March 22, 2012 in ATDC News

Guest Blog: Crowdfunding – Coming Soon to a Social Network Near You?

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For entrepreneurs, fundraising at the early stages of a business is a daunting task. Identifying prospective investors and persuading them to place a bet on a company without a product, revenue, or customers is often the most challenging issue entrepreneurs face today. But all of that is about to change soon if Congress has its way in the days and weeks ahead. The Jumpstart Our Business Startup Act (JOBS) includes provisions to legalize crowdfunding, a method of fundraising employing general solicitation techniques via the internet, email, and social media. The Act also contains various provisions to relax restrictions on companies that undertake initial public offerings and remain as public companies, but the crowdfunding legislation is perhaps the most intriguing aspect of the proposed new law.

Currently, federal and state securities laws prohibit general solicitations in unregistered offerings and often require investors to meet certain minimum requirements regarding net worth, income, and sophistication. As approved by the House of Representatives, the JOBS Act would allow companies to raise up to $1,000,000 from numerous small investors without these requirements. No investor could invest in an offering more than the lesser of 10% of the investor’s annual income or $10,000. Congress believes these new laws will result in many more companies raising capital and therefore hiring employees and improving the economy, and they’re probably right.

Imagine the possibilities: A college student with over 1,000 friends on Facebook writes a status update describing a new business idea he just came up with and offers to sell 20% of his company for $1,000,000. Friends provide comments with offers to invest as little as $10, providing an aggregate amount of capital for him to get his business off the ground. An entrepreneur posts a YouTube video about his new venture on his Twitter feed which gets re-tweeted to millions of people, many of whom sign up to invest small amounts of capital individually but collectively total $1,000,000. An active mommy blogger with a large following decides to start a company in an unrelated field but solicits funds from her loyal readers with whom she has built a trusting relationship but most of whom she doesn’t personally know. Clearly, crowdfunding would legally open doors to capital that were previously unimaginable.

But crowdfunding is not without its risks. Critics of the legislation believe this type of fundraising will lead to rampant fraud and abuse, creating a “boiler room” type of atmosphere. Companies could face increased administrative burdens and legal costs to keep track of their large shareholder bases without any public oversight. VCs and other institutional investors, who typically invest after the earliest stages of a business, may be reluctant to invest in companies that have potentially unwieldy shareholder bases who could be disruptive to management and pose challenges to smooth exits by large strategic buyers. The SEC, which strongly opposes the JOBS Act, would surely promulgate various rules and regulations regarding crowdfunding if the Act became law to narrow what would be an almost limitless playing field for fundraising.

The JOBS Act still faces several proposed amendments in the Senate, including a potential requirement to provide financial statements to investors and a reduction in the investment limits to the lesser of $2,000 or 5% of annual income for those investors with a net worth or annual income of less than $100,000, but allowing investors with a higher net worth or annual income to invest potentially more than the current limits in the House bill. Other potential amendments may include a requirement that crowdfunding intermediaries register with federal and state securities regulators and presumably be subject to some qualification process and scrutiny.

If the Senate approves these or other potential amendments, the House could pass the Senate’s bill, or they may seek to reconcile any differences between the chambers in a conference committee on the legislation before approving a single bill and sending it to the White House to be signed into law. The timing will become clearer after Senate action on Thursday; but unlike most recent legislative efforts on Capitol Hill, the JOBS Act has broad-based, bipartisan support in nearly every respect, and many pundits believe it will soon become law in a form close to that of the House bill. So, ready or not, crowdfunding is close to becoming a legal reality, and the startup landscape may never be the same again.

Douglas R. Spear is a partner with Nelson Mullins Riley & Scarborough LLP, an ATDC sponsor company.

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