While “crowdfunding” has become an incredibly popular means of raising money for everything from artistic projects to lifesaving medical care, the concept is also widely misunderstood. The reason for this is most likely due to the fact that “crowdfunding” is an umbrella term used to describe a wide range of fund-raising activities. The term itself simply means raising money from a potentially unlimited number of people over the Internet. The devil is in the details, however, and a variety of different models and platforms have appeared creating different ways of achieving a company or individual’s fund-raising goals.
These crowdfunding models fall into two overarching categories: donation models, where the contributor is donating money to projects with no expectation of return, and equity models, where the contributor is investing money in exchange for equity or debt securities in the company. Within these categories, multiple models and platforms exist for connecting fund-raisers and potential contributors, and new models will no doubt continue to be created as the concept of “crowdfunding” continues to grow in popularity.
The most recent development in the “crowdfunding” universe is the adoption by the Securities Exchange Commission (SEC) of final rules allowing equity crowdfunding from nonaccredited investors. Under the Securities Act of 1933, the offer and sales of securities requires either registration or an exemption from registration. Therefore, all securities-based crowdfunding must be registered with the SEC or have an exemption. Since 2013, companies have had the option of “crowdfunding” from an unlimited number of accredited investors under the Rule 506(c) exemption of the SEC Regulation D. The SEC’s new rules, authorized by Section 4(a)(6) of the Securities Act (Regulation Crowdfunding), provide an exemption for crowdfunding securities offerings to nonaccredited investors, but come with strings attached. While these offerings each have their own limitations, there is a lot of excitement surrounding the SEC’s foray into crowdfunding.
This article will discuss five models of crowdfunding that appear most popular and, therefore, most relevant to legal practitioners. Three of these models are donation-based, and two are securities-based. We will begin with a discussion of the donation-based models associated with the three largest crowdfunding websites, Kickstarter, GoFundMe, and Indigogo, along with some associated legal challenges. The bulk of this article, however, will be dedicated to the two securities-based crowdfunding models now approved by the SEC, which are Rule 506(c)’s “unlimited” model and the new Regulation Crowdfunding “limited” model. The benefits and challenges of each model will be discussed before offering our closing thoughts on the state of crowdfunding as it stands today.
The Donation Models
The most common and widely recognized category of crowdfunding is donation-based crowdfunding. The top three websites that offer this service are GoFundMe, Kickstarter, and Indigogo. Donation-based crowdfunding operates much like giving to charity, in that the contributor has no expectation of receiving anything in return for their contribution, but unlike giving to charity the contributor will also not receive a tax credit for their donation. As such, the contributors on these sites are giving money to projects with no expectation of personal return, unless the fund-raiser or website offers such an incentive. Each of these three sites offers a slightly different variation on this model.
The “GoFundMe” Model
GoFundMe (www.gofundme.com) advertises itself as “The World’s #1 Personal Fundraising Site,” and practices perhaps the purest variation on the donation-based crowdfunding model. Anyone seeking to raise money through the site can start a campaign, advertise it to the world, and collect the donations. Unlike other websites you do not have to reach a certain goal in order to get funded (although they do offer an “all-or-nothing” option). You keep any and all of the donations you receive, subject to the website’s 5 percent fee. The company boasts that over $1 billion has been raised on the site.
GoFundMe also offers an option for nonprofit organizations to raise money through the site. This option requires the nonprofit to get verified first, but once they are, contributors to these campaigns will receive the tax deduction for charitable donations. This characteristic makes GoFundMe particularly appealing to charitable and nonprofit organizations. As we will see, other sites do not necessarily offer this option.
The “Kickstarter” Model
Kickstarter’s (www.kickstarter.com) model is a slight variation on the donation-based crowdfunding model in that the website requires “creators” to set and meet a fund-raising goal before they will get funded. If the creator fails to meet their goal, all the donations are returned to the “backers” who pledged their support. Kickstarter defends this practice by arguing that setting a minimum bar creates less risk for both creators and backers, and also motivates all parties to achieve their goal. In the end, the company argues that the vast majority of those who reach at least 20 percent of their goal go on to reach their funding goal.
Kickstarter also has two other characteristic differences that separate it from its largest competitor, GoFundMe. First, unlike GoFundMe, Kickstarter does not have a mechanism for raising charitable contribution through the site, a significant impediment for a nonprofit organization looking to raise funds. Second, Kickstarter does allow creators to offer “rewards” to backers, which range from small tokens of appreciation for backers who give smaller amounts to valuable products and services for backers who give larger amounts.
Kickstarter’s reward system has run into some legal hurdles, however. Some backers pledge money believing that they are buying the “reward,” rather than donating to a potential business, and when the “reward” never materializes, which could happen for any number of reasons, the backer might sue. The Internet is littered with horror stories such as Hanfree, where a Kickstarter campaign failed as a result of unforeseen manufacturing challenges and the backers sued the founder for fraud leaving him bankrupt. Kickstarter’s founder responded to these lawsuits in a blog post entitled “Kickstarter is NOT a Store,” but the allegations of fraud have not gone away.
The “Indigogo” Model
Indigogo’s (www.indigogo.com) model of donation-based crowdfunding is an all of the above approach. The website offers both “fixed” and “flexible” funding options, with the “fixed” option reflecting Kickstarter’s all-or-nothing model and the “flexible” option reflecting GoFundMe’s pure donations model. Like GoFundMe, Indigogo also offers a mechanism for verifying 501(c)(3) status and taking charitable donations, and also lacks the “rewards” system that has plagued Kickstarter. This approach seems aimed at taking the best aspects of both of the largest websites in the field, and giving fund-raisers more flexibility in choosing how they want to raise money.
The Securities Models
In 2012, Congress sought to open a new avenue of crowdfunding where companies could raise money by selling securities through the Internet. Through the JOBS Act of 2012, the SEC’s prohibition on general solicitation and advertising of security offerings was removed for certain offerings. This rule (502(c)) prohibits companies from advertising the sale of stock through mass distribution outlets such as newspapers, magazines, television, radio, or the Internet. The Rule’s limitation, along with the fund-raising caps and accredited investor requirements of most of the Regulation D exemptions, effectively prohibited the sale of securities to large numbers of nonaccredited investors outside of a public offering. In other words, it prohibited securities-based crowdfunding.
When it passed the JOBS Act of 2012, Congress ordered the SEC to eliminate this prohibition on general solicitation and advertising in two instances. Title II of the JOBS Act ordered the SEC to allow solicitation and advertising under Rule 506(c) for an offerings made solely to accredited investors. Title III of the JOBS Act ordered amended Section 4(a) of the Securities Act of 1933 to allow for solicitation and advertising in to unaccredited investors in a limited offering. These two provisions form the basis of the new securities-based crowdfunding options available to entrepreneurs and small businesses.
The Unlimited Option – 506(c) Offering
The general rule is that a company offering and selling its securities must register those securities with the SEC and then comply with the ongoing reporting obligations under the Securities Exchange Act arising as a result of such public offering. Since these requirement would be onerous and untenable to small companies looking to raise relatively small amounts of money, most companies look for an exemption from the registration requirements. Regulation D offers numerous safe harbors for smaller transactions, the most commonly used of which, according to the SEC, is Rule 506.
Initially, Rule 506 allowed an issuer to raise an unlimited amount of money subject to certain requirements. First, the issuer cannot sell to more than 35 nonaccredited investors. The issuer may, however, sell to unlimited number of accredited investors, a fairly easy requirement for which a company can show compliance because accredited investors can simply “self-certify” as to their status. Second, the issuer is prohibited from using general solicitation and advertising. This exemption option is still available in the form of a Rule 506(b) offering.
Following the JOBS Act, the SEC has now expanded the Rule to include a 506(c) offering, which has the same unlimited ceiling on the amount of money a company can raise but also allows for general solicitation and advertising. However, Congress and the SEC did not simply drop the ban on solicitation and advertising without imposing other limitations. Rule 506(c) offerings have two major limitation that differ from Rule 506(b) offerings. First, a Rule 506(c) offering cannot be used to sell to any nonaccredited investors, eliminating the option to sell to 35 nonaccredited investors under 506(b). Second, and perhaps more importantly, an issuer must exercise reasonable due diligence to “verify” that the investors are all accredited investors, in other words, the self-certification allowed under Rule 506(b) is not permitted under Rule 506(c).
The 506(c) offering is the first form of securities-based crowdfunding approved by the SEC. Of the two crowdfunding options, the 506(c) offering is the only one with no ceiling on the amount of money that can be raised. As one might expect, however, this unlimited option comes with significant limitations. Even though an issuer is permitted to use the Internet and advertising to sell their securities, the requirement that all investors be accredited is a significant limitation on how widely those securities can be sold. Furthermore, the due diligence required to “verify” that all the investors are accredited does put some additional administrative burden and risk on the issuer. However, an issuer can avoid much of this direct burden by using a third party verification service or requiring investors to show certification from their brokers or accountants on which the issuer can rely.
The New Limited Option – “Regulation Crowdfunding” Offering
While Title II of the JOBS Act created an unlimited option for crowdfunding but only for high net-worth “accredited” investors, Title III created a limited crowdfunding option open to all investors. Title III amended the Securities Act of 1933 to add Section 4(a)(6), which creates a crowdfunding option available to any investor regardless of the size of their income or net worth. However, the law would only become effective after the SEC issued implementing rules, putting the issue at the end of a long backlog of SEC rule-making priorities. On October 30, 2015, the SEC finally approved its final rules on Section 4(a)(6) offerings, which it labeled “Regulation Crowdfunding.” This option will become available in early 2016.
Fund-raising and investing limits. Like the 506(c) offering, an issuer offering securities in a Section 4(a)(6) offering will be able to use general solicitations and advertising, including online, in order to sell its securities. However, unlike a 506(c) offering, the Section 4(a)(6) offering allows anyone to invest, not just “accredited” investors. This would seem like a huge benefit, but the law and the SEC put in place two stringent limitations, presumably to balance the additional protections the SEC believes are needed for nonaccredited investors. First, an issuer cannot raise more than an aggregate total of $1 million in any 12-month period. This cap contrasts sharply with the uncapped 506(c) offering.
Second, there are limits on how much an individual can invest in a Section 4(a)(6) offering. For individuals with an annual income or net worth under $100,000, they are limited to the greater of $2,000 or 5 percent of their annual income or net worth. For wealthier individuals who have an annual salary or net worth greater than $100,000, they are still limited to 10 percent of the lesser of their income or net worth. Finally, an investor can purchase no more than $100,000 worth of securities through all Regulation Crowdfunding offerings in any 12-month period.
It is worth noting that this high net-worth definition is quite a bit lower than the normal “accredited” investor standard, which is an individual annual salary of $200,000 or a $1 million net worth. Furthermore, this condition is very unique in that none of the other exemptions from registration, including Rule 506(c), put a cap on the investment amount an individual investor can make. This cap may be disappointing to high net-worth investors who want to invest heavily in numerous crowdfunded offerings.
Required disclosures. Unlike the Regulation D exemptions, an issuer relying on Section 4(a)(6) must make certain disclosures on a new “Form C,” and will be required to file an annual report with the SEC. The required disclosures on Form C include:
- The price of the securities (or method for determining the price);
- The target offering amount;
- The deadline for reaching the targeted amount;
- Whether the company will accept investments beyond the targeted amount;
- A discussion of the company’s financial condition;
- Financial statements and tax returns either audited or reviewed by an independent public accountant, depending on the amount of the offering;
- A description of the business;
- How the proceeds will be used;
- Information about the directors, officers, and controlling shareholders; and
- Certain third-party transactions.
While these disclosures are nowhere near as extensive as a full public offering or even a smaller offering under Regulation A, they are comparable to what a company would likely provide if selling its securities through a private placement memorandum (PPM), a common disclosure document used in many Regulation D offerings. Where these Regulation Crowdfunding disclosures depart from a typical early stage PPM is the requirement for audited financials if the company proposes to raise more than $500,000 in any Regulation Crowdfunding offering after its initial offering. Many early stage companies, especially those likely looking to raise funds through crowdfunding, do not normally have audited financials because of the high cost of their preparation.
By requiring these PPM-like disclosures, annual reports and better quality financials, the SEC is trying to protect the nonaccredited investors who likely have less investment experience and can not bear as well the risk of loss of their investment. This is a similar approach seen in the Regulation Rule 506 offerings where the inclusion of nonaccredited investors requires the company to provide certain disclosures that would otherwise not be required. By providing this additional protection for investors, there is a greater cost to the offering. Depending on how efficiently the company can compile the disclosure information and the required annual report to be filed with the SEC and whether a company must provide audited financials, the costs of conducting a Regulation Crowdfunding offering on the company may be substantial. This will force issuers to balance the fund-raising potential of the offering with the costs in both dollars and time associated with such an offering.
Brokers and crowdfunding platforms (FINRA). Perhaps the greatest distinction between a Regulation Crowdfunding offering and a Regulation D offerings is the requirement that a Regulation Crowdfunding offering be made through a registered broker-dealer or a registered “funding portal.” In response to this requirement, the SEC ordered all Self-Regulatory Organizations (SROs) to issue rules regulating these intermediaries. The only SRO for broker-dealers and funding portals is the Financial Industry Regulatory Authority (FINRA), which released its proposed rules for funding portals on October 9, 2015. Those rules include, among other things:
- Rule 110, which requires funding portals to become members of FINRA and outlines the application process for becoming such a member.
- Rule 200, which regulates funding portal communications with investors and prohibits, among other things:
- False, exaggerated, unwarranted, promisory, or misleading statements or claims;
- Material omissions of fact or qualifications;
- Exaggerated or unwarranted claims, opinions, forecasts, or predictions regarding performance.
- Rule 300(c), which requires funding portals to report violations.
- Rule 800(b), which requires funding portals to make certain public disclosures similar to FINRA’s “BrokerCheck” system.
The funding portal requirement seems natural, given the popularity of websites like Kickstarter and GoFundMe. Regulation Crowdfunding eases the path for funding portals to facilitate the offer and sale of securities in crowdfunding transactions. Prior to Regulation Crowdfunding, these funding portals would have needed to register as a broker-dealer to engage in these transactions. Registering as a funding portal will be less onerous than registering as and maintaining a broker-dealer status.
However, it will also be an additional cost that the company will have to bear. It’s not clear why an intermediary is necessary. Perhaps Congress and the SEC believed that companies would try to take advantage of unsophisticated investors if they were permitted to sell securities through their own websites. On the other hand, they might have just assumed funding portals were the only means of effectively regulating crowdfunding, though that seems unlikely since they have long allowed companies to sell directly to investors through Regulation D. Either way, issuers and investors will have to interact through these new funding portals, and it will be interesting to see exactly how these intermediaries develop. Perhaps even more importantly, companies will be looking to see how much they increase the costs of these transactions.
Although the crowdfunding community is excited about the SEC’s new 4(a)(6) option, its long-term success seems questionable, given the other Rule 506(c) option already available. Also, a smart start-up looking to raise a small amount of money is not going to drastically blow up its cap table by conducting a Section 4(a)(6) campaign, when a good idea with a smart founder can easily raise donations on Kickstarter or GoFundMe. Furthermore, with all the Kickstarter horror stories out there, just imagine the damage those same people could do as stockholders, rather than simply as donors. A start-up simply would not be wise to take on an army of unsophisticated investors for the sake of a few thousand dollars.
Likewise, a good crowdfunding platform could, ironically, further diminish the appeal of the Section 4(a)(6) option for more established companies. Many crowdfunding platforms have developed good ways to identify accredited investors thereby reducing the expense of “verifying” the investor’s status under Regulation D’s 506(c) exemption. With that expense eliminated, why would a company choose a disclosure heavy 4(a)(6) offering with low caps on individual investors, when they can focus on a few high income investors through the portal for an unlimited 506(c) offering?
With these scenarios in mind, the value of a 4(a)(6) offering seems like it will always be outweighted by the potential costs in time, resources, and potential capitalization issues when compared to the alternatives already available. It is, however, far too early to make a definitive prediction, and Section 4(a)(6) may benefit greatly from the ingenuity of funding portals and other intermediaries. Whatever the eventual fate of Section 4(a)(6), crowdfunding, whether donation based or securities based, is here to stay, and the greatest developments in this young fast growing universe are still yet to come.