Crowdfunding: The Legal Need-to-Know : Under30CEO Crowdfunding: The Legal Need-to-Know : Under30CEO
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Crowdfunding: The Legal Need-to-Know

| May 9, 2013 | 3 Comments

Crowdfunding Legal TipsI’m going dispel a myth right now: You cannot legally sell equity through a crowdfunding website in the US right now.  But you will be able to soon.  Well, sometime soon.  Here I’ll tell you what you’ll be able to do under the new crowdfunding law, and what you can do right now.

Many business owners know there’s some kind of registration requirement that goes along with fundraising, but don’t know exactly what it is.  As in, “I need to prepare a prospectus, don’t I?”  Others assume they can sell equity to anyone or take a loan from anyone, and don’t know there are detailed rules they must follow.  There’s actually a large and complex set of regulations on capital fundraising.

Securities Laws

Securities laws, specifically the Securities Act of 1933 and the Securities Exchange Act of 1934, were enacted after the stock market crash of 1929, to protect consumers from shady salesmen who would sell fake “investments.”  Consumers had no real way to tell the difference between a solid investment and a fraudulent one.  Securities laws attempted to fix that problem by creating a registration requirement, so that before selling an investment opportunity, a business must disclose lots of detailed information, such as its business plan and owners’ identities.  This is supposed to give investors the information they need to decide whether to buy the stock.

These laws also ensure that most businesses cannot afford to comply.  A full registration can cost hundreds of thousands of dollars because of the extensive attorney and accountant time required to prepare the registration.  For most small businesses, it’s not an option.  To raise the capital you need, you’ll have to find an exemption from the registration requirement.

Right now, the most popular exemptions have to do with selling securities to “accredited investors,” which are generally wealthy individuals (as defined by SEC rules) or companies or funds with more than $5 million in assets.  But in order to raise large dollar amounts from one or a few investors, you need to play a certain game having to do with a business plan for very fast growth.

For many companies, crowdfunding is a much more realistic source of funds, or the only potential source of funds.  First, the pool of potential investors is much much larger, and it includes your friends and family.  Second, small investors have different reasons and goals than venture capitalists.  The small investor might be someone who believes in you and wants to see you succeed.  Many people want to invest in a local business that they hope stays in the community for a long time.  People might just want to invest in the financial health of their neighborhood, or they might feel their investment is safer in a business they know rather than in “Wall Street.”  So crowdfunding will make money available to the types of business that appeals to these values.

The JOBS Act, passed in 2012, contains a section called the CROWDFUND Act.  It will allow businesses to sell equity and take loans—to sell securities—through crowdfunding, without doing the expensive registration.  The new CROWDFUND Act will let you raise up to $1,000,000 in any 12-month period.  There are limitations: you’ll have to go through a portal that is registered with the SEC, and you cannot advertise except to direct people to the portal.  Just as many crowdfunding sites do now, you’ll have to say what the money will be used for, and you will have to set a target and a deadline.  If you don’t meet the target, you get nothing, and all of the investors get their money back.  There’s a limit on how much any one investor can invest (the greater of $2,000 or 5% of income or net worth for non-wealthy people).  You’ll also have to make certain information, such as your business plan, financial condition, and identity of owners, available to the SEC and to potential investors.  This is just a general list to give you an idea of the process.

I sometimes find blog posts and articles that talk as though the CROWDFUND Act is in effect now.  It isn’t.  That is because the CROWDFUND Act requires the SEC to make rules, and it hasn’t yet.  Practically speaking, in order to do any equity crowdfunding, you must use a portal, and the portal must follow rules set by the SEC, but the SEC hasn’t made those rules yet, so there is no way for the portal to do any sales under this Act yet.  But it’s good to know what’s coming.

So what do you need to know to crowdfund right now?

You cannot sell securities, but you may ask for donations.  That is what Kickstarter is—a site where people raise donations for their for-profit projects.  This is not regulated by securities laws, because donations are not securities.  A security is an investment where the investor expects some kind of return without doing any work himself.  No one expects to make money from a donation, so securities laws don’t apply.  You can offer small gifts in exchange for donations, because a gift with only nominal cash value couldn’t be considered a return on an investment.  But you should know there is a limit on what you can offer in exchange for someone’s money–you can’t turn the transaction into an investment.

Another strategy is pre-selling.  For example, on CrowdSupply.com, customers select a new, cool product to invest in, and put up the cash that will allow that product to be produced.  The customer gets one of the first production units, a special version of the product, or some other recognition.  This is a little more into the gray area between a purchase and an investment, but there’s a strong argument that securities laws do not apply here because customers are simply purchasing a product.

Using your creativity, you can probably think of other ways to raise cash up front, maybe offer something fun in return, and build your community of friends and future customers, without selling something that could be considered an investment.  And when the CROWDFUND Act goes into effect, it’ll open up a huge new market for stock in your company.

Sarah Kaplan is business attorney for green businesses, cooperatives, and social enterprises.  For example, Sarah can explain the capital structure of a worker-owned business, and what’s involved in becoming a benefit corporation.  Visit Sarah at www.sarahkaplanlaw.com, or connect at https://www.twitter.com/SarahKaplanLaw or www.facebook.com/sarahkaplanlaw.

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Category: Startup Advice