Crowdfunding – Boom or Bust for Entrepreneurs?

Last month, President Obama signed into law the Jumpstart Our Business Startups (JOBS) Act, legislation was designed to help entrepreneurs raise capital with presumably fewer administrative and legal road blocks.

Will the act prove to be a catalyst for job growth? Like anything else, the devil is in the details.  We’ll all have to wait until the SEC releases final compliance regulations in coming months.  However, my guess is that more jobs will initially be created for lawyers who will be asked to help keep entrepreneurs and their risk-sensitive board members away from liability and compliance missteps.

Here are some short answers to questions I’ve received from FOXBusiness.com readers in recent weeks.

What is crowdfunding?

Before the JOBS Act, securities regulations prevented privately-held companies from advertising their securities to the general public.  Now through crowdfunding, entrepreneurial companies can raise capital by selling small amounts of equity to presumably a larger audience of online investors.

Can I solicit potential investors through my own Website?

No.  Despite common perception, crowdfunding regulations don’t allow entrepreneurs to start promoting and selling securities through their own websites. To do so, would violate a long list of state and federal securities laws.  The new legislation requires entrepreneurs to solicit prospective investors only through approved “funding portals,” which will have to comply with upcoming SEC regulations.

Do these portals act like traditional brokers?

Not really. A funding portal will serve as an administrative service that processes the securities purchase transaction and the dissemination of information. However, entrepreneurs may be disappointed when they realize that their offering will essentially compete against all other companies that the portal represents. Currently, portals cannot actively recommend specific investments like licensed business brokers.

How much will my company be able to raise each year? 

Companies, called “issuers,” will be able to raise an aggregate of $1 million each year during a 12-month period.

How much can I raise from any single investor?

The amount entrepreneurs can raise from any single investor depends on the personal financial situation of the investor. The new crowdfunding provisions allow personal investors with annual incomes or net worths that are less than $100,000 to invest the greater of $2,000 or 5% of the investor’s net worth or annual income. Investors with annual incomes or net worths that are greater than $100,000 can invest 10% of annual income or net worth.

What’s the difference between investor qualification for a crowdfunding deal and accredited investors?

Accredited investors, sometimes called “qualified investors,” have annual incomes over $250,000 and a net worth of $1 million or more. The value of a primary residence cannot be included in the net worth calculation.

Suppose an investor lies about his or her financial situation in order to buy shares in my hot company?

This is the issue that worries the SEC, company founders, board members and corporate attorneys.  If investors make money, everyone is happy. But when investors lose money, opportunistic plaintiff attorneys will look aggressively for errors in company disclosures.

The SEC is expected to weigh in soon on just how companies and portals will collect personal financial information from crowdfund participants.

What are the reporting obligations of companies?

For offerings less than $100,000 in a 12-month period, companies are only obligated to provide in-house prepared financial statements. For offerings between $100,000 and $500,000 in a 12- month period, companies are obligated to produce financial statements that have been “reviewed” by an outside accounting firm. And for offerings greater than $500,000 in a 12-month period, companies are obligated to provide audited financial statements. Entrepreneurs should understand the extra costs associated with conducting annual audits in terms of management time and professional service fees before crossing this last funding threshold.

What’s the venture capital world think of crowdfunding?

There are other aspects of the JOBS Act that excite angel investment clubs and VC funds. The act relaxes several rules that will make it easier and less costly for growth-oriented companies to go public, which helps VCs cash out their investment stakes hopefully at a nifty profit.

With regard to crowdfunding, astute investors will be cautious in their due diligence and not add capital to companies that may have disputes with prior round shareholders. Traditionally, VC fund managers shy away from deals in which there are too many small or perhaps financially unsophisticated shareholders that could prove a nuisance in coming years.

Who can benefit most from crowdfunding? 

So far, I like crowdfunding best for for-profit, social entrepreneurs to appeal to investors who may not be as rigorous about disclosure and investment performance as purely financially-motivated investors. I also like the concept of crowdfunding for project-oriented entrepreneurs who want to fund a film or an initiative with a relatively short-term investment horizon.

Technology and other high-aspiration entrepreneurs who expect to raise multiple rounds of funding should pursue crowdfunding to non-accredited investors with caution.  It’s too easy for ambitious entrepreneurs to raise a first round of funds at a relatively high per share valuation to less astute investors and then face harsher per share deal terms when they are desperate to raise a larger round of capital from more sophisticated investors. This situation – called a down round – happens when entrepreneurs haven’t quite delivered on their revenue growth forecasts.

Are there any ‘gotchas’ to crowdfunding?

Entrepreneurs may also have a harder time enticing high caliber business professionals to join a crowdfunded company’s board of directors until the liability issues and limits of directors and officer liability insurance coverage becomes clearer.  I probably wouldn’t join the board of directors of a for-profit company that plans to use crowdfunding as a capital raising tool until the final regulations are in place and portals can demonstrate that they have adequate systems infrastructure to manage transactions for a broad investor audience.

Another nasty gotcha is for overly eager entrepreneurs to lose potential patent rights by disclosing too much of their inventions in crowdfunding solicitations before filing patent applications in the U.S. or in other countries.

Any last recommendations?

Startups and companies up to five years old are the source of sustainable job growth in America.  Modernizing securities laws in order to expand capital availability for entrepreneurs is a good thing, provided of course that both buyer and seller beware.

Susan Schreter is a 20-year veteran of the venture finance community and entrepreneurship educator.  Her work is dedicated to improving startup longevity in rural, urban and suburban America.   She is the founder of www.takecommand.org, a community service organization that offers the largest centralized database of startup and small business funding sources in the U.S.   Follow Susan on Twitter @TakeCommand.