DIY Entrepreneurship: Regulation Crowdfunding

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DIY Entrepreneurship: Regulation Crowdfunding

by Sherry Ward, AltTox Contributing Editor
Posted: September 25, 2016

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In late July, Beta Bionics, a Boston startup developing an artificial pancreas device for type I diabetes, became the first company to raise $1 million from 775 different investors using the new crowdfunding rules (Rosenblum, 2016). By August 13, three U.S. companies were reported to have reached the annual $1 million limit for funding under the new regulation, Regulation Crowdfunding (Alois, 2016).

Start-ups and early stage companies often struggle to obtain sufficient funding to sustain operations until their product reaches the market. Funding for early stages of development may be obtained from personal resources, friends and family, banks and other loan programs, and government grants. Equity funding through angel investors and venture capital organizations are often sought on a competitive basis, but usually require some demonstration of product/service proof-of-concept and market demand.

With the finalization of new rules for crowdfunding on May 16, 2016, entrepreneurs now have a new source of equity funding. Crowdfunding could become a valuable source of start-up funds for many types of companies, but especially for those producing products/services with finite markets, such as those working to develop and validate non-animal toxicity test methods. This democratization of entrepreneurship could also facilitate opportunities for non-traditional entrepreneurs, promoting greater diversity in company ownership.

What is crowdfunding?

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Crowdfunding, as we understand it now, involves using the Internet to raise capital, typically as small contributions from many individuals, to support a new venture or project. “Individuals interested in the crowdfunding campaign … decide whether to fund the campaign based on the collective ‘wisdom of the crowd.'” As of December 2014, there were more than 1000 crowdfunding platforms worldwide with 375 in North America; projected to reach 2000 platforms by 2016 [the most recent statistics found].

Some of the early online platforms were the rewards-based crowdfunding sites, such as Indiegogo and Kickstarter, launched in 2008 and 2009, respectively. These sites primarily fund arts and social projects, are not regulated by the U.S. Securities and Exchange Commission (SEC), and provide some type of “reward” for numerous small donations (e.g., a ticket, album, tee shirt, or similar “product”). The all-or-nothing funding model of Kickstarter, where projects receive funding only if they receive the full amount initially requested for a particular project, reported a 36 percent success rate through 2015 (Freedman & Nutting, 2015). Although there is no guarantee that an investor will receive the promised reward, the rate of actual fraud has been very low. Similar types of crowdfunding platforms include those involved with peer-to-peer lending and personal (donation-based) fundraising campaigns.

Until recently, crowdfunding as a method to make debt or equity investments in private companies was limited in the U.S. to accredited investors. That has now changed with the adoption of Regulation Crowdfunding, so that individuals in the U.S. can now buy an interest in private companies that make crowdfunding offerings. Often called investment or equity crowdfunding, this activity is regulated in the U.S. by the SEC under Regulation Crowdfunding.

Regulation Crowdfunding

Crowdfunding is a relatively new source of funding for companies. Along with this novel source for accessing capital come new risks. Regulating crowdfunding is the way to manage these risks, while maintaining crowdfunding as a source of funds to stimulate the growth of new and/or small businesses.

Regulation Crowdfunding was adopted on October 30, 2015 to implement Title III of the Jumpstart Our Business Startups (JOBS) Act of 2012, with transactions permitted beginning May 16, 2016.

The JOBS Act revised a number of rules established under previous securities legislation, and is intended to support the growth of new small businesses and jobs by lessening regulatory requirements in raising public funds. The JOBS Act is one of the major pieces of legislation enacted to affect U.S. financial markets since the financial crisis of 2008, another being the Dodd-Frank Act of 2010, which provided for a broader overhaul of the financial system and agencies (Shock, 2012). Shock explains, “With the economy appearing to slowly recover at the beginning of 2012, Congress saw the need to help our smaller businesses raise funds in our public capital markets.”

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All transactions conducted under Regulation Crowdfunding must be conducted through approved funding portals. The rules impose financial limits on both the company seeking funds and the investors. Companies can raise up to $1 million in a 12-month period, and investors are subject to annual limitations on the amount they invest based on their income and net worth.

Title III is only one of six parts of the JOBS Act. Anyone interested in Title III/Regulation Crowdfunding investments needs to be aware of several other forms of crowdfunding related to different sections of the JOBS Act. Title II/Regulation D permits general solicitation for certain types of offerings, but is only available to accredited investors. Title IV/Regulation A+ (mini IPO) expanded the previous regulation so that Issuers can raise funds in any 12-month period through public offerings with relaxed registration and disclosure requirements for up to $50 million. Both of these fundraising options could involve the use of crowdfunding platforms, but are regulated differently, and generally of interest to a different type of investor. This article covers only Regulation Crowdfunding, the regulation that implements Title III of the JOBS Act. The SEC has published the final rules enacted to date for the various parts of the JOBS Act.

Equity crowdfunding initiatives are also underway in many other countries, several well ahead of Regulation Crowdfunding. For example, research conducted on alternative financing activities in the United Kingdom found that “Equity crowdfunding continues to grow rapidly jumping 295% to £332 million from only £84 million in 2014. This segment now represents 15% of all UK seed and venture funding” (Zhang, Ziegler, Garvey, Baeck & Bone, 2016). Crowdfunding rules still vary across Europe, although the European Commission recognizes the importance of “a pan-European approach to better connect SMEs [small and nedium-sized enterprises] with a range of funding sources” (Lewis, 2015).

The Company

One of a company’s first steps is to determine whether it would benefit from using crowdfunding to raise capital. Equity crowdfunding involves selling a portion of your company to investors and providing them with a return on their investment. Very early stage companies might benefit more from a rewards-based crowdfunding campaign that would not dilute ownership of the company, but would still provide funding to develop product proof-of-concept.

In the U.S., investment or equity crowdfunding is regulated and can only be conducted using one of the approved crowdfunding platforms that is registered with the SEC. To raise equity by crowdfunding, the small business needs to establish the value of their venture, and be aware of legal and reporting rules, as well as fees and other obligations. Companies also need to set a reasonable fundraising goal, because funds are returned to investors for offers that are not fully funded. To assist with compliance, the SEC provides the publication “A Small Entity Compliance Guide for Issuers.”

According to the thought leaders behind one crowdfunding platform, “Equity crowdfunding could be the great equalizer for entrepreneurs and small businesses by allowing them to bypass the banks who will not lend to them, the venture capitalists who want to take advantage of them, and wealthy Wall Street types who ignore them.” However, they also emphasized the need to consider the costs for effective marketing, including expertise in driving traffic to your online offering through an effective marketing plan, and the $1 million cap, which are potential limitations.

Popular companies and products, and those with social marketing skills can expect to be most successful. For example, in early August, BrewDog, a large craft brewer in Scotland, reached the $1 million funding benchmark only three days after launching their campaign to fund a new brewery in the U.S.

Companies also need to fully understand securities laws and their obligations to investors. Andersen and Georgiades (2016) remind executives that “While issuers are now permitted to use general solicitation, the antifraud provisions of the federal securities laws remain applicable to the offer and sale of securities. Issuers and platforms where the securities offering is posted must ensure that their statements are not misleading, including that there are no misrepresentations or omissions of material fact regarding the company, the securities offered or the offering itself.”

The Investor

While crowdfunding platforms and financial professionals have been preparing for equity crowdfunding for several years, this is the first year investors can participate. There are many online sources of information on crowdfunding. Investors need to confirm they have reputable and correct advice and understand the risks before becoming involved.

There are various types of securities offered, and fully understanding the risks, company valuations, and possible return on an investment is complicated. Crowdfunding portals are required to provide general information on the risks to potential investors, and typically explain the types of securities available to the small investor. The SEC and the Financial Industry Regulatory Authority (FINRA) provide detailed investor guidance on equity crowdfunding. A full understanding of these investments requires substantial research and/or consultation with a professional. Legal firms and professional organizations that specialize in crowdfunding advice are emerging to handle this demand.

Equity crowdfunding should not be thought of as a stock-like investment. One of the differences is the liquidity of the investment. Crowdfund shares cannot be sold in the first year, and will possibly have no market for many years. The risk is also greater. Information on the companies raising funds is usually limited, and many may fail. Only funds you are willing to lose should be invested. A useful rule is to invest in products/companies you love, so that any loss is less painful. The best fundraisers will stay in touch with their investors, and even find ways to involve them in their marketing efforts. A successful partnership should emerge where both parties find some benefit, even if just in knowing they have supported a good product, idea, or team.

Assessing Utilization and Impact

As indicated in the several examples cited above, some companies quickly reached their annual funding limit of $1 million using the new crowdfunding platforms. The proliferation of funding platforms becoming populated with investor offers suggests that investor crowdfunding is on its way to acceptance among entrepreneurs and investors. However, the impact of Regulation Crowdfunding on new business creation and job growth, with its adoption only several months ago, cannot yet be determined.

Investor crowdfunding does not appear to be utilized at this time, at least in the U.S., by companies involved in developing products or services for regulatory testing. If you see any, please let us know! It can, however, be considered now as one of the methods available for new and existing private firms in this sector to raise capital.

Equity crowdfunding portals, some with mixed offerings (Reg CF; Reg A+), include:

Accredited investor only crowdfunding portals include:

Rewards-based crowdfunding portals include:

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