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Monday, October 20, 2014

Crowdfunding and the JOBS Act


Crowdfunding allows a large number of investors to fund a specific project or business. When the Jumpstart Our Business Startups (JOBS) Act was signed into law in April 2012, the concept had already been around for years, with “rewards-based” crowdfunding platforms such as kickstarter.com (launched in 2009) and indiegogo.com (launched in 2008) helping companies raise money from investors in exchange for goods or services.

The JOBS Act was seen as a game-changer for technology startups, however, because it let companies offer crowdfunding investors equity positions for their money, rather than a product or service. This potentially opened up a huge new pool of investment capital.

Two-and-a-half years after the legislation was signed, things haven’t quite gone according to plan. A significant portion of the JOBS Act is still on hold, although one type of equity-based crowdfunding has gotten off the ground. In the meantime, rewards-based crowdfunding has continued to grow, and some startups are now using it as a springboard to attract equity financing from large investors.

Background
The JOBS Act included two parts related to crowdfunding. The first, known as Title II, loosened the marketing restrictions on companies and allowed them to advertise and “generally solicit” for private company stock. It also allowed companies to take equity funding from accredited investors (defined as having a net worth of at least $1 million, or an annual income of $200,000 for the current and past two years)

The second part, known as Title III, allowed companies to raise money from small (non-accredited) investors in return for equity―a potentially huge development. Companies could raise up to $1 million a year through an online funding portal or registered broker-dealer, and small investors could invest a maximum of $2000 to $100,000, depending on their income and net worth.

Where things stand now
Title II went into effect in September 2013, and since then equity crowdfunding has been gaining traction with accredited investors. As of the third quarter of 2014, the equity platform Crowdfunder.com had helped close rounds of funding for 32 companies, with an average deal size of $1.6 million. 

As rewards-based crowdfunding continues to take hold (Kickstarter has successfully raised almost $1.2 billion to date, including $174 million for technology projects), it’s also playing a growing role in helping startups get equity investment. Some companies are now raising initial funds on rewards-based platforms, then using those successful campaigns to validate their project and attract rounds of equity funding from accredited crowdfunding investors and venture capital funds.

For example, smart bulb startup Lifx recently raised $12 million in venture capital after a successful $1.3 million Kickstarter campaign, and Neil Young's digital music startup PonoMusic raised $6 million in its first week on Crowdfunder, after raising $6.2 million via Kickstarter.  Roughly 10 percent of the 443 hardware projects raising at least $100,000 on Kickstarter or Indiegogo have gone on to raise venture capital totaling $321 million, according to a recent report by research firm CB Insights

Meanwhile, the Title III rules opening up equity crowdfunding to small investors remain on hold. They haven’t been finalized by the SEC, and the subject has become a political football, with the proposed rules criticized for being too regulation-heavy and costly for startups to implement, given that companies can only raise $1 million a year. (The opposing view is that the fundraising limit and regulations are necessary to protect investors and prevent fraud.)

The proposed Title III rules require an issuer to file with the SEC and disclose the names of directors, officers, and individuals holding more than 20 percent of its shares.  Companies must also disclose a business plan outlining the intended use of the proceeds, the target offering amount, and certain financial information, depending on the offering size:

  • Offerings under $100,000 - income tax returns and financial statements certified by the issuer’s principal executive officer
  • Offerings greater than $100,000 and under $500,000 - financial statements reviewed by an independent CPA
  • Offerings greater than $500,000 – financial statements audited by an independent CPA

It’s anyone’s guess as to when, or if, the SEC will finalize some version of Title III, or what that final version will look like. In the meantime, crowdfunding continues to evolve and add an exciting new element to the capital markets.

Crowdfunding is not a one-size-fits-all solution, however, and startups need to weigh the funding benefits against the potential drawbacks. Answering to a large investor base can ultimately distract management from running their business, for example, and the repercussions of missing disclosure requirements can be significant.  Technology companies should work closely with their CPAs and legal counsel to determine if crowdfunding is right for them and create a strategy for success.

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