Client Alerts
March 11, 2013

Crowdfunding: The preferred financing tool of the internet era?

Stites & Harbison Client Alert, March 11, 2013

Under30CEO.com, a media website focused on ambitious Generation Y members, is polling its readers as to which U.S. cities present the best opportunities for young entrepreneurs. There are 45 cities nominated in three categories based on population, and Louisville is in competition with 14 other cities, including Chicago, Boston, New York, Austin, Washington, D.C., San Francisco, Seattle, Nashville, and Houston. In ranking these cities, voters are asked to consider each city’s available business/lifestyle balance from the perspective of an entrepreneur deciding where to establish a new business. While the availability of lifestyle options is certainly an important factor in deciding where to start a new business, without access to capital, even the most talented entrepreneurs with the most innovative ideas are likely to never get off the ground. An innovation known as “crowdfunding” may prove to be an exciting breakthrough in this arena, depending on the final decision of rulemaking authorities at the SEC, which is expected in the near future.

The financing options available to start-up companies today are limited because ideas and concepts are much more difficult to value and sell than bricks and mortar or cash flows. Family and friends are often a starting spot for entrepreneurs seeking bootstrap financing because of the vested interest that those folks have in the entrepreneurs’ success and their willingness to take a chance when no one else will. However, the population of family and friends is limited, which in turn limits that population’s overall effectiveness as an avenue to capital.

With the enactment of the Jumpstart Our Business Startups Act of 2012, (“JOBS Act”), the options may be changing in the entrepreneur’s favor. One element of the JOBS Act builds off the momentum of “crowdfunding” websites by allowing companies to raise up to $1 million annually from investors, without having to register the offering with the Securities and Exchange Commission or state regulators. In addition, businesses will be able to use the internet to connect directly with millions of potential investors. The SEC has yet to release its final rules related to crowdfunding, and until those rules are finally implemented, raising investment capital through crowdfunding is not permitted. However, entrepreneurs and investors remain hopeful that these rules will add a valuable new dimension to the capital markets.

Today, “crowdfunding” is used to describe any collective effort to pool money through the internet in support of projects, causes, and organizations. Until the SEC’s final rules are promulgated, the use of crowdfunding to issue equity or debt securities to investors through the internet remains illegal. As a result, crowdfunding as a funding source for small businesses currently requires more creative utilization. Examples can be found on popular websites like Kickstarter, where up-and-coming musicians can try to raise the money required to record and publish their new album by offering those who pledge funds in support of their project a reward, such as a signed copy of the album, if the “crowd” is successful in raising the funds necessary to make the album a reality. Inventors with exciting new product designs may pitch their ideas to site visitors, with those making pledges in support of the projects receiving, in some cases, delivery of the finished product out of the first run of production if the project’s fundraising goals are met by the “crowd.” Crowdfunding has also been successful in raising money for social causes through websites like Crowdrise, where registered charities may seek supportive contributions from the public.

The JOBS Act looks to build off the excitement that these crowdfunding sites have generated in the marketplace by allowing businesses to raise money through the sale of equity or debt securities to the public. Businesses would be permitted to raise up to $1 million in investments through crowdfunding investments, without the businesses having to register the offering with the SEC, so long as specific individual investment limitations are not exceeded and certain other conditions are met.

One of the conditions contemplated by the JOBS Act is the use of intermediaries called “funding portals” which would connect businesses seeking capital with individuals interested in making investments. Hundreds of website platforms have emerged in hopes of filling this role. If successful, this platform could develop a strong network of businesses and investors, with minimal cost and less complexity than exists in today’s fundraising marketplace. Young businesses that previously did not have the connections or the resources required to convert their stories and ideas into essential capital would have a whole new world available to them.

Though the JOBS Act is the law, the SEC still must enact related rules before equity or debt securities can actually be offered by businesses to the “crowd.” Among those rules will be the registration requirements for funding portals, which businesses and investors hope will prove lenient enough to encourage a broad portal network that can support an expansive capital marketplace. However, skeptics are concerned about the possibility for increased fraud and abuse by connecting starving businesses with potentially unsophisticated investors. According to Congress’ mandate to the SEC in the Jobs Act, these rules are technically long overdue, and entrepreneurs and investors alike are anxious to see if the final language will include enough flexibility to allow an active marketplace to develop but stringent enough to discourage fraud and abuse. Only time will tell whether the crowdfunding will actually evolve as a meaningful tool in the capital marketplace.

Please contact Jim Seiffert (jseiffert@stites.com) if you are interested in learning more about crowdfunding as a financing tool for your business or an opportunity for investment.

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