Invest in Who You Know – Part 1
There’s an old saying that you should “invest in what you know,” but what’s far more valuable is when you can “invest in who you know” as well. The new crowdfunding laws are not designed to nurture this; they are meant to prohibit investment conversations with the...
DPOs and Crowdfunding: What’s the Difference?
With all of the recent changes in the securities laws ushered in by the 2012 JOBS Act, it may be helpful now to take a step back and look at how these changes fit into the broader landscape of capital-raising for small and medium sized businesses.
We’ll start with a definition of “crowdfunding.” This is a versatile term that means raising small amounts from many people, rather than large amounts from a few. In practice it includes both, because in any crowdfunding campaign you also want a few people putting in large amounts alongside the many putting in small amounts.
But there are several types of crowdfunding. Here are the major ones:
Donations: On donation-based portals like DonorsChoose.org, contributors get nothing in return for their donation, other than (maybe) a tax deduction. It works well for nonprofits, but not so well for others.
Rewards and pre-sale: Portals like Indiegogo and Kickstarter have surged in popularity. They can offer a variety of incentives, like a signed copy of your favorite band’s latest record or discounts off merchandise. But contributors still can’t get their money back or any financial return on investment.
Peer-to-peer lending: Also surging in popularity, portals like Prosper and Lending Club do offer a true investment in the sense that investors can get their money back and a return on their investment. From a borrower’s point of view, however, it looks (and typically is) more like a bank loan in the sense that the portal dictates the terms.
Investment crowdfunding: This is a true securities offering by an “issuer” (the for profit or nonprofit company raising the money) that is open for investment by the “crowd” (meaning both accredited and non-accredited investors). Since securities laws at both the state and federal level regulate these investments, it is important that a company gets sound legal advice to help it map out the best securities compliance strategy for its needs.
The category of “investment crowdfunding” can itself be broken down into several distinct legal strategies:
Title III exempt crowdfunding: This is the one that has generated the most buzz since the SEC issued enabling regulations on October 31, 2015. It’s a federal exemption that pre-empts state law and allows a company to raise up to $1 million from investors in all states. It has some pretty tight limitations that many think will limit its usefulness. One potential disadvantage is that it requires the use of a third-party intermediary portal, regulated by FINRA, which will significantly add to the costs. The new regulations will go into effect in May of 2016.
State-specific exempt crowdfunding: While waiting for the SEC’s Title III regulations, more than half of the states enacted their own crowdfunding laws. Most of them were modeled after Title III, though some of them are less restrictive. For example, a few do not require use of a third-party portal. Now that Title III is about to go into effect, most of them will probably not get much use, except for those that will remain advantageous because they are less restrictive.
Nonprofit direct public offering: The SEC and most states allow a charitable organization to offer an investment without securities registration, though a notice filing may be required. For nonprofits in those states, this is the easiest way to do a direct public offering. A few states, notably California, do not have such an exemption and require registration even for nonprofits.
Intrastate direct public offering: This may be the most popular strategy for direct public offerings because it allows a company to raise an unlimited amount of money, as long as all investors are in the same state (along with a few other requirements). It requires state-level registration of the offering, which is not nearly as burdensome or expensive as a federal registration; and it can be cost-effective for raises as small as $250,000.
Rule 504 direct public offering: This strategy allows a company to take investment from multiple states, as long as you register (or otherwise find an appropriate exemption) in each of those states. The disadvantage of this strategy is that there is a $1 million aggregate cap. The SEC recently proposed to increase the cap to $5 million, but there is no way to predict (or if) that will happen. Still, it can be an attractive strategy because it allows for a public offering in one state, while still being able to take private investment from other states.
Regulation A+ direct public offering: This strategy was also spawned by the 2012 JOBS Act and allows a company to raise up to $50 million from investors in multiple states. The main disadvantage is that it is a much more burdensome process that in some ways is akin to a full-blown SEC registration. It actually includes two different variants: Tier 1 allows a company to raise up to $20 million without audited financials, but it does require registration in each state where investors reside. Tier 1, which allows raises up to the full $50 million, requires audited financials but pre-empts state law.
So is a direct public offering (DPO) the same as crowdfunding? Not exactly. As indicated above, investment crowdfunding includes both direct public offerings and exempt crowdfunding. There are two reasons why Title III exempt crowdfunding, in particular, is not a direct public offering: First, it is not direct because the rules require use of a third-party crowdfunding portal. Second, while it has some of the characteristics of a public offering (i.e., it’s open to non-accredited investors), there are limitations on your ability to market the offering (specifically, all communications must go through the portal), so it may not be a true public offering.
Another distinction between a DPO and exempt crowdfunding is that most DPOs are vetted by either state regulators (in the case of intrastate or Rule 504 DPOs) or by the SEC (in the case of Regulation A+). In both Title III and state-specific exempt crowdfunding there is no regulatory review. This regulatory exemption can cut both ways: While it can help you launch your offering faster and at a lower cost, you may find that investors have less confidence than they might have in a registered offer that the state regulators reviewed.
At Cutting Edge Capital we like crowdfunding of any variety, because it democratizes the capital-raising process. The old conventional wisdom is that once you’ve tapped out your friends and family, your options are to get a loan from a bank or an investment from an angel, a venture capital firm or other institutional investor. Regardless of the option, your fate is in the hands of wealthy individuals or organizations who will make their decision largely on the basis of how much money you can make for them… and how fast they can get their money and their large returns back out.
But with investment crowdfunding you can raise capital from your own community, however you may define it – your neighbors, customers, affinity groups, or even your professional network. And their investment decisions may be based on much more than just profit or a quick exit. This opens the door for true impact investment for everyone.
We note that a lot of investment portals out there that purport to be crowdfunding portals are really only open to accredited investors, in reliance on the SEC Rule 506(c) exemption that allows for general solicitation and advertising. Yet even though an offering that is only open to the wealthiest 3% of Americans doesn’t qualify as true crowdfunding, these portals can still provide a great service for entrepreneurs, and we’ve worked with a number of t
At Cutting Edge Capital, while we’re best known for our work with direct public offerings, we help our clients with many capital-raising strategies, including private placements, Rule 506 offerings (with or without general solicitation), and exempt crowdfunding. If you’d like to discuss which strategy is best for your enterprise, please.
DPOs and Crowdfunding: What’s the Difference?
With all of the recent changes in the securities laws ushered in by the 2012 JOBS Act, it may be helpful now to take a step back and look at how these changes fit into the broader landscape of capital-raising for small and medium sized businesses. We’ll start with a...
Are all these new crowdfunding sites operating in full compliance with securities laws?
These days it seems there’s a crowdfunding platform for … well, just about everything. We all know the pioneers, Kickstarter and Indiegogo being chief among them, but there are many, many more platforms to choose from out there (at least 1,250 according to one report), and a new one seems to come online every day.
We think crowdfunding is perfectly suited to not only raise funds but also build community. Being crowdfunders ourselves (of the “investment crowdfunding” variety), we have seen firsthand how crowdfunding can help get projects off the ground and connect to a community of loyal supporters, while sharing profits with them in return.
There is no doubt crowdfunding has disrupted traditional finance, and revolutionized the way people raise funds. For that, we only have to take a quick look at the top-highest crowdfunding projects of all time: $87 million for “Star Citizen,” a video game (goal: $500,000); $20 million for “Pebble Time,” a smartwatch (goal: $500,000); and, our favorite, $13 million for the “Coolest Cooler,” the “Swiss Army knife” of coolers (goal: $50,000). We hope that those who gave so generously are feeling okay about for-profit companies that use the crowd in place of having to deal with those pesky investors that expect a return if a profit is made, but we also question the integrity of the approach if a company has no intention of sharing its profits with its backers.
And then there are the new “investment” crowdfunding sites we have been tracking. As with their predecessor donation-based crowdfunding platforms, new equity crowdfunding platforms formed under the various provisions of the JOBS Act of 2012 seem to crop up every day, promising growth capital for entrepreneurs and returns for investors. And on top of these new platforms, there is still the question whether the most highly anticipated and much-ballyhooed provision of the JOBS Act, Title III will ever come to fruition, providing equity crowdfunding for “the masses,” both accredited and unaccredited investors.
One example that recently caught our eye was an online retailer that launched a new crowdfunding platform that allows their independent retailers to post new “project” ideas they want to develop, with campaigns that include the scope, goals, and products they wish to offer, and then describe how receiving “funding” will help them to grow. The individuals that “fund” these projects will, hopefully, receive one of the products that are produced if the entire new project can get “funded.”
At first blush it looks very similar to other non-securities crowdfunding platforms—more of a pre-order approach for a product to be made once enough funds are received to make the product. What made this interesting to us, however, was how the company described this new platform. In their words, they said that this would provide “financing and product development” to the small businesses listed on their website, and they characterized this as a “viable and friendly alternative to traditional financing channels.” Suddenly we are now seeing new platforms moving from simply pre-ordering products to financing new businesses, with the online retailer taking a 3.5% fee on all of the financing if the new project reaches its goal, while the consumer simply receives a product.
We’re all for innovations that empower people to access capital in a way that lets them achieve their mission, but the sheer number of crowdfunding sites that are proliferating these days, and the similarities to investing and brokering by some does give us pause as we reflect on the possible challenges. Perhaps these new platforms will continue the disruption started a decade ago where new companies opted to get funded via pre-orders instead of seeking investment dollars first. Here in California, we have watched and waited to see if the state regulators would intervene and consider these pre-orders to be securities, as they did long ago with their decision on pre-payment for a membership in a country club that did not yet exist.
While no actions have been taken yet on these new platforms, we wonder whether the regulators will begin to look at these sites differently when the facilitator is charging a success fee for having connected new businesses seeking “alternative financing” opportunities with individuals willing to fund them, even if all they hope to get from the funding is a product that will be made.
Are these platforms actually offering “securities” that should be regulated? Are platforms that are run by broker dealers actually performing their obligations around due diligence and ensuring that the offering is suitable for each investor? And what happens when an investor decides that they got a raw deal, never received a product, or thought they should be getting some other kind of return for having helped finance a new business? These platforms are still so new that it is hard to predict whether the regulators, working slow and steady (at a pace far different from those running with the bulls), once they have sorted through all of these new changes, will begin to act.
Thinking about launching a crowdfunding portal? (Who isn’t?) Before you do, know what you’re getting into. Crowdfunding as a market has yet to mature, and there is the real possibility of major shakeout from one or a few big players running afoul of securities laws. Our advice: don’t take that risk; do your compliance first, and stay within the bounds of the law. You’ll thank us when the bubble bursts and the crowdfunding platform implosion comes.
For the first time, the Federal Trade Commission (FTC) has fined someone for using “unfair or deceptive” acts related to the crowdfunding site Kickstarter.
In May 2012, Erik Chevalier launched a 30-day online fundraising campaign on Kickstarter, seeking to raise $35,000 to create a fantasy board game called “The Doom That Came to Atlantic City.”
When the fundraising campaign closed on June 6, 2012, Erik had raised $122,874 from 1,246 individuals, including over 1,000, or about 85% of backers, who had pledged more than $75 each, according to the FTC complaint. As it turns out, Atlantic City is indeed a gambling destination. Nucky Thompson would have been thrilled.
Backers thought they were helping launch a new board game, but ended up funding personal items, rent, and moving expenses for the “game maker.” Given the popularity of the crowdfunding industry (which raised a collective $16.2 billion dollars last year) it is surprising this is the first time the agency has taken legal action to protect online users.
While outright fraud is rare on platforms such as Kickstarter and Indiegogo, it is up to the users/backers to detect and report fraud and sort out conflicts. We recommend that if you want to back a campaign on a crowdfunding platform, you perform some due diligence so you aren’t trapped in the Doom of Atlantic City.