legislation “will allow Main Street small businesses and high-growth enterprises to raise capital from investors more efficiently, allowing small and young firms across the country to grow and hire faster.”6 The JOBS Act contains a provision entitled “Capital Raising Online While Deterring Fraud and Unethical Non-Disclosure Act of 2012” (“CROWDFUND Act”),7 which is designed to facilitate the non-traditional type of financing Pebble used to such success.8 Essentially, the CROWDFUND Act lessens the regulatory burden on small businesses, particularly the extensive obligations imposed pursuant to the Securities Act as amended by the Sarbanes-Oxley Act,9 to potentially enable these businesses to raise funds quicker and from a wider variety and greater number of sources. Beyond businesses like Pebble, which pursue the traditional entrepreneurial goal of financial profit, the CROWDFUND Act could also significantly benefit “social entrepreneurs.”10 At the same time, in an environment of less regulatory requirements and on-line promotions, potential investors considering crowdfunding offerings must be especially wary of the potential for fraud.11
In this article we explore crowdfunding — its history and its potential future — particularly in light of the CROWDFUND Act, with its stated purpose of facilitating capital formation in the United States. Part A of this article briefly describes the definition, rationale, and practice of “crowdfunding,” noting its distinction from investment clubs and its various types. Part B provides an overview of the CROWDFUND Act, particularly its key provisions, relationship with state laws, and the status of related rulemaking by the Securities and Exchange Commission (“SEC”) and the Financial Industry Regulatory Authority (“FINRA”). Part C considers the impact of the CROWDFUND Act on entrepreneurs’ crowdfunding activities, both before and during the offer or sale of securities. Part D reflects on criticisms of crowdfunding generally and the CROWDFUND Act specifically. Finally, Part E discusses how entrepreneurs and their legal representatives may want to help shape the crowdfunding process moving forward.
A. Crowdfunding: Definition, Rationale, and Practice
1. What is ‘Crowdfunding’?
U.S. Congressman Peter McHenry, member of both the U.S. House Financial Services Committee and the U.S. House Committee on Oversight and Government Reform as well as a sponsor of the original crowdfunding legislation in the U.S. House of Representatives, describes “crowdfunding” as “essentially the ability of individuals to pool their money in support of a common cause. Crowdfunding has traditionally taken place in the realm of charity or the arts, but through online communities and social networking, it could have positive implications for America’s small businesses and investors.”12 Tom Szaky, chief executive of the social enterprise TerraCycle,13 even more succinctly defines the phenomenon as “a way for people anywhere (‘the crowd’) to use the Internet to find and finance endeavors they believe in.”14
Entrepreneurs have historically relied on three main types of mechanisms to acquire seed funding: appealing to venture capitalists and other “accredited investors,”15 entering business plan competitions, and self-financing. By design, these mechanisms are limited in terms of the potential number of enterprises that can secure funding and the potential amount of money that each can raise. Moreover, the first two mechanisms often require significant time and effort to pursue and the third entails personal financial risk on the part of the entrepreneur.
Crowdfunding can be used as an alternative or supplement to these more traditional means of raising capital. Crowdfunding engages a wider array of donors, who may choose to support a greater number of enterprises and who may contribute more funds and possibly do so more quickly and with less effort by and risk to the entrepreneur. Not only does crowdfunding provide a mechanism to entrepreneurs of raising capital, but it also provides an opportunity for investors — including those with limited means — to purchase equity in enterprises they would like to support or think will be profitable. Because of the way it facilitates both groups’ respective interests, crowdfunding democratizes entrepreneurship.
2. Crowdfunding Directly and Indirectly
There are several kinds of crowdfunding entrepreneurs could pursue based on the type of enterprise, the amount of funding sought, and the timeframe for the capital campaign. Many entrepreneurs employ crowdfunding directly. Political campaigns also increasingly use crowdfunding directly. Some third parties, like Kickstarter, facilitate crowdfunding indirectly, but may do so for a fee.16
The appendix to this article contains a list of such third parties, some of which specialize in particular categories of enterprises, like consumer products (including mobile apps and other technology), non-profit organizations, poverty alleviation, healthcare, and food.17 The appendix includes the self-described purpose for each of these online crowdfunding platforms.
3. Crowdfunding Types
There are two primary types of crowdfunding.18 One is crowdfunding for donations, which involves simply collecting contributions with no promise of return on investment (“ROI”). This form of crowdfunding — often used for charitable purposes — is and has been legal; both entrepreneurs and third-party platforms have lawfully employed this fundraising mechanism. The other main kind of crowdfunding is crowdfunding for investments, which involves soliciting investment capital and providing equity.19 It is this latter kind of crowdfunding that is the subject of the CROWDFUND Act. In fact, some have argued that “crowdraising” is a more appropriate term for this phenomenon of crowdfunding for investments, to help distinguish it from the existing, legal form of crowdfunding for donations.20
This second type of crowdfunding — for investments — can be divided into “impact bonds” and “impact stocks,” either of which is transferable among investors. Third-party social enterprise crowdfunding platform Impact Trader defines impact bonds as those that provide no interest or ROI but do allow the investor to retake the original amount invested; impact stocks are those that provide investors with actual ROI.21
B. The CROWDFUND Act
1. Key Provisions
As crowdfunding has expanded, it has increasingly come within the scope of the securities laws. In particular, crowdfunding raises funds by offering securities to the general public.22 The Securities Act regulates the registration and offering of the sale of “securities.”23 It requires that potential investors receive financial and other information about securities offered for public sale (i.e., a “public offering”) and prohibits fraud in the sale of securities.24 Section 5 of the Act prohibits the offer or sale of any security unless a prospectus containing the prescribed disclosure is delivered and a registration statement is in effect, except where an exemption is available for the transaction or class of securities.25 The Securities Exchange Act of 1934 (“Securities Exchange Act”) sets forth requirements for registration of a class of securities, regulates the trading of securities, and regulates brokers.26
The CROWDFUND Act amended the Securities Act and the Securities Exchange Act to insert a “startup exemption”27 for crowdfunding. The CROWDFUND Act permits individuals beyond accredited investors to invest in start-up ventures. In addition, although maximum fundraising is limited, it potentially lightens the administrative burden on entrepreneurs who elect to raise capital under this new registration exemption by reducing the type, number, and scope of SEC filings and disclosures that are likely to be required. In other words, the CROWDFUND Act allows entrepreneurs to engage in crowdfunding conduct that would otherwise require registration as a public offering.28 Specifically, the CROWDFUND Act added a transaction exemption via new Section 4(6) to the Securities Act. This exemption involves the offer or sale of securities by “issuers,”29 provided that the issuer meets four conditions,30 which are designed to protect investors and in the public interest. First, the aggregate amount of securities sold by the issuer to all investors during the previous 12 months must not exceed $1,000,000. Second, although the number of investors is not limited, the aggregate amount of securities sold by the issuer to a single investor during the previous 12 months must not exceed (i) the greater of $2,000 or 5% of the annual income or net worth of such investor, if either the annual income or the net worth of the investor is less than $100,000, and (ii) 10% of the annual income or net worth of such investor, as applicable, not to exceed a maximum aggregate amount sold of $100,000, if either the annual income or net worth of the investor is equal to or more than $100,000. Third, the transaction must be conducted through a broker31 or funding portal32 that complies with various requirements,33 including that it register with the SEC as a broker or funding portal and with any applicable self-regulatory organization and provide such disclosure as the SEC shall determine appropriate. In addition, the broker or funding portal must ensure that each investor reviews investor-education information, take measures to reduce the risk of fraud and protect the privacy of information collected from investors in such transactions, and make available to the SEC and to potential investors information provided by the issuer. It cannot compensate promoters, finders, or lead generators or prohibit its key staff from having any financial interest in an issuer using its services. Finally, a broker or funding portal must comply with other requirements as the SEC may prescribe.34 The fourth condition is that the issuer itself must comply with various requirements, including that it:
1. file with the SEC, provide to investors and the relevant broker or funding portal, and make available to potential investors:
- the issuer’s name, legal status, physical address, and website address;
- the names of the issuer’s directors, officers, any similar staff, and holders of more than 20% of the issuer’s shares;
- a description of the issuer’s business and anticipated business plan;
- a description of the issuer’s financial condition;
- a description of the issuer’s stated purpose and intended use of the proceeds of its target offering amount;
- the issuer’s target offering amount, the deadline to reach that amount, and regular updates on the issuer’s progress in meeting that amount;
- the price to the public of the securities or the method of determining the price;
- a description of the issuer’s ownership and capital structure; and
- such other information as the SEC may prescribe;
2. not advertise the terms of the offering, except for notices which direct investors to the broker or funding portal;
3. disclose compensation to persons who promote the issuer’s offerings through communication channels provided by a broker or funding portal;
4. file at least annually with the SEC and provide to investors reports of the issuer’s results of operations and financial statements; and
5. comply with other such requirements as the SEC may prescribe.
An entrepreneurial issuer may be liable for material misstatements and omissions.35 In addition, an issuer may be liable for the general anti-fraud provisions of Section 10(b), for registration statement liability pursuant to Section 11, and for rescission of transactions with an unregistered broker-dealer.
Securities issued pursuant to a transaction under Section 4(6) may not be transferred by the purchaser of such securities during a one-year period beginning on the date of purchase, except to the issuer of the securities, to an accredited investor, as part of an offering registered with the SEC, to a family member, or in connection with the death or divorce of the purchaser.
2. Relationship with State Laws
In addition to federal laws regulating the offering and sale of securities, individual states also have their own such laws, popularly known as “blue sky” laws.36 The CROWDFUND Act amended the Securities Act to include securities sold pursuant to the CROWDFUND Act as “covered securities,” meaning that the federal legislation preempted state law and thus states may not require the registration or qualification of, or impose documentation conditions on, such securities.37 In addition, except for the state of the issuer’s principal place of business or any state in which purchasers of 50% of the aggregate amount of the issue are residents, states may not require a filing or fee for relevant securities.38 However, under the CROWDFUND Act, states explicitly preserve their authority to investigate and bring enforcement actions against fraud, deceit, or unlawful conduct involving securities or securities actions in the crowdfunding context.39 The CROWDFUND Act also amended the Securities Exchange Act to insert a prohibition on state enforcement actions against a registered funding portal with respect to its business — except, in certain circumstances, for the state in which the portal’s principal place of business is located.40
3. Status of the SEC’s and FINRA’s Rulemaking
The legal scope and operation of restrictions on crowdfunding for investments have yet to be determined; individuals who pursue unauthorized use of crowdfunding could suffer penalties. As the SEC warned on April 23, 2012: “The [JOBS] Act requires the [SEC] to adopt rules to implement a new exemption that will allow crowdfunding. Until then, we are reminding issuers that any offers or sales of securities purporting to rely on the crowdfunding exemption would be unlawful under the federal securities laws.”41
As provided in the JOBS Act itself, the SEC is required to issue these rules within 270 days of the Act’s enactment on April 5, 2012,42 which will be December 31, 2012. Some observers, however, anticipate that the SEC’s work drafting these rules may continue into 2013.43 The SEC began soliciting general comments about its rulemaking as soon as President Obama signed the JOBS Act,44 but it is not yet known when the public can expect such proposals or submit comments about them.45 In the interim, the SEC has provided some guidance in the form of FAQs about portions of the CROWDFUND Act.46 FINRA, as the only association for registered securities, will be responsible, along with the SEC, for implementing the crowdfunding regime.47 Until August 31, 2012, FINRA solicited public comment on the appropriate scope of its rules that will apply to registered funding portals and member firms engaging in crowdfunding activities.48 Now that its comment period has expired, FINRA is preparing its proposed rules.49 As with the SEC, some observers predict that FINRA’s work could continue through 2013, possibly even into the second half of the year,50 after which the public will have the opportunity to comment on FINRA’s proposed rules. Further, the SEC will have to approve FINRA’s rules after a period of public notice and comment.
C. Impact of the CROWDFUND Act on Entrepreneurs’ Crowdfunding
Even though the SEC and FINRA have not yet promulgated relevant rules, there are a number of compliance items that entrepreneurs will need to satisfy to qualify as issuers. This “to do” list can be divided into objectives entrepreneurs must complete before the offer or sale of securities, and objectives entrepreneurs will have a continuing obligation to undertake during those offers and sales. To meet these requirements and others which the SEC and FINRA may mandate, entrepreneurs must determine whether they have the time and expertise to handle these matters internally or whether they should enlist the assistance of accountants and legal and financial advisers.
1. To Do – Before Offer/Sale of Securities
- Crowdfunding Outside the United States: Entrepreneurs operating abroad should research and then continuously comply with crowdfunding regulations in all non-U.S. jurisdictions in which they operate.
- Crowdfunding Within the United States: Entrepreneurs operating domestically should research and then continuously comply with “blue sky” laws in (a) the state in which their principal place of business is located and (b) if 50% of the purchasers of their issue are residents of a single state and that state is different from where their principal place of business is located, then that state, as well.
- Monitoring Sales of Securities: Because the CROWDFUND Act prohibits the issuer from offering or selling securities if the issuer has already sold specified aggregate amounts to all investors and any single investor during the 12-month period preceding the date of such transaction, issuers must monitor their sales of securities both before and during those offers and sales. Because the aggregate amount of securities permitted to be sold by the issuer to a single investor is a function of the investor’s annual income or net worth, entrepreneurs must take steps that the SEC stipulates to ensure that no investor exceeds these investment limits. Of course, entrepreneurs are limited in their ability to ascertain the financial details of third parties, so entrepreneurs may seek to shift the burden to investors themselves. One way to do so would be to require potential investors to disclose their annual incomes or net worth, or else to certify, for example, that 5% of those figures do not exceed $2,000 and that both of those figures are less than $100,000. Further, the SEC may impose “reasonableness” or other requirements associated with this condition.51
- Assessing Compliance of Broker or Funding Portal with Various Requirements: Because the CROWDFUND Act requires issuers to conduct transactions through brokers or funding portals that comply with various requirements, entrepreneurs must first select a broker or funding portal through which to conduct transactions, and must second assess the compliance of that broker or funding portal with the SEC’s requirements. As with investors, entrepreneurs are limited in the extent to which they can monitor third parties (here, brokers and funding portals), and so may seek to shift the burden to those parties. One way would be to require brokers and funding portals through which entrepreneurs conduct transactions to affirm their ongoing compliance with the SEC’s stated requirements upon entering into underwriting agreements with such entities.
- Setting the Target Offering Amount: Because issuers must set a target offering amount and the deadline to reach that amount, entrepreneurs will need to review such targets and deadlines internally and possibly enlist the assistance of financial experts. In addition, issuers will need to develop mechanisms to track their progress in fundraising.
- Preparing Key Descriptions: Because issuers must provide the SEC, investors, and the relevant broker or funding portal with various descriptions (pertaining to, inter alia, names of key staff and shareholders, current and anticipated business, the financial condition of the venture, the purpose and use of proceeds, the securities’ price or method of determining the price, ownership and capital structure), entrepreneurs must prepare to submit such documentation.
2. To Do – During Offer/Sale of Securities
- Monitoring Sales of Securities: See above.
- Assessing Compliance of Broker or Funding Portal with Various Requirements: See above.
- Meeting the Target Offering Amount: Because issuers must provide regular updates on their progress in meeting their target offering amounts, entrepreneurs will periodically need to prepare and submit such reports.
- Reporting and Disclosing: Because the SEC requires issuers to continuously report or disclose at least two categories of information (the issuer’s results of operations and financial statements as well as compensation to certain promoters), entrepreneurs will need to monitor and then prepare and submit such reports.
- Advertising: Because issuers are prohibited from advertising the terms of the offering, except for notices directing investors to the broker or funding portal, entrepreneurs must refrain from including any such information in their direct advertisements and must ensure that third-party advertisers do not include any such information either.
- Monitoring the Federal Register for Changes in Limits Under the CROWDFUND Act : The SEC will adjust the dollar amounts in the CROWDFUND Act at least every five years to reflect any change in the Consumer Price Index. The SEC will publish notice of such adjustments in the Federal Register.52 Entrepreneurs should therefore monitor the Federal Register for such adjustments and then factor those changes into their crowdfunding activities.
D. Criticisms of Crowdfunding
Crowdfunding generally, and the CROWDFUND Act specifically, are not without skeptics, as evident from the numerous comments already submitted to the SEC and published by the press. In this part, we summarize the primary arguments against crowdfunding and some of its operational features.
1. Criticisms of the Concept …
Some critiques of the CROWDFUND Act concern the underlying concept. One concern is that crowdfunding could turn into “crowdfleecing.” A journalist has predicted this potential for abuse: “No question, fraud will occur. If con artists can send you emails that look as if they come from your bank, they will be able to set up counterfeit sites that appear to belong to authentic groups raising capital.”53 An SEC commenter has expressed another concern: for crowdfunding that is not deliberately malicious, equity investors will still suffer because they “simply cannot know enough about the highly risky ventures or the highly complex venture investing process to make informed investment decisions,” particularly with the minimal requirements for public disclosure.54 Moreover, some industry watchers worry that, because the recent financial crisis was caused, in large part, by a lack of regulation, the relaxation in regulation integral to the CROWDFUND Act will only make matters worse.55
2. … And the Devilish Details
Other critiques of the CROWDFUND Act concern the legislation’s details.56 Some SEC commenters caution that the Act’s actual utility may be limited. Considering the amount of time and resources — including through possibly hiring external accountants, auditors, and advisers — and the extent of comprehension and monitoring that will be required to meet the initial and continuing complex requirements of the Act, these commenters suggest that it remains to be seen just how much less burdened entrepreneurs will be in crowdfunding.
One method of alleviating this potential burden, as suggested by SEC commenters, would be for the SEC to promulgate rules that are as simple, inexpensive, specific, and manageable as possible. Although it is unclear to what extent this proposal would increase or decrease issuers’ administrative burden, some SEC commenters have stated that the disclosures enumerated in the CROWDFUND Act are not sufficiently detailed and so have suggested that the SEC require issuers to fill out particular forms — such as the North American Securities Administrators Association’s Form U-7 — or else provide model language or detailed templates which elicit and standardize the type of information required from issuers.
Another method of alleviating this potential burden, also suggested by SEC commenters, would be to increase the financial amounts that trigger certain actions. For example, some commenters have suggested that the annual maximum limit on the aggregate amount sold to all investors by the issuer to qualify for the crowdfunding exemption should be raised from the proposed $1,000,000 to at least $5,000,000 or even $10,000,000 because of the high cost of labor as well as purchasing, manufacturing, and shipping goods. As another example, some SEC commenters have suggested that requiring an audit for a company raising $500,000 annually is unreasonable, given how limited the financial information of that company would be and how much an audit would cost in both time and money. Again, these critics suggest raising the limit — to $1,000,000 per year or even $10,000,000 per year — before triggering a mandatory audit.
Beyond entrepreneurs themselves, some SEC commenters are concerned with how other parties in the process of crowdfunding will fare. For example, such individuals have suggested that the SEC should permit funding portals to charge closing fees. Without such charges, funding portals may not be able to operate because nascent issuers may not have sufficient funds to pay upfront fees.
E. Shaping the Future
As mentioned above, the SEC and FINRA are still in the process of rulemaking for the CROWDFUND Act. The deliberate pace of these agencies’ work, however, should not be interpreted as a lack of interest or priority. According to the director of the SEC’s Los Angeles regional office, Michele Layne, crowdfunding “is an area of concern.”57
Various stakeholders monitor and advocate developments on crowdfunding, and will presumably seek to shape this rulemaking. Two of the most notable stakeholders are the Crowdfunding Professional Association (“CfPA”)58 and the Crowdfund Intermediary Regulatory Advocates (“CFIRA”).59 This process also presents other stakeholders who could be significantly impacted by the CROWDFUND Act with the opportunity to offer input. Entrepreneurs and their legal representatives are well-placed to provide valuable and weighty public commentary to the SEC and FINRA.
Heather L. Traeger is a partner in O’Melveny & Myers LLP’s Financial Services Practice, Theodore W. Kassinger is a partner in O’Melveny’s Integrated Legal Strategies Practice, and Zachary D. Kaufman is an associate in O’Melveny’s Litigation Department. All are resident in the Firm’s Washington, DC office.
The opinions expressed in this article do not necessarily reflect the views of O’Melveny or its clients, and should not be relied upon as legal advice. This article is current as of December 4, 2012.
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