Crowdfunding – Will It Change the World of Financing Small Businesses in the US?

Unfortunately no one will know for sure until the Securities and Exchange Commission (“SEC”) issues rules to implement the use crowdfunding for financing small businesses. These rules should be in place later this year or early 2013. But the possibilities of crowdfunding are creating a lot of excitement, generating strong opinions both pro and con and prompting many to line up in hopes of profiting by facilitating crowdfunding for other businesses.

Crowdfunding is the process of raising money for a project or venture from many people who each generally contribute in small amounts. This technique has been used to raise money for a wide variety of purposes including musicians and other artists seeking support from fans, political campaigns, disaster relief efforts, microcredits for entrepreneurs in poor countries, philanthropic projects and social change efforts. Crowdfunding has even been used to finance in vitro fertilization.

But until recently crowdfunding has been illegal for use in selling securities by small businesses. Then the “Jumpstart Our Business Startups Act” aka the JOBS Act became law in April. One part of this law created a new exemption under the Securities Act of 1933 which allows the sale of securities to a large number of unaccredited investors through crowdfunding.

The basic law, per http://majorityleader.gov/uploadedfiles/JOBSACTOnePager.pdf, “allows companies to pool up to $1 million (author addition – per year) from investors without registering with the SEC, or up to $2 million if the company provides investors with audited financial statements. Individual contributions are limited to $10,000 or 10 percent of the investor’s annual income, whichever is less.”

But the devil will be in the details. Most of the rules that will govern crowdfunding as a means to raise money for businesses, and the actual mechanics as to how this process will work under the new law will be determined by the SEC. These rules could help make crowdfunding an accessible, popular way for small businesses to raise capital, or mire crowdfunding in a morass of restrictive regulations and/or red tape that will make this technique impractical.

One important note – as the SEC has not yet issued its rules and regulations on crowdfunding, they have publicly warned us all that any offers or sales of securities claiming to be exempt from registration under the new JOBS Act are still illegal at this point.

Proponents of crowdfunding as a means of raising money for small businesses point out that in the current environment it is difficult for entrepreneurs and small businesspersons to raise equity funds from investors or get loans from banks or other lendors. Also, it’s often not cost-effective to raise only $1 to $2 million from accredited investors. They also note that current exemptions from registration are based on dollar amounts that haven’t changed in a generation or more. So they believe the new rules will be great for start-ups and small businesses.

Opponents point to the reduced accountability and almost certain increase in fraud. This will possibly increase the cost, and decrease availability, of capital for legitimate, honest businesses. Why would investors from around the world flock to US equity markets when the level of fraud is as high, or higher, than other markets around the world? In the future, shareholder litigation could become a major source of securities regulation for the financing of start-up and small businesses.

One other potential problem is how will facilitators, or “intermediaries”, make money in helping small businesses raise capital? Given the relatively small amounts involved, most wanna-be intermediaries are web-based. Up to now, crowdfunding has been mainly a labor of love for both contributors (actually donators rather than investors) and those who have organized the fundraising. Presumably, those now positioning themselves to raise money in this space will want to make money.

So, as noted at the outset of this article, whether crowdfunding becomes an important new source of funds for small business, a cesspool of fraud or a bureaucratic nightmare will depend largely on the rules put forth by the SEC.