Introduction
Crowdfunding is the collective effort of individuals who network and pool their money, usually via the internet, to support efforts initiated by other people or organizations1. Crowdfunding is used in support of a wide variety of activities, including disaster relief, citizen journalism, support of artists by fans, political campaigns, and increasingly for startup company funding2.
Crowdfunding can also refer to the funding of a company by selling small amounts of equity to many investors. This form of crowdfunding has recently received attention from policymakers in the United States with direct mention in the JOBS Act; legislation that allows for a wider pool of small investors with fewer restrictions3. While the JOBS Act awaits implementation, hybrid models, such as Mosaic Inc.4, are using existing securities laws to enable the public in approved states to invest directly in projects as part of a crowd.
The table below provides a summary of the key regulatory provisions and how they may apply (pending final approval) to those endeavoring to integrate this funding source. This article addresses both opportunities and key concerns and what banks and financial services firms need to do to ensure compliance.
Crowdfunding is a source of investment seed money, and if the proposal is adopted by the Securities and Exchange Commission (SEC), this would mark a major shift in how small U.S. companies can raise money in the private securities market.
Private companies are currently allowed to solicit only accredited investors – those with a net worth of at least $1 million, excluding the value of their homes, or with annual income of more than $200,000. The crowdfunding rule would let small businesses raise up to $1 million a year by tapping unaccredited investors.
It remains to be seen if the plan goes far enough in limiting regulatory costs (mainly associated with filings and compliance) so that small businesses find crowdfunding desirable. The measure would still impose a number of disclosure rules and other requirements on small companies and crowdfunding intermediaries5.
Title II (506(c))
Title III Regulation Crowdfunding (Reg.CF)
(proposed)
Title IV Regulation A+
(Reg.A+) (proposed)
Tier1
Tier 2
Offering Cap
None
$1 million
$5 million
$50 million
Type of Securities
No limitations
No limitations
Equity, debt or debt convertible into equity (or guarantees thereof)
Transferability
Restricted securities subject to Rule 144 holding periods (one year for non-affiliates)
Restricted securities for one year
Freely transferable
State Preemption
State preemption subject to state notice filings
State preemption
Required to comply with all applicable state securities laws
State preemption
Investor Qualification
Accredited Investors only
General public
General public
Investor Limits
No limitation
Greater of $2k or 5% of annual income or net worth if <$100k;10% of annual income or net worth if $100k or greater capped at $100K
No limitation
10% of annual income or net worth
Section 12(g)
Reporting Cap
Up to 500 general public and 2,000 accredited investors before Securities and Exchange Commission reporting required
Reporting requirements do not apply
Up to 500 general public and 2,000 accredited investors before SEC reporting required
Sales Disclosure
No requisite offering document – usually a Private Placement Memorandum (PPM) (subject to anti-fraud rules)
Form C
Form 1-A Offering Circular
Ongoing Disclosure
None
Form C-AR
Form 1-Z within 30 days after termination or completion of offering
Annual, semi-annual and current reporting requirements
Financial Statements
No requisite financial statements (subject to anti-fraud rules)
Generally Accepted Accounting Principles (GAAP) financial statements for past two years; tax returns if raising $100k or <; reviewed if raising > $100k up to $500k;
audited if raising >$500k
GAAP financials for past two years (only need to be audited if already available)
Audited GAAP financial statements for past two years
SEC Approval
None required
None required
SEC must affirmatively qualify offering prior to any sales
Testing the
Waters
Not applicable
Sales disclosure must go through the funding portal, limited advertising of portal offerings allowed outside of portal
Solicitation of interests permitted prior to offering as long as solicitation materials filed with the SEC at time of sale
Bad Actor
Disqualification
Bad actor participation disqualifies offering
Bad actor participation disqualifies offering
Bad actor participation
disqualifies offering
Accredited Investor verification
Must take “reasonable steps” to ensure investor is accredited
Not applicable
Not applicable
Electronic Filing
on Electronic Data Gathering, Analysis and Retrieval (EDGAR)
Only Form D required after initial close
Form C and ongoing disclosure requirements
Form 1-A
Form 1-A and ongoing disclosure requirements
Portal Broker-Dealer (BD) Registration
Funding portal must be registered broker-dealer in order to receive transaction based compensation
Can be registered funding portal or broker-dealer in order to receive transaction based compensation
Compensated solicitors must be registered broker-dealers to receive transaction based compensation
12(a)(2) Liability
Private civil fraud liability
Private civil fraud liability
Private civil fraud liability
10b-5 Liability
SEC/private anti-fraud liability
SEC/private anti-fraud liability
SEC/private anti-fraud liability

 

Crowdfunding
Essentially, online crowdfunding platforms (CFPs) provide a funding mechanism that facilitate the exchange of money, goods or services between funders and fundraisers. Their power lies in the fact that, by operating through the internet, they make it possible for large numbers of disparate, individual investors to pool together their resources to fund specific projects. The sorts of returns that these funders receive on their investment may vary greatly according to the business model adopted by the specific CFP. Some platforms offer investors the chance to earn a conventional fixed interest rate; others provide funders with compensation in the form of some type of equity or profit-share arrangement. As a further alternative, some platforms also allow fundraisers to provide non-monetary payoffs, such as a first-edition release of the product being funded.
The SEC and Financial Industry Regulatory Authority (FINRA) proposals set out rules to introduce the concept of utilizing CFPs for raising seed capital. Seed capital can be distinguished from venture capital in that venture capital investments tend to come from institutional investors and tend to involve significantly more money, an arm’s length transactions, and much greater complexity in the contracts and corporate structure that accompany the investment. Seed funding can involve a higher risk than normal venture capital funding since the investor does not see any existing projects to evaluate for funding. Hence, the investments made are usually lower (in the tens of thousands to the hundreds of thousands of dollars range) as against normal venture capital investment (in the hundreds of thousands to the millions of dollars range) for similar levels of stake in the company6.
Trends
Although still in its infancy, the crowdfunding industry has managed to attract a significant number of investors from across the globe. Current estimates put the amount of money raised in 2012 alone at $2.2 billion (€1.6 billion), with forecasts for continued growth over the coming years.
According to a 2012 report by Massolution, over 55% of all successful crowdfunding campaigns originated in Europe (North America accounted for approximately 48% of the rest), with the latest estimates suggesting that over 650,000 different crowdfunding campaigns were launched in 2011 alone7.
The fact that most funders who give to online crowdfunding campaigns in Europe still do not receive (or expect) a significant monetary return on their investment suggests the value of the emotional and ethical returns from CFPs outweigh the profit considerations.
Fred Wilson, co-founder of the venture capital firm Union Square Ventures (which has invested in Twitter, Inc., Tumblr, Inc., Foursquare Labs. Inc. and Zynga, Inc.), predicts that once it gets up and running, the equity crowdfunding market will reach $300 billion and will be largely driven by families and individuals investing a small percentage of their assets via crowdfunding. As a point of comparison, a study from  Crowdsourcing LLC reports that about $1.5 billion was raised from 452 crowdfunding platforms in 20118.
Opportunities
Crowdfunding impacts no group more than it does venture capitalists (VC). Companies that crowd fund typically raise $1 million or less. This is the sweet spot for VCs. For the vast majority of VCs, it is both difficult and time consuming to generate quality deal flow. This is where great equity crowdfunding sites come in: a well curated site saves time, and extends the reach, for VC investors. This allows the investor to focus all their efforts on due diligence, which will ultimately yield a higher return on their time. Furthermore, the diligence materials available on an online platform should be detailed and organized, as crowdfunding platforms have to aggregate a company’s materials before it raises on the site. The availability of these diligence materials alone – of businesses that have already survived a strong crowdfunding site’s stringent internal review process – can save VC countless hours, allowing them to focus on their own due diligence9.
Concerns
William Galvin, Secretary of the Commonwealth for Massachusetts, is concerned about crowdfunding risks and has sent a letter to the SEC identifying crowdfunding’ s many pitfalls. Mr. Galvin writes:
“While this picture of the potential benefits of crowdfunding is undeniably attractive, as regulators we must be vigilant that the exemption will not become a tool for financial fraud and abuse…Unscrupulous penny stock promoters have used misrepresentations to market obscure and low-value stocks to individuals, often through pump and dump schemes. These kinds of fraud operators have not gone away.”
By its nature, crowdfunding appeals to a less sophisticated investor who will invest in any project they think will be “the next Facebook”. Typical crowdfunding investors, even with basic disclosure requirements for participation, won’t have the investment savvy to determine whether an investment is real or a fraud. Many fraudsters and scam artists are brilliant at presenting their investments on paper to meet the very basic disclosures of crowdfunding10. Broader Anti-Money Laundering (AML) concerns are addressed under the SEC bad actors rule11.
While unintentional, crowdfunding is tailor made to assist fraudsters in duping unsophisticated “investors.” Indeed, even if the SEC, in an attempt to avert fraud, increases the amount of disclosures, the individual investment contributions will still be too small for law enforcement authorities to expend resources to investigate or for attorneys to take on a fraud lawsuit, unless of course a contingency business litigator can bring a class action.
Galvin specifically noted:
“The typical crowdfunding offering will be small (many may be far below $1 million), so there is the great risk that these offerings will fly under the radars of many regulators.”
Even more disconcerting is the impact of social networking and potential fraudulent schemes through crowdfunding. Galvin writes:

“We expect that various kinds of social media will be used in tandem with crowdfunding. This may involve forums or message sharing through a portal’s website; it may involve current social media channels (especially Twitter® and Facebook®); and is likely to involve new channels and technologies…There is the great risk that pump and dump operators will use social media to improperly promote these offerings.”

Furthermore while crowdfunding requires certain minimum disclosures, people seeking funds via crowdfunding portals will not have to adhere to the same level of disclosure as normal businesses with a prospectus. Galvin continues:
“In this segment of the market, company information may be limited or simply false, and investors typically lack investment sophistication and are often insufficiently cautious.”

Conclusion

As with many new technology advancements early adopters can benefit from enhanced earnings spreads while assuming the cost of the previously unknown business risks. Conversely, later adopters may benefit from the internal control “lessons learned” and possibly drive down the spread until such time as the product or channel becomes a plain vanilla offering.
As its use will likely continue to grow exponentially through the end of the decade, The two greatest challenges facing firms today in implementing a crowdfunding platform are compliance related rather than technological. Specifically, the due diligence regarding the management capability and integrity of companies seeking funding and the education and monitoring of small investor investment portfolios.

Footnotes:

  1. Ordanini, A.; Miceli, L.; Pizzetti, M.; Parasuraman, A. (2011). “Crowd-funding: Transforming customers into investors through innovative service platforms”. Journal of Service Management, Vol. 22, Issue 4.
  2. ”Welcome to The crowdfunding Wiki!”. Michael Sullivan and pbworks consensus group: http://crowdfunding.pbworks.com/w/page/10402176/Crowdfunding
  3. ”What Is Crowdfunding And How Does It Benefit The Economy”. Tanya Prive, November 27, 2012, Forbes: http://www.forbes.com/sites/tanyaprive/2012/11/27/what-is-crowdfunding-and-how-does-it-benefit-the-economy/.
  4. Mosaic is a solar project finance company based in Oakland, California. Founded in 2010, Mosaic enables Crowdfunding of loans for solar development projects. Source: Wikipedia.
  5. “The Matrix: Crowdfunding and other JOBS Act Exemptions,” Seyfarth Shaw LLP, January 9, 2014:  Shaw: http://www.calstockexchange.com/wp-content/uploads/2012/08/TheMatrixCrowdfundingandotherJOBSActExemptions010914.pdf.
  6. Source: Wikipedia: http://en.wikipedia.org/wiki/Seed_funding.
  7. ”Crowdfunding and civic society in Europe: A profitable partnership?” Matthew Hollow, Academia.edu: http://www.academia.edu/3415172/Crowdfunding_and_Civic_Society_in_Europe_A_Profitable_Partnership
  8. ”Top 10 Crowdfunding Sites,” Kara Scharwath, July 16, 2012, Triple Pundit: http://www.triplepundit.com/2012/07/emerging-next-generation-crowdfunding-platform-roundup/
  9. “Crowdfunding – Why Angels, Venture Capitalists and Private Equity Investors All May Benefit,” Ryan Caldbeck, August 7, 2013, Forbes: http://www.forbes.com/sites/ryancaldbeck/2013/08/07/crowdfunding-why-angels-venture-capitalists-and-private-equity-investors-all-may-benefit/
  10. “Crowdfunding: Potential Legal Disaster Waiting to Happen,” Eric Savitz, November 22, 2012, Forbes: http://www.forbes.com/sites/ericsavitz/2012/10/22/crowdfunding-potential-legal-disaster-waiting-to-happen/.
  11. ”Disqualification of Felons and Other “Bad Actors” from Rule 506 Offerings,” Release No. 33-9414; File No. S7-21-11, Securities and Exchange Commission: http://www.sec.gov/rules/final/2013/33-9414.pdf
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