The Real Deal on Crowdfunding

By Susan SchreterBusiness on Main

Will the JOBS Act really help entrepreneurs raise (and save) money? Learn the benefits of this new legislation, as well as what you should look out for.

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Last month, President Obama signed into law the JOBS Act, which stands for Jumpstart Our Business Startups. This legislation moved swiftly through Congress and enjoyed unusual support from Republicans and Democrats. The primary purpose of the legislation is to help entrepreneurs and fast-growing companies sidestep some long-standing securities regulations that prevented entrepreneurs from promoting and selling shares in privately held companies to the general public.

Because many nitty-gritty details associated with the JOBS Act have yet to be worked out by the Securities and Exchange Commission, it’s tough to say if the act will save entrepreneurs any money in terms of legal and accounting bills or help them raise capital from an online audience via “crowdfunding.”

Megan Muir, corporate and securities attorney with DLA Piper, says, “Crowdfunding may open up more opportunities for companies to appeal to a broader audience of prospective investors. However, the relaxed rules don’t lessen the obligations of companies to adequately disclose information about their operations and risks associated with the investment. Misrepresentations in any kind of securities transaction can create significant liability for company officers and directors.”

Here are some key components of the JOBS Act with regard to crowdfunding:

- Investor qualification. While crowdfunding participants don’t have to be high-net-worth accredited investors, a personal investor’s financial status remains important for eligibility. Investors with annual income or net worth less than $100,000 can invest the greater of just $2,000 or five percent of the investor’s net worth or annual income. Investors with annual income or net worth greater than $100,000 can invest 10 percent of their annual income or net worth.

This compares favorably to the SEC’s stiffer criteria for accredited investors, who must have an annual income of $250,000 and a net worth of $1 million, excluding the value of a primary residence.

- Portal requirement. An entrepreneurial company that wishes to sell securities to investors is called an “issuer.” This name can be misleading because entrepreneurs are not allowed to simply set up a website and start “issuing” or selling securities to prospective investors. All solicitation information and transactions must take place through an independent funding “portal.”

“Key issues for the SEC to address are the verification requirements and record-keeping responsibilities of portals and securities issuers regarding crowdfunding participant income and net-worth qualifications. Until all the final regulations are in place, and the obligations of the various parties are spelled out, it’s unclear how portals will price their services or even how many portals will even want to handle transactions with non-accredited investors,” says Muir.

- Maximum offering. Issuers will be allowed to raise up to $1 million in funding during a 12-month period, which is the funding sweet spot for most startups. Funding from institutional investors and high-net-worth accredited investors may be additional sources of capital for growth-oriented companies.

- Accounting obligations. 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, which can give entrepreneurs sticker shock in terms of auditor fees and added administrative burdens associated with preparing financial statements to audit standards.

- Public company disclosure requirements.

ed One of the trickier aspects of the new legislation is the shareholder threshold in which a company must incur all the disclosure costs associated with being a reporting “public company.” The JOBS Act raises the threshold number of shareholders to 2,000 individuals or 500 non-accredited investors. A qualified securities lawyer can help entrepreneurs work through these definitions and certain exceptions for employees and other types of institutional shareholders.

Who can benefit most from crowdfunding? Crowdfunding may be a cost-effective way for project-oriented entrepreneurs, such as low-budget filmmakers, to raise funds in a single investment round. Crowdfunding may also help for-profit social entrepreneurs appeal to investors who may not be as rigorous about disclosure and investment performance as financially motivated investors.

Technology and other high-aspiration entrepreneurs who expect to raise multiple rounds of funding should pursue non-accredited investor crowdfunding with caution. Traditionally, venture capital 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 or may not understand the real-world concept of a down round — whereby opportunistic investors buy shares in a struggling company at a lower purchase price than the first round of crowdfunded investors.

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 become less ambiguous.

Another nasty gotcha is for 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 other countries.

Caveat emptor is the well-known Latin phrase that reminds buyers to beware. With crowdfunding, it seems that both buyers and sellers of securities must proceed with caution.

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