Sometime early next year, the Securities and Exchange Commission is expected to propose rules that would pave the way for “equity crowdfunding,” harnessing the groupthink of social media as a tool for capital investment.
Small public companies (those with revenues of less than $5 million) could be able to raise up to $1 million using this approach to sell stock or promote revenue-based financing. Even ahead of those regulations, however—foisted upon the SEC by the JOBS Act—some companies are trying to get ahead of the crowdfunding race, through a careful parsing of Regulation D exemptions and state securities laws and adapting the “reward” based model already in use.
Among the Websites already running is Bolstr.com. Co-founder Charlie Tribbett says the service, which launched last month, aims to serve the neglected market for small business capital. This market, typified by the sort of no-interest loans hashed out over a dinner table, is estimated at about $50 billion a year, he says, with tremendous growth potential.
The catch? The forthcoming rules for crowdfunding platforms will only allow them to solicit donation-based capital from investors. So Bolstr acts only as a middleman—it transfers no money directly from investors to a business. Instead, it serves as the platform for companies to launch their own fundraising efforts.
The process, however, is a bit more complicated than that may sound.
“We ended up doing a state-by-state blue sky regulatory analysis and incorporated all the current securities laws into a technology platform,” Tribbett says. “The software will tell [companies] exactly what they need to do to stay in compliance with those regulatory laws of the state the investor resides in.”
The system, he says, uses the Regulation D exemption that allows small-business owners to conduct a private offering with both accredited and non-accredited investors. Other efforts have traditionally worked exclusively with accredited investors by registering as a broker-dealer or partnering with one. But it isn't economically feasible to be a broker-dealer and help businesses raise sums of $25,000 or less, Tribbett says. His service also offers a means for investors to get some near-term liquidity through top lines sales the business owner agrees to share over a defined time frame.
Another new breed of crowdfunder is IPO Village, which brings pre-IPO deals to retail investors. Its owner is First Line Capital, a boutique investment banking firm founded by Simon Erblich.
The company says it doesn't have to wait until the JOBS Act is fully implemented, because it crowdfunds publicly traded stock. Its role, like Bolstr, is as an intermediary. Unlike other crowdfunding sites that focus on private offerings, its hosted public offerings are offered to members on a first-come-first-served basis. IPO Village, through First Line Capital, funds the legal, accounting, and underwriting costs associated with the initial public offering. That investment is reimbursed from proceeds once the company makes money and equity shares are later sold.
Its first facilitated IPO is on behalf of a medical device company that has yet to be named due to quiet-period rules. The secrecy, however, hasn't stopped nearly $1 million in pledges from about 500 investors.
“It will be risky for everyone in the healthcare crowdfunding industry if fraudulent or flaky companies and projects get funded.”
—Patricia Salber,
CEO,
Health Tech Hatch
“We can fund our offering not with institutional money, which is much harder on valuation, but through the public without any middlemen,” Erblich says. “What we are dong isn't trying to figure out how to do it without disclosures and without registering these public offerings. We are doing it the right way from a regulatory perspective. We are not trying to reinvent the wheel.”
Like traditional crowdfunding sites such as KickStarter and IndieGogo, Health Tech Hatch, a crowdfunding site specifically for the healthcare sector, is still limited to donation and rewards-based crowdfunding, says CEO Patricia Salber, who is also vice chair of the National Crowdfunding Association. Even with that restriction, it still assists entrepreneurs with getting projects funded, developed, and sold.
Salber says all projects are evaluated to make sure that the proponent can actually complete his or her project.
“It will be risky for everyone in the healthcare crowdfunding industry if fraudulent or flaky companies and projects get funded,” she says. “Going forward, when we're able to do equity crowdfunding, the issues will become more complex, including more thorough due diligence of the companies, good communication, transparency, and an understanding of how to structure deals so that it doesn't adversely affect a company's ability to raise money via angels or venture capitalists.”
One naysayer of these efforts is David Isenberg, professor of management practice at Babson College and founding executive director of the Babson Entrepreneurship Ecosystem Project. He is a vocal critic of equity crowdfunding as pushed by the JOBS Act, and regularly receives hate mail from its proponents.
Rather than democratizing access to capital for entrepreneurs, Isenberg (himself a longtime angel investor), sees equity crowdfunding as a dangerous game that many retail-level investors will play without fully understanding the rules.
Purchasing stock in early-stage ventures is complex and fraught with risk, he says, and investor and entrepreneur interests are seldom aligned at this juncture. Necessary due diligence—an expensive prospect for all venture capital efforts—could ultimately prove too complicated, costly, and impractical for these new initiatives.
Isenberg asserts that venture capital investing, even when it involves high-multiple, high-growth companies, is always risky. If experts in the VC world routinely lose money at the game—and they do—novices attracted by the prospect of crowdfunding startups will certainly face unreasonable odds, he warns.
“You've got all the downside and none of the upside,” he says. “It's extremely likely the average investor will lose money. That's the destruction of value, not the creation of value.”
How It Might Work
Sherwood Neiss, co-founder the Crowdfunding Professional Association, was one of three entrepreneurs who authored the framework for equity-based crowdfunding that ultimately made its way into the JOBS Act. He views it as a crucial blueprint for minimizing fraud and doing the best possible to ensure an honest, vibrant marketplace—which, he insists, is indeed possible.
FRAMEWORK CRITERIA
The following is an excerpt from the CrowdFund Investing Framework developed by Sherwood Neiss, Jason Best and Zak Cassady-Dorion. Any entrepreneur/business that does not meet the criteria outlined below or “graduates” from the framework would have to comply with existing SEC rules.
Amount & Class of Shares: A “funding window of up to $1M” for entrepreneurs and small businesses, defined as one with average annual gross revenue of less than $5M during each of the last three years or since incorporation if the business has existed for less than three years. Common stock is on par with similarly used shares in early stage rounds of family and friends financing and RBF is a new form of financing where investors own a percent of future revenue for a certain period of time.
Limit: Investments from unaccredited investors will be capped at $10,000 or 10% of their prior years Adjusted Gross Income (AGI). The $10,000 limit is in line with other established financial disclosure limits like those on banking transfer reporting requirements. Accredited investors will not be subject to any limits.
Risk Disclosure: Accreditation should be attached to investors understanding of the risks inherent in this type of investment. Prior to using these platforms, investors will have to agree using current standard verification technology that they understand there is no guarantee of return, that they could lose their entire investment and that their liquidity/return is limited to any dividends, sale, public offering or a merger of the company.
500-Investor Rule: Eliminate the 500-investor limit for Crowdfund investing.
State Law: Exempt these offerings from state law registration requirements based on the limited size of the amount that can be raised, but leave intact a simplified and modified state law notice filing requirements, similar to the way SEC Rule 506 currently works, but less cumbersome.
General Solicitation: Allow for general solicitation on registered platforms where individuals, companies and investors can meet virtually, ideas can be vetted by the community as a sort of peer review and individuals can make informed decisions regarding whether or not to invest their money.
Filing & Reporting: Standardized forms based on industry best practices will be used to maintain transparency and reduce time and expense for all parties. They will be electronically maintained using standardized procedures. Post funding standardized and automated reporting for use of proceeds will be required on a quarterly basis by entrepreneurs. Platforms will provide the SEC monthly offering reports that include information on: deals funded, entrepreneurs' names, social security numbers, addresses, date of births, amount of capital raised, list of investors and individual dollar amount contributed.
Platform broker/dealer exemption: Due the small nature of the dollar amount, and the high volume of automated activity, allow facilitation of funding for securities without need for a (FINRA) broker/dealer license by the facilitator.
Availability: This exemption shall not be available to foreign issuers, investment companies, and public companies.
Source: Crowdfund Investing Framework.
For example, the SEC could include in its final rule a background check for entrepreneurs. Investors may need to take a pre-qualifying, standardized test to assess their knowledge of the investment and the potential downside. They could also be required to create a risk profile that would cap their investment at an upper limit of $10,000, or 10 percent of their prior year's Adjusted Gross Income.
Under Neiss's framework, standardized forms, based on industry best practices and maintained electronically, would be used “to maintain transparency and reduce time and expense for all parties.” Automated reporting for use of proceeds would be required on a quarterly basis by entrepreneurs, and platforms would provide the SEC monthly offering reports that include detailed information on both investments and investors. The industry would be overseen by a self-regulatory organization that reports to the SEC.
Among the most important items, Neiss says, is that no money will change hands until an entrepreneur's funding target is completely pledged.
“There is nothing you can do to prevent typical fraud in the name of crowdfunding,” he says. “It happens all the time. Fraud is fraud. Just because they say, ‘It's crowdfunding!' when they are committing fraud, that doesn't mean crowdfunding is bad.”
Neiss adds that any schemers who see crowdfunding as easy way to raise cash will get a rude awakening.
“There are much easier ways to commit fraud than to go through all this,” he says.
Even the staunchest advocates of crowdfunding, however, still fret about the rush to market that the SEC's forthcoming rules will trigger.
“It definitely feels like there is a massive land grab going on and there are hundreds of platforms lunching in light of this new legislation,” Tribbett says. “Whenever there is a major change like this, everyone wants to try to profit from it. We believe that the ones focused on the mission and not the land grab are going to be the ones who are successful.
“Yes, there are going to be 1,000 sites that are going to come up,” Erblich says. “And yes, there is going to be havoc. There are going to be SEC penalties and inquiries. There is going to be fraud and those sites that just can't get anything done. Then the herd is going to start to thin out. You will be left with only the crowdfunding sites that are successful and can generate the crowds.”
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