Start-Up Launchpad Blog

The Rise of Crowdfunding as a Source of Capital - October 27, 2011

Rob Dixon, corporate and securities lawHow to efficiently raise capital is a common topic that we discuss with our start-up clients who have reached the stage of trying to figure out how to get their ideas off the ground. With the law at your fingertips like never before, many clients have at least a superficial understanding of the securities laws that apply to the capital raising process. In fact, most of our clients correctly understand that, when issuing stock or LLC interests in their new ventures to investors, it behooves them to find an exemption from the SEC's registration requirements, because registering a securities offering is very complicated and very expensive.

 

Entrepreneurs, as a rule, are a creative and tech-savvy lot, and they often pose creative and tech-infused questions to their (sometimes) less creative lawyers. When those questions involve innovative ideas about raising capital, applying traditional rules to non-traditional scenarios can sometimes be a challenge. A hypothetical (ahem) example:   

 

Client: I just ran a marathon and used an online donation site to raise $10 from 1,000 people to buy shoes for kids in Kenya. Could I do something similar to raise money for the production of my awesome new iPhone app?

 

Lawyer: Wow - look at the time. Can I call you back tomorrow? 

As those in the start-up world know, this concept is called crowdfunding. Crowdfunding is a web-based, grass roots effort in which people pool resources to raise money for a common cause.  It is a cheap and easy way to raise a little money from a lot of people (for things like buying shoes for kids in Kenya). While the early incarnations of crowdfunding often tended to be used for charitable pursuits, it didn't take long for entrepreneurs to realize that those charitable models could be applied to their start-ups, as long as investments could be made in compliance with an available securities law exemption.      

 

One federal exemption relied upon by many start-ups in the seed capital phase is Rule 504 under the Securities Act of 1933. Rule 504 allows a company to issue $1 million of its securities within a 12-month period to an unlimited number of investors, provided that the company files a fairly basic notice with the SEC and also complies with applicable state securities laws. When issued pursuant to a 504 exemption, investors generally may not sell the company's securities that they receive, unless that subsequent sale is registered with the SEC or another registration exemption is available. (Exceptions to this resale restriction exist when, for example, the company registers the offering at the state level in states that require the filing of a registration statement and the delivery of a disclosure document to investors.)   

 

Crowdfunding sites geared towards start-ups have begun to emerge. In their early stages, it was difficult to determine how these sites managed the securities law compliance aspect of raising start-up capital, but at least one of the leading sites now promotes assistance with Rule 504 compliance, and with another exemption available for investments solely by sophisticated, or "accredited," investors. As for the 504 exemption, $1 million is a good sum of money that would enable many start-ups to get up and running. For other, rapidly-growing businesses that have moved beyond the seed phase, larger sums may be needed. Depending on the profile of potential investors, raising that next $2-3 million can become more complex when, for example, your lawyer informs you that you need to prepare a 30-page, in-depth disclosure document to deliver to investors before you can take their cash.     

 

For those who have been frustrated by this process, don't despair - your government is listening. President Obama himself announced that relaxing securities law requirements to facilitate the use of crowdfunding is a key component of his jobs initiative and, at least for this idea, Congress is on boardLegislation is even moving through the U.S. House that, among other things, would raise to $5 million the amount of capital that a business could raise from an unlimited number of investors through crowdfunding, and would also preempt the states' ability to require registration of these offerings at the state level. Before uncorking the champagne, though, entrepreneurs should know that the current bill is encountering resistance from state securities regulators, who generally don't like to be preempted. Nevertheless, crowdfunding is gaining momentum and now has support at the highest levels in Washington, which alone is a very positive development for entrepreneurs.

 

At least for now, we would advise those of you gearing up your Facebook pages to spread the word about a tremendous investment opportunity to make sure that, when doing so, you will not run afoul of existing securities laws. Stay tuned, though, because it looks like help is on the way.