Crowdfunding. You've heard of it, maybe you've even participated in someone's Kickstarter campaign. Did you know there is a difference between donation-based crowdfunding and equity-based crowdfunding? How can you let others know that your company is open for investment without running afoul of the Securities and Exchange Commission (SEC) regulations?
You may be thinking, “my company isn’t public, so there’s no way SEC regulations apply to me.” They do. In the past ten years, however, your crowdfunding options have expanded significantly. But before you start e-mailing your subscribers to purchase shares in your company consider the available options and their requirements. I’m going to give you an overview of all three.
Donation-Based Crowdfunding (Kickstarter, GoFundMe, and Indigogo)
Donation-based crowdfunding sites have a fundamentally different function than the two equity-based options; they don't involve the offer or sale of securities and are regulated by consumer protection laws.
How do they work? You raise a small amount of money from each backer to raise enough capital to fund your project. Primarily, these platforms work like a charity and funders have no expectation of returns on their contribution – not even a tax credit for charitable giving.
What about the rewards structures that some companies offer to incentivize donations? At the risk of being overly generic to avoid diving into a rabbit hole, I'll touch on this. If you decide to provide reward incentives for donations, you've elevated your level of risk by creating a contract with each backer that has the right to hold you accountable for delivering the reward as advertised. For instance, if you end up providing a product that isn’t as described (lower quality, lacking in features and so on) you could be sued for breach of contract individually or as a class action. Most platforms contain terms explicitly stating that any promises you make, are between fund seekers and donators (not with the platforms themselves). Just google Kickstarter lawsuit, and you'll get the picture.
A crucial point to remember is that you can’t offer equity in your company in a donation-based crowdfunding campaign. You must make clear that no backer receives stake or profit share. Shy away from using any words that insinuate investment, like “shareholder” or “investor.”
As you would expect, people are less likely to fund a company when they don't get anything in return - it's human nature. If you haven't launched your company, donation-based crowdfunding can be an excellent way to validate and test your idea.
506(c) Securities-Based Crowdfunding
What if you’re looking for more extensive investment than donation-based platforms can provide and you're considering offering equity for cash, or in legal-speak, a securities offering. Generally, the SEC prohibits the solicitation and advertising of security offerings in mass outlets, like the internet, for both public and private companies. So how do you find investors? Rule 506(c) of the Jobs Act of 2012 gives us an exemption that may be an excellent consideration for your company.
How does it work? 506(c) allows you to raise an unlimited amount of money AND you can solicit and advertise for the sale of securities. You’ll see why this is important once you read the third option below. Unlimited investment and advertising, however, don’t come without some requirements.
First, under a 506(c) offering, you can only sell securities to accredited investors, meaning a person with an annual income of at least $200,000 or $300,000 if married for the last two years and the future expectation of earning the same or more. An individual can also be considered an accredited investor if they have a net worth exceeding $1 million. As always, there’s more to determining what constitutes an individual accredited investor; entities also have their own qualifications. Since this is a subject on its own, I wanted to give you a basic idea.
Second, you are required to conduct reasonable due diligence and “verify” that investors are accredited. It’s generally a good idea to either use a verification service or require all investors to provide reliable certification documents.
Regulation Crowdfunding Section 4(a)(6)
As with 506(c) crowdfunding, Section 4(a)(6) lets you advertise and solicit investments online (or through other mass distribution) to sell equity in your company. 4(a)(6) allows anyone to invest, not just accredited investors; this means your sister, friend, brother, neighbor, whoever can legally invest, can all have a little piece of your company. Don’t get too excited, though, because this exemption is far from the wild west funding mechanism that it initially comes off as; it’s attached with several limitations and requirements.
You are limited to raising no more than an aggregate total of $1,070,000 in one year.
Individuals with an annual income or net worth under $107,000 can only invest the greater of $2,200 or 5% of their annual income or net worth.
Individuals that make more than $100,000 are limited to 10% of the lesser of their income or net worth.
No investor, regardless of his or her worth, can invest more than $100,000 in a year.
Although not nearly as time-consuming and costly as the reporting requirements for public companies, you must still meet annual reporting requirements with the SEC and comply with advertising limitations. Note that under the above two options, no SEC reporting requirements exist. Here, the SEC is attempting to provide some protection to non-accredited investors.
You can’t sell securities on your own website. All funding under this section must be made through a registered funding portal, for instance, Wefunder Portal LLC, Truecrowd Inc., and EquityBender LLC.
It’s good practice to weigh the compliance requirements, legal risks, diminution in equity, availability, and how much capital you can raise under each crowdfunding avenue. The reporting requirements and investment caps under 4(a)(6), coupled with the risk of being sued by non-accredited stockholders may make the risk greater than the reward. I would suggest heavily considering donation-based (if available) and 506(c) securities-based funding before settling on the 4(a)(6) route.
The information in this blog post (“post”) is provided for general informational purposes only, and may not reflect the current law in your jurisdiction. No information contained in this post should be construed as legal advice, nor is it intended to be a substitute for legal counsel on any subject matter. No reader of this post should act or refrain from acting on the basis of any information included in, or accessible through, this Post without seeking the appropriate legal or other professional advice on the particular facts and circumstances at issue from a lawyer licensed in the recipient’s state, country or other appropriate licensing jurisdiction.