How to tell if crowdfunding is right for your business
If you own or are starting a small business, we don't have to tell you how tough it is to raise capital from outside investors. Persuading someone to risk money on your company is difficult enough. But even finding that someone is a challenge, for many reasons, including legal restrictions against advertising for investment.
Federal and Maine securities laws allow you to solicit investments from a very limited number of people you already know. But how do you reach potential investors you don't know? Three alternatives you might consider under current law are: a small registered public offering; a private placement through a licensed securities broker; or pitches to venture capital firms and other professional investors.
Starting sometime next year, business owners will have another option for locating investors. The new Jumpstart Our Small Business Startups Act allows small companies to engage in non-registered public offerings of up to $1 million per year through “crowdfunding” transactions. Here are some key features and conditions of crowdfunding:
Crowdfunding is not allowed until after the Securities and Exchange Commission adopts detailed regulations. The JOBS Act gives the SEC broad discretion in setting rules that will govern these offerings. The new rules are supposed to be ready by Jan. 1, 2013. However, crowdfunding is complicated and controversial, and it is very possible that the SEC will take longer than this.
Crowdfunding offerings must be conducted through a registered broker or a registered funding portal. The $1 million cap might offer too little incentive for a traditional broker to take the lead role in a crowdfunding offering. However, several other companies have announced an intention to register with the SEC as “funding portals.” Portals will act as bulletin boards for the posting of permissible crowdfunding offerings. Unlike registered brokers, portals will not be allowed to actively solicit purchases or offer investment advice or recommendations.
The JOBS Act lists several topics that a company must address in written disclosures to prospective investors, and the SEC will likely require additional disclosures. For offerings greater than $100,000, the company will need to provide financial statements that have been reviewed or audited by an independent outside accountant, under standards to be defined in the SEC's crowdfunding rule.
The company must strictly limit the maximum investment per investor. The JOBS Act limits the maximum amount of securities a company may sell to an investor within any 12-month period. The general limit is $2,000 per investor, except that those with net worth exceeding $40,000 may invest up to 5% of net worth, and those with net worth of $100,000 or more may invest up to 10% of net worth (but not more than $100,000).
The company may engage in only limited advertising of the offering. The statute permits publication of notices that direct investors to the funding portal or broker, and the SEC is likely to impose other rules regulating publicity surrounding the offering.
After the offering, the company must continue to provide follow-up reports to the SEC and investors. At a minimum, these will include financial statements and a description of recent operations and results.
Bottom line
Crowdfunding is an interesting concept that relaxes securities law requirements in exchange for strict limits on the amount that investors can put at risk in the company. It remains to be seen whether the SEC will provide relatively simple guidelines allowing companies to conduct crowdfunding offerings at low cost, or whether the required disclosure materials and reports will be so detailed as to require extensive input from lawyers and accountants. The SEC faces a difficult task in striking a balance between two competing goals of the legislation: (a) making it easier for companies to raise capital, while (b) protecting investors from unscrupulous or incompetent promoters.
Will crowdfunding be right for your company?
Here are some factors that might give your company a leg up to pursue crowdfunding:
- Your company has a well-known, respected brand and/or was quite profitable for the past two years and/or experienced impressive growth during that period and/or has a line of business that is a particularly “hot” area for investment
- Your company has a good working relationship with your bank or an existing source of capital, such that you can be flexible in timing a crowdfunding offering and are not totally dependent on the success of that offering
- Having a way-larger-than-normal number of investors would actually provide advantages to your company, over and above the capital raised
Here are some factors that might suggest crowdfunding is not right for you:
- Your company's business model is highly capital-intensive, such that a one-time infusion of a few hundred thousand dollars would likely not be sufficient to fuel ongoing expansion plans
- You are reluctant to publicize the past two years' worth of financial data for your company, or will be reluctant to provide investors with detailed periodic updates in the future
- Your company does not have a history of good compliance with tax laws
- Someone associated with your company has been accused of a serious crime in the past five years, or was convicted of a serious crime in the past 10 years.
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