By Dan Ovadia
What is Crowdfunding?
Crowdfunding is the process by which a business raises a relatively small amount of capital from a large number of funders. Crowdfunding networks rely on social media to get the word out about their product while attracting a broad base of supporters. The crowdfunding concept has arguably existed as far back as the 1700s, but the modern incarnation started in the late 1990s and began building serious momentum in the mid/late 2000s. The global crowdfunding industry continues to grow exponentially with $2.7 billion raised in 2012 and $5.1 billion raised in 2013; experts project that the global market could exceed $90 billion in 2025.
Reward-Based v. Equity-Based Crowdfunding
Within the crowdfunding industry, there are two primary funding models: rewards–based and equity–based. Reward based crowdfunding sites like Kickstarter allow companies to offer funders rewards/products in exchange for their support – essentially serving as a presale website. In contrast, equity-based crowdfunding allows funders to take an equity position in the venture. Historically, equity-based crowdfunding was conducted following Rule 506 of Regulation D. Rule 506 provides an exemption from §5 of the Securities Act of 1933 and thus allows companies to fundraise privately from accredited investors (those with significant assets) without the extensive §5 registration process.
Equity Crowdfunding Expanded Through the JOBS Act
Passed by Congress and signed into law by President Obama in 2012, the Jumpstart Our Business Startups (JOBS) Act was intended to spur job creation by providing startup companies with greater access to investor capital. Both Title II and Title III of the JOBS Act focused on making the “startup financing process more accessible and efficient.” Title III accomplished this by creating an additional crowdfunding exemption to the Securities Act of 1933. This exemption opened the door for non-accredited investors to participate in equity crowdfunding. To further facilitate crowdfunding, Congress charged the SEC with developing new rules to align with Title III. Subsequently, in October of 2013, the SEC proposed a set of rules on crowdfunding and opened a 90-day period for public comment (which included a letter from Cornell Law’s own Securities Law Clinic). On October 30, 2015, the SEC adopted a final version of the rules; these rules are set to become effective in 2016.
Key Details of Title III
It is worth noting that under Title III, a company can only raise up to $1,000,000. Additionally, the amount a non-accredited investor can invest is governed by their financial circumstances. One can invest: (a) the greater of $2,000 or 5 percent of the lesser of their annual income or net worth, if either the annual income or the net worth of the investor is less than $100,000; and (b) 10 percent of the lesser of their annual income or net worth, if both the annual income and net worth of the investor is equal to or more than $100,000. From the issuer’s perspective, the level of required disclosure is based on the amount being raised. As a result, compliance is cheapest for companies raising under $100,000. Compliance is progressively more costly for companies raising between $100,000 – $500,000 and then more so for those raising over $500,000. Regardless of the offering size, §4A of the 1933 Act requires issuers utilize a broker or registered funding portal.
Appeal and Criticism of the Title III
While many applaud the objectives of the JOBS Act, and specifically Title III, many experts in the crowdfunding industry have serious concerns about the legislation’s current form. On the one hand, crowdfunding enthusiasts believe that these new regulations will finally allow average investors the opportunity to participate in potentially extraordinary opportunities (e.g. venture capitalist Peter Thiel’s $500,000 investment in Facebook ultimately exceeded $1 billion in value). But on the other hand, most early stage companies fail and perhaps the average investor should be sheltered from such risky investments. Additionally, there may be an adverse selection problem such that the very best companies may pursue more traditional funding sources and thus leave average investors with the least compelling opportunities. Furthermore, concerns over fraud have been echoed since the introduction of the JOBS Act. The Act removes certain investor protection mechanisms thus, leaving less sophisticated investors, who are ill-equipped to assess potential fraud, more vulnerable to being defrauded by companies.
For issuers, some initially postulated that opening crowdfunding to a broader population would allow for a reduction in the cost of capital. But disclosure and compliance costs have emerged as a major concern. Some estimates have pegged such costs at between 15 and 40 percent of the equity offering, an extraordinarily high and likely prohibitive cost for capital. This high cost, coupled with other hurdles under Title III, make it likely that companies will instead elect continue to raise funds through accredited investors using the less onerous Rule 506 of Regulation D.
Overall, an expansion of crowdfunding is inevitable. Reward and donation-based sites like Kickstarter, Indiegogo and gofundme and others will likely continue to flourish. But in its current form, Title III crowdfunding fails to live up to the promise that many in the crowdfunding space had desired. All hope is not lost as revisions to Title III could position the regulation to become more desirable to both issuers and investors.