Many entrepreneurs or small business owners find it difficult in getting their venture off the ground because of insufficient capital. Typically, the most common sources of starting capital for small-businesses are personal funds and investment or gifts from friends and family. However, in recent years, another method has begun to catch the attention of both innovative entrepreneurs and potential investors: crowdfunding.
Understanding Crowdfunding
Crowdfunding is the act of collecting funds for a project or venture from a large group of people interested in seeing its success. Crowdfunding has exploded in popularity after finding its home on the Internet. The Internet reaches people all around the world and unites them toward donating and investing in ideas they want to see become reality. It is the perfect medium for a concept like crowdfunding. Hundreds of crowdfunding sites have been established in order to help innovators and young businesses find their audience and have a chance in taking the first step toward success. Stellar video game projects, a reboot of a popular children’s show, and even a simple bowl of potato salad are among the 22,252 success stories in 2014 on Kickstarter alone. As a result of these tremendous successes, many see crowdfunding as an enticing and excellent way to raise capital for their great idea. The question lies in what type of crowdfunding would be best for you.
Regarding the thousands of Kickstarter projects, all of these startups are a form of rewards-based crowdfunding. This is where in exchange for their donations, contributors will get some sort of compensation in the form of a t-shirt, a copy of the media that would be produced, or similar merchandise. These kinds of rewards are free from legislation because they fail to fall under the category of “securities.”
What about businesses who want to start up in this similar format? Rewards-based crowdfunding doesn’t complement or justify the long term establishment of, hopefully, a growing company. Instead, one can look towards equity crowdfunding.
What is Equity Crowdfunding?
Equity crowdfunding is raising capital in exchange for equity securities, such as stock within the prospective business. Prior to recent legislation, it was illegal to sell securities in a “general solicitation” unless they were registered under federal and state security laws according to the Securities and Exchange Commission, established in 1933. Following the crash of the stock market, one of the main purposes of the SEC was to protect investors from falling into fraudulent traps. It established rules as to which particular securities could be sold as well as requiring that all businesses have their financial information publicly available for all potential investors. As a result, investors would be readily informed of their financial decisions and be aware of any risks.
Over time, the relevance of these rules was questioned as opponents argued for some sort of update to security regulations. It was unfair, some argued, to ban equity crowdfunding through the Internet since at the time the SEC was formed we did not have the Internet or modern computers. In response, Congress passed the Jumpstart Our Business Startups (JOBS) Act which President Obama signed in 2012. The JOBS Act passage helped open the doors for both businesses and potential investors to take advantage of equity crowdfunding.
Freedom with Regulations
The JOBS Act tackles the issue of regulating and managing equity crowdfunding. The purpose of the Act is to give small and mid-size business access to capital thru equity sales. Title II and III address the principal issue directly. The key difference between the two is the type of equity they govern. Title II allows entrepreneurs who engage in equity crowdfunding to raise an unlimited amount of funds from an unlimited number of accredited investors through crowdfunding. This exposes businesses to around 6-8 million accredited investors in the U.S., but they must go through necessary measures in order to verify the accreditation status of potential investors. This still limits the pool of potential investors, but that is where Title III is critical to the crowdfunding formula. It allows unaccredited investors to participate and contribute limited investments to businesses seeking capital. This expands the list of potential investors to an additional 50 million individuals. This is not without its own set of regulations, nonetheless.
The restrictions present within Title III help establish a standard for entrepreneurs who wish to take advantage of equity crowdfunding and potential investors looking to partake in these ventures. Regulations for the businesses include United States localization, a maximum cap of $1 million raised in a 12 month period, and financial transparency for all potential investors. This includes a business plan that reveals the intended use of the capital as well as full disclosure of management within the company. Financial records and documents are a vital requirement in order to escape any potential claims of misleading information which could potentially lead to a lawsuit. Limits have also been placed on the unaccredited investors which determine how much equity they can purchase depending on their annual income or net worth. This is mainly in place in order to protect them from failed investments and not suffer severe losses as a result.
Recommended Steps in the Path towards Success
Thanks to legislative processes, equity crowdfunding has become a legal and viable option to startup businesses across the nation. If you are one of those who find interest in taking this approach, consider the following first steps to take before delving into the world of crowdfunding:
- Develop a Business Plan
Nothing shows preparation and dedication more than a well formed business plan to present to potential investors. It provides an established framework for the inner workings of the company as well as establishing priorities. Be sure to have a long term plan and self-evaluating steps in-between in order to show investors how you will measure their progress in reaching their goals.
- Legal Preparation
As mentioned previously, there is an enormous amount of responsibility and regulation that comes with equity crowdfunding. Be sure to research the types of equity and their differing degrees of rules and limitations in order to avoid any pitfalls that could sink your business. Make sure you have all the appropriate paperwork and statutorily required financial records and that they truthfully represents your financial position and goals for investment. Seeking legal advice or hiring a good attorney will definitely make sure that you are fully prepared for the crowdfunding market.
- Study varying Crowdfunding Platforms
Despite equity crowdfunding having been legalized just a few short years ago, there are hundreds of websites ready to help start your campaign. You should find a vendor who have security and compliance programs in place, such as following policies that prevent fraud or maintain a large investor population. The more advantages you have, the more likely it is that you’ll reach success.
- Pinpoint your Key Audience
Understanding who will be most attracted to your growing business is absolutely critical. Identify the niche group of investors who would be interested in your venture. It is fine if you wish to appeal to a broader audience, but never run the risk of losing your key supporters.
- Understand the Risks
Amongst the high number of successes we witness each day, there are even more failures hiding behind the scenes. This is usually a result of not gathering a large enough audience or not having a coherent and structured plan. No matter the reason, there is always going to be some risk with every startup. The best thing to do is be as prepared as possible and hope for the best.
If you’re interested in starting up your own business, or have any questions regarding equity crowdfunding and startups, feel free to contact the Law Office of Mark Smith, PLLC.