New legislation by Obama and Congress relaxes solicitation
by start-ups
By Jim Brendel
Originally published in Accounting Today
The trendy new term in the high tech arena is “crowdfunding.”
Both the President and Congress jumped on the crowdfunding bandwagon as a way
to show they are doing something about the economy by passing the JOBS Act.
What exactly is crowdfunding? Here’s one introduction through the eyes of a
professional accountant and auditor.
Essentially, crowdfunding is the ability for a large group
of people to band together and make small investments that collectively are
enough to fund a start-up company. Prior to the act, that wasn’t feasible
because the limit on the number of shareholders before having to report as a
public company was 500. The legislation raises that to 2,000. Naturally, this
will be done over the internet, through what the legislation terms “funding
portals.”
It’s a hot topic for businesses because they are always
looking to raise capital. The hard part is figuring out a way to get investors
together. Without some kind of exchange, only tech savvy companies that had a
web-based business could raise money that way. Now several funding portal
websites have risen to fill the crowdfunding void. Anyone, even if not incorporated,
will be able to use crowdfunding. It is only limited by the attractiveness of
your idea and ability to present it.
Kickstarter, CircleUp
and Fundable
The remarkable thing about crowdfunding is how successful
it’s been even though the SEC hasn’t created rules for it; they are not due
until the end of 2012. The appetite for small investments in companies is
proven by the report that the website Kickstarter has raised more than $200 million
for 22,000 product offerings. Two million people have supported these products,
receiving nothing more than what amounts to a digital “attaboy” and maybe a
sample of the product. Investors
are termed “supporters” because they don’t currently receive any ownership in
or financial information about the retail product start-ups. In April, the SEC reminded issuers that
“any offers or sales of securities purporting to rely on the crowdfunding
exemption would be unlawful under the federal securities laws.”
Kickstarter
started all this three years ago. Co-founder Yancey Stricker was quoted as saying that only five
percent of the projects appealing for funding are rejected, while 56 percent of
them fail to meet their fundraising goals. Film fundings are the most
successful projects on the site, with 12 Kickstarter films showing in the
Tribeca Film Festival this year. Company officials say they won’t switch to
equity shares, even when the SEC rules are out.
Here’s a typical reward for supporters of ReAct Theater in
Seattle: For $10, you get an admission to a play in the theater; for only $30,
you receive invitations to cast events and backstage passes; for $250, you can
have dinner with the theater’s board and for $1,000 or more get a special VIP
night with a pre-show dinner, front row seats and drinks after with cast
members.
CircleUp,
on the other hand, offers direct share ownership in consumer product start-ups
in return for your financial support. According to the company’s website, “Your
ownership will be proportional to the amount you invest. As the company grows,
so will your equity investment. This ownership will allow you to receive
distributions when the business is sold or if dividends are paid.” The site
does not offer a rewards model. CircleUp is able to offer equity because they
currently only accept “accredited investors,” who must have $200,000 of annual
income or $1 million in net worth.
Fundable attempts a
combination of both methods. The company said that it will – as required by the
new law – register with the SEC and a yet-to-be decided self-regulatory body as
a broker-dealer before it can sell shares of companies. CircleUp will have to
do the same in order to offer shares to the public. Fundable charges companies
5 percent of every dollar raised. One of its successful products was an
elevation training mask that simulates training at elevation for runners and
cyclists. The product goal was to raise $10,000 and it had raised $14,000 a
month before its deadline. The most popular “reward” level was $75. For that
you got a mask, a beanie and a t-shirt.
To the trained eye, there are some obvious challenges to crowdfunding.
The first and most obvious is the probability that it could be used for
fraudulent activity. The second is that even if investors receive actual shares
of the company once the SEC rules are set, these shares are private and
illiquid, meaning that once you’ve bought them there’s little chance that you
will be able to sell them to someone else. The crowdfunding sites are not
exchanges, just angel investment collectors. The third is that there are few
requirements – if any – to inform investors about what’s happening with the
company. SEC chairwoman Mary
Schapiro has already said that the JOBS Act would weaken investor protection.
SEC attorney John Eckstein of Fairfield & Woods in
Denver notes that crowdfunded shares per the JOBS Act are to be sold in a
transaction which is exempt from registration under the 1933 Act (new Section
4(a)(6)).
“We are all assuming that the shares once they have come to
rest in the hands of an investor will be 'restricted' stock which cannot be
resold unless they are subsequently registered under the 1934 Act or exempt
(e.g. Rule 144 or "Section 4(a)(1 1/2)" type transactions,” Eckstein
says. “The SEC has a lot of regulation writing to do to make the rules for this
new exemption clear and facile for the use by issuers, intermediaries,
investors, and service providers such as accountants and lawyers. Many things
are yet to be determined.”
Eckstein says there is a political battle for the right to
be the self-regulatory agency over portals.
“FINRA (Financial Industry Regulatory Authority) would
certainly like the job, but there is at least one new portal trade association (Crowdfund
Intermediary Regulatory Association) trying to form to do the job. My bet is on
FINRA, which is also trying to get the job of regulating registered investment
advisers after Dodd-Frank, but there are reasons why FINRA may not be the best
public policy choice,” Eckstein says.
Crowdfunded companies that raise more than $1 million during
one 12-month period or have more than 500 shareholders will have to register as
public companies and begin public reporting. Until then, these new looser
regulations will no doubt allow some winning companies to emerge. They will
probably be in the minority however, as some real stinkers emerge a year or two
after they receive funding. Of course, that’s the nature of venture investing.
About the author
James Brendel, CPA, CFE, is the national director of audit and
accounting for Hein & Associates LLP,
a full-service public accounting and advisory firm with offices in Denver,
Houston, Dallas and Orange County. He specializes in SEC reporting and assists
companies with public offerings and complex accounting issues. Brendel can be
reached at jbrendel@heincpa.com or
303.298.9600.
