What is Equity Crowdfunding?
The SEC finalized equity crowdfunding (Reg CF) regulations in May 2016. This innovative new law allows small businesses, entrepreneurs, and startups to raise capital through equity or debt sales to the “crowd” just as a public company could.
Reg CF Basics:
- Any business can raise up to $1.07M over a 12-month period and can set a minimum and maximum range
- Businesses sell their financial instruments over a FINRA-approved portal
- Investors are subject to limits based on income and net worth, and usually must hold the investment for one year
- Businesses are required to track financial instruments and file a year-end report with the SEC
Any successful equity crowdfund has three components: Legal, Accounting, and Marketing. A successful raise will usually require around $20K upfront and will be subject to portal fees after a successful raise.
Equity Crowdfunding so far
As of August 14, 2017, businesses have raised $53,353,149 through equity crowdfunding.
Credit: Crowdfund Capital Advisors
Almost 400 businesses have participated through 29 active portals. Businesses from a variety of sectors have utilized Reg CF with food and beverage, entertainment, sports, and transportation leading the way:
Credit: Crowdfund Capital Advisors
Certain portals have begun to separate themselves but it is very fluid and some outperform depending on the type of business.
Credit: Crowdfund Capital Advisors
Congress and the financial media have discussed several ‘fixes’ to make equity crowdfunding more dynamic, including the Reg CF provisions of the Financial CHOICE Act. While no guarantee any fixes will happen, many in Congress recognize the need for improvement. Some of the most discussed modifications are:
- Raising the annual raise limit to $5M or $10M
- Removing investment limits for accredited investors
- Removing or lessening the accounting burden
- Removing or lessening the solicitation rules
What Equity Crowdfunding can do for your business
Besides capital to help your business grow, Reg CF provides other benefits unique to this model.
- Broaden your investor base: Unlike other funding models, Reg CF can diversify your investor base from both a financial and geographical standpoint. Portals can accept investors from anywhere in the US, giving your business a potential foothold in all 50 states.
- Turn your customers into marketers: Reg CF allows your customers to become financially invested in your business and see their investment grow as your business grows. This provides a free marketing campaign for your business with every new investor.
- Incentivize your investors: Reg CF allows you to give out perks as part of the investment. Depending on the product this could include the product itself, ‘founder’ status on your website, access to events, or anything else that may induce an investment.
- Prove value to institutional investors: A successful Reg CF raise can show larger, institutional investors your business is ready for the big money. Many larger investors are now requiring “social proof” of a company’s business model. Your business can show larger investors value and momentum and provide your business “bridge money” while larger investors evaluate your model.
How Jossey PLLC can help capitalize your business
- Handle all disclosures and regulatory compliance with the SEC. This includes your Form C, and any other legal issues
- Research the best portal for your product, make recommendation based on the best fit for your product
- Recommend a particular financial instrument and tailor the contract to fit your needs
- Review contracts, negotiate with vendors, recommend accountant and marketer
- Free advertising and profile on my blog thecrowdfundinglawyers.com (approximately 2,000 unique visitors/month)
- On call for any legal, regulatory, compliance question you have usually get back with an answer in less than 24 hours.
Post Raise (additional monthly fee):
- Act as general counsel for your business. Answer any legal, regulatory, or compliance question that may arise. Review contracts, negotiate with vendors, and give general advice on employment and other business issues.
- Track your instruments: track any change of ownership throughout the year as required by SEC regulations.
- End of year report: Handle your year-end report as required by SEC regulations.
This document is for informational purposes only. It does not represent a contract, offer, or any legal obligation on the part of Jossey PLLC. Many factors go into a successful raise including appeal of the product, competition for the product, the quality of the marketing, operating history of the company, experience of management, and ability to self-generate crowd investors. Legal and regulatory compliance is only one part. Investing in small companies and startups carries lots of risk, there is no guarantee your business will have a successful raise.
While other entertainment sectors like music and cable television have seen paradigmatic disruptions in the past 15 years, Hollywood has thus far proven immune. That’s about to change. Equity crowdfunding and blockchain distribution may be about to turn Tinseltown upside down.
Currently the movie business operates in an esoteric netherworld, full of middlemen, secret contracts, and mafia-like protection rackets. Major studio heads and a few A-list actors gain fortune and fame and everyone else ekes out a living even while working on summer blockbusters. Hollywood’s financial structure is murkier than the latest spy-thriller. According to opaque industry accounting, even runaway hits like The Hobbit trilogy lose money.
How are movie dollars made? According to reports, major studios generate their bulk revenue from licensing deals with broadcast networks, all of which are owned by the studio’s corporate conglomerates. This makes it nearly impossible for outsiders lacking massive archives to break through without a steady stream of hits.
Rewards crowdfunding platforms like Kickstarter and Indiegogo tried to breach the Hollywood fortress but Tiseltown gatekeepers repelled them. Enticing the crowd with DVDs and other goodies preproduction distracts talent, robs films of commercial value, and degrades marketing and licensing opportunities.
Enter equity crowdfunding. Reg CF—now a year old—allows moviegoers to become equity partners in films and share in their potential success. Instead of a DVD, Reg CF investors get ownership. Perquisites are still available and producers can offer large investors roles as extras, access to exclusive parties with the actors, or behind-the-scenes looks at production.
Producer’s not only get their projects partially funded through crowdfunding but also get a readymade marketing operation. The potential for financial payout incentivizes Reg CF investors to work for the film’s success. This cast of potentially hundreds or thousands of acolytes gleefully spreads the word on social media and their other networks, building grassroots excitement for a movie premier. Traditional advertising can’t buy this type of organic hype.
Two movies crowdfunded on Mircoventures/Indiegogo portals have been early adopters. Animated film ‘Bunny Bravo’ has raised almost $150K towards its goal of 200K to cover distribution and marketing. ‘Field Guide to Evil’ successfully completed a $500K offering earlier this year.
Entertainment is one of the leading sectors of the nascent equity crowdfunding movement. According to Crowdfund Capital Advisors, entertainment ventures have received almost $3.5M in funding thus far.
Further down the road, blockchain technology may give Hollywood another shock. This new concept aims to excise everyone but the ‘creatives’ from filmmaking. Through decentralized online distribution, cryptocurrency, ‘smart’ contracts, and IP ownership, blockchain may signal an alternative way to make movies.
Nick Ayton of The 21 Million Project is producing a film/tv series using this concept. He claims he can cut a film budget by a factor of 5 or 6 through blockchain, thereby making a $30 million film for a $5 million. The 21 Million Project has committed 80% of profits to holders of 21MCoin, the online security financing the film. These crowd investors will receive film royalties in perpetuity.
It remains to be seen if blockchain becomes the new standard and if so how long it will take, but what is certain is crowdfunding is here to stay and everyone that doesn’t adapt, even Hollywood fat cats, will be left behind.
By Jossey PLLC
The SEC recently warned equity crowdfunding investors about a popular Reg CF security called a ‘SAFE’—Simple Agreement for Future Equity. The Commission is concerned investors purchasing SAFEs may be unaware of their risks and should be cautious of this “exotic” Silicon Valley security.
Although SAFEs have drawbacks for early investors, if done with favorable terms they provide potentially big returns while giving early stage companies freedom to manage initial growth without the burdens associated with traditional securities. Investors should always weigh risks and understand their investments but SAFEs are not inherently unsafe, they can benefit both startups and early investors.
SAFE’s are a product of Y Combinator, rated by Forbes the most successful startup incubator. Its companies have a combined valuation of $8 billion and include well-known names like Reddit and Airbnb. SAFEs were born as an alternative to the convertible notes Silicon Valley startups provided early investors, which featured sometimes-burdensome interest rates and maturity dates.
As the SEC notes, SAFEs are not equity or debt, like a warrant they promise future equity if the company reaches certain benchmarks or triggering events. These could include future funding rounds, acquisition, or IPO. A SAFE in essence rewards early investors willing take bigger risks with larger returns if the company progresses as forecast.
This promise, however, comes with drawbacks on the investor side. Investors don’t get immediate ownership as they would with common stock. They have no voting rights and, there may be buyout clauses, or repurchase rights that could lessen the SAFE’s appeal. They are not debt so accrue no interest and, of course, they may never convert if the triggering event doesn’t happen.
But the factors that work against SAFEs investors have reciprocal benefits for young companies. They provide capital to entrepreneurs without strings that stifle flexibility and innovation in the early stages and allow the company to adapt to market conditions. The security documents are relatively simple meaning less time for tedious negotiations over details germane to bigger financing rounds. And the lack of voting rights or maturity dates allows entrepreneurs flexibility to grow without the burden of multiple owners or the threat of looming debt payments.
Should Reg CF investors invest in SAFEs?
Many companies considering equity crowdfunding fit the SAFE model. They are early stage ventures with limitless potential but need quick, simple financing to implement next-level growth or reach benchmarks that trigger future funding. As with any investment, the terms are paramount. Does the SAFE come with a generous valuation cap or discount rate that adequately rewards early investors taking bigger risks and granting more autonomy? These details inform whether a particular SAFE is worth the risk.
Companies offering SAFEs on Reg CF should realize these bigger investor risks and provide perks and very favorable terms with market caps and discount rates. They should also realize they are competing against other SAFEs and instruments that give investors more upfront security.
But generally SAFEs are not unsafe, they require a bigger risk upfront for a heftier reward later on.
This post is not legal or financial advice. Investors should consult a lawyer before purchasing any financial instrument through Reg CF.
By Jossey PLLC
Few issues in Washington get prodigious bipartisan support, but the 2012 JOBS Act’s equity crowdfunding title was one. After a long delay, Reg CF finally went live in last May.
But a year on some are asking, ‘Where is the Crowd?’ The crowdfunding total is approaching $40 million but it should be billions. A recalcitrant SEC and onerous regulations are two possible answers to why equity crowdfunding has experienced steady but unspectacular growth in year one.
To solve this, the House passed the Financial CHOICE Act. Although mostly a remedy to Dodd Frank, the Act includes a complete overhaul of equity crowdfunding. In fact, it includes a complete deregulation. According to CrowdfundInsider.com:
- gone are limits on how much a company can raise;
- gone are requirements for financial statements or, for that matter, any other type of disclosure;
- gone are requirements to file annual reports after completing a raise;
- gone is the risk of inadvertently becoming a fully reporting company, as purchasers of these securities are not counted towards the 500 non-accredited shareholder limit;
- gone is the requirement to conduct the offering on an SEC and FINRA registered portal;
- gone are restrictions on “off portal” solicitation and advertising; and
- gone are the restrictions on how much an investor can invest.
The chances of complete deregulation are slim. First, the bill has yet to face the Senate where some or all of it could be tossed in reconciliation. Second, the SEC must implement what survives. Some have accused the agency as being openly hostile to the very idea of crowdfunding. As Edward Knight, Executive Vice President and General Counsel of NASDAQ, stated in a March JOBS Act hearing for the House Committee on Financial Services:
From the outset the SEC’s view of [equity crowdfunding] was they were not for this they and made it shall I say needlessly complicated and did not approach it except as this this was something where the public is going to get harmed and we need to narrow it as much as possible.
At the very least, the SEC doesn’t seem to react well to change. Acting SEC Chairman Michael Piwowar described the changes the JOBS Act makes to the SEC’s mission this way:
The JOBS Act requires the Commission to think of capital formation and investor protection in fundamentally different ways than we have in the past. The crowdfunding provision of the JOBS Act forces us to think outside of our historical securities regulation box and to create a different paradigm than the one we have used for the past eight decades.
Whether through the CHOICE Act or a standalone bill, equity crowdfunding needs changes to reach its potential to provide much needed capital to America’s entrepreneurs and small businesses. The sooner Congress enacts these reforms the faster America’s economic engine can start humming again.
By Jossey PLLC
Equity crowdfunding celebrated its first birthday last week. The innovative securities law democratizes business capitalization and allows anyone to potentially make a bundle on a young company. Although Congress must tweak the law to realize its potential the future looks bright.
The naysayers fretted equity crowdfunding wouldn’t work. They said scandal and fraud would taint the process. Thus far they are wrong; the system of checks and balances between accountants and lawyers representing companies and due diligence by funding portals has combined to root out fraud while educating investors about the risks.
According to Catherine Yushina, COO & Co-Founder of Startwise, so far 265 companies have entered the equity crowdfunding market aggregating an impressive $37 million in investment. Around half have successfully completed a fundraising round.
But this is just the beginning. There are approximately 100 million startups opening each year and only 798 venture capital funds in the U.S. And of existing small businesses, 80% have never considered alternative funding options. That is changing rapidly. In the next few years the alternative funding market will grow to 20% of small business capitalization.
Early adopters represent a wide-range of industries including tech, real estate, fashion, sports, and entertainment. Food & Beverage and Wine & Spirits lead taking a combined almost $11 million.
But it’s not just about the boon to new businesses needing capital. On the giving end, millions of people now have the opportunity to invest in newest companies at a fraction of previous amounts. Before Title III of the JOBS Act the SEC only allowed “accredited investors” to participate in crowdfunding. This represented about 8 million people. Now around 240 million people can invest in potentially lucrative ventures at their beginning stages.
More exciting is that confidence is growing in the new markets. According to We-Funder, the average early investment was under $250, by the end 2016 it had jumped to $833 per person.
Seeing the success rewards based crowdfunding platforms have started offering securities. Crowdfunding platform giant Indiegogo is an impressive 12 for 12 in successful startup funding.
The future looks bright but Congress still has a role. When the SEC finalized the rules, it determined limits from the statute. Instead of taking the higher of annual income and net worth as the operative number to base the limit it went with the lower.
This can be big a difference. For instance under this approach, an investor with annual income of $50,000 a year and $105,000 in net worth would be subject to an investment limit of $2,500, in contrast to the proposed rules in which that same investor would have been eligible for an investment limit of $10,500. Using this lower limit hampers a startup’s most fervent supporters from pushing a potential issue over the top. Moreover, the overall limit of a little over $1 million per year is too low for many crowdfunded projects and harms market fluidity and dynamism. Another current proposal calls for tax credits for equity crowdfund investors.
While Congress hashes out improvements, the future of equity crowdfunding is bright. Given the number small businesses and startups in the US and the number of potential investors analysts could be discussing future birthdays in terms of billions, not millions.
By Jossey PLLC
Equity crowdfunding’s first six months ended in December, the numbers are in and the outlook is promising. So far, the crowd has given entrepreneurs and business startups millions in funding, filling a crucial market gap. As the kinks are worked out crowdfunding will continue to expand and become a viable option for thousands more new and growing American businesses. But in just a half year the industry’s dynamism is already apparent.
Crowdfunding in all forms topped venture capital in 2016. The crowdfunding industry is doubling or more every year. As stated in a recent article, equity crowdfunding alone will surpass venture capital as the leading source of startup money by 2020 if it stays on the same trajectory.
During the first six months businesses could take advantage of equity crowdfunding, 187 issuers made offerings, 24 were pulled leaving 163 asking for a total of $18 million. As of January 15, 33 offerings with year-end deadlines had closed receiving $10 million. Each month in 2016 brought an average of 22 new offerings over a variety of industries and through multiple portals.
According to the SEC, the average offering was targeting $110,000; the average scale of new offering activity on a monthly basis was approximately $2.4 million. Among those that reported non-zero total assets or sales in the prior fiscal year, the median asset growth was 15% and median sales growth 80% for the most recent fiscal year.
Early adopters were mostly small companies needing quick infusions of cash. About 40% of issuers reported non-zero revenue and 9% of issuers reported a net profit in the most recent fiscal year. Among issuers that reported non-zero assets in the prior fiscal year, the median growth rate was 15%. Thus crowdfunding is providing funds to new businesses that current markets weren’t servicing: startups and young businesses with relatively modest financial needs and lacking the sophistication or need for bigger offerings. Most issuers, 36%, opted for common or preferred equity. Debt accounted for 20%, and there were various other security types, such as units, convertibles, “simple agreements for future equity,” and others (including revenue sharing and membership / limited liability company (LLC) interests).
So what is exactly is equity crowdfunding?
It is part of the Jumpstart of Our Business Startups (JOBS) Act. Congress enacted this law on April 5, 2012. Title III of the JOBS Act amended Section 4 of the Securities Act of 1933 (Securities Act) and created a new exemption from registration for Internet-based securities offerings of up to $1 million over a 12- month period.
Here are the basics:
- A given issuer is able to raise up to $1 million across all crowdfunding offerings in a 12- month period. An issuer must raise at least the target amount to receive funds. Crowdfunding securities are generally subject to resale limitations for one year.
- The rules imposed limits on the amount that an investor can invest in all Title III crowdfunding offerings over a 12-month period. Investors with both an annual income and net worth of at least $100,000 can invest up to 10% of the lesser of annual income or net worth, but an investor’s total investment across all Title III offerings may not exceed $100,000 in a 12-month period. Other investors can invest the greater of $2,000 and 5% of the lesser of annual income or net worth;
- Crowdfunding issuers are subject to disclosure requirements at the time of the offering (on Form C), during the offering’s progress and on completion of the offering (on Form C-U) and annually in the form of annual reporting requirements (on Form C-AR).
- Issuers in larger offerings face additional financial statement requirements – in offerings of over $100,000 in a 12-month period, financial statements must be reviewed by an independent accountant, and in offerings of over $500,000 in a 12-month period (except the issuer’s first offering), financial statements must be audited.
- Crowdfunding securities must be offered through a registered broker-dealer or a registered funding portal, a new intermediary type established by the 2015 rules. These intermediaries are mandated to take measures to reduce the risk of fraud, make required disclosures about issuers available to the public, provide communication channels to permit discussion of offerings on the platform, disclose the compensation received by an intermediary, provide educational materials to investors, and comply with additional requirements related to investor commitments, notices to investors, and maintenance and transmission of funds. Registered funding portals that participate in crowdfunding offerings may engage in a narrower set of activities than broker-dealers.
According to the SEC, As of December 31, 2016, 13 funding portals have facilitated equity crowdfunding offerings. FINRA has approved an additional 8 portals and many more will arrive in 2017. The five largest portals based on the number of offerings accounted for 71% of initiated offerings. Hence, the majority of offering activity is limited to only a quarter of the active intermediaries in the crowdfunding market. The results are more skewed towards the five largest intermediaries when considering only completed offerings; they accounted for more than 90% of market share.
The future of equity crowdfunding is bright but could be even brighter. Some Congressional fixes could make it explode. In the next post, I will discuss how Congress could help even more entrepreneurs and small businesses with some fixes.
By Jossey PLLC