Crowdfunding E-Book

Steven Dresner

• Herausgeber: John Wiley & Sons
• Kategorie: Fachliteratur
• Serie: Bloomberg Professional
• Sprache: Englisch

Seitenzahl: 446

Veröffentlichungsjahr: 2014

Beschreibung

A groundbreaking book on the growing trend of crowdfunding

Crowdfunding has gained considerable traction over the last few years. By combining the Internet/social media with equity-based financing, it is poised to usher in a new asset class that will change how early stage and small business financing transactions are consummated. Author Steven Dresner, Founder and CEO of Dealflow.com, understands the nuances of how crowdfunding can help companies gain much needed access to capital, and now he shares those insights with you.

Engaging and informative, this book will serve the needs of a global audience comprising entrepreneurs, financiers, and other professionals. It skillfully addresses the market dynamics that are catapulting crowdfunding into the mainstream and explores essential issues ranging from planning an online campaign, post-transaction management, and business planning to securities law and tax issues.

• Puts the business of crowdfunding in perspective with a look at the current marketplace, overview of important data, and legitimate concerns
• Examines effective techniques for communicating with the crowd
• Details equity-based financing and other sources such as debt instruments
• Contains contributions from a wide array of individuals involved in the worlds of finance, law and accounting, social media, marketing, as well as DealFlow Media's own staff

Crowdfunding affords-start ups and other smaller businesses better access to capital via the Internet/social media. It also allows an investor of any size to back a business of their choosing. This new book will show you what this process entails and how it can benefit everyone involved.

Leseprobe

Contents

Acknowledgments

Introduction

Part I: The Business of Crowdfunding

Chapter 1: Crowdfunding: A Historical Perspective

Crowdfunding Isn’t New

Why Crowdfunding Disappeared

Regulation D, Sarbanes-Oxley, and Regulatory Reform

The Modern Era

Chapter 2: Understanding the “Crowd”

Quality Entrepreneurs and Ideas

Working on the Fundamentals for Crowdfunding: First Things First

Finding a Solution, Filling a Need

How Small Business Owners Can Prepare for Crowd Investing

A Radically Transformed Environment

Chapter 3: A Statistical View of Crowdfunding

The Marketplace

Crowdfunding Models

The Market Outlook

Chapter 4: Current Market Dynamics

Rewards-Based Crowdfunding

Investment Crowdfunding

Charity/Donation Crowdfunding

Niche Crowdfunding Platforms

Market Testing with Rewards-Based Crowdfunding

Broker-Dealers Entering the “Accredited” Crowdfunding Space

Crowdfunding as a Political Tool

Fraud in Noninvestment Crowdfunding

No Fraud in Investment Crowdfunding? (Not Yet at Least)

Additional Resources

Part II: Preparing for Your Crowdfunding campaign

Chapter 5: Business Planning in Preparation for a Crowdfunding Campaign

Writing a Business Plan Disclosure Document

Basic Information

Description of the Business

Description of Financial Condition

Use of Proceeds and Offering Amount

Valuing Your Company: Pricing Securities and Understanding Capital Structure

Reviewed versus Audited Financial Statements

Budgeting, Projections, and Forecasting

Conclusion

Chapter 6: Protecting Your Intellectual Property

The Importance of Protecting IP on Crowdfunding Platforms

Patents: Protecting Ideas

Copyright: Protection of Creative Works

Trademark: Designations of Source or Origin

Trade Secret Protection

IP Portfolio Management: A Best Practice

Chapter 7: Understanding Your Investor Options

The Decision to Bring on Investors

General Obligations to Investors

Investor Education Obligations

Maximizing Investor Participation

Capital Spectrum

Chapter 8: Communicating with Your Investors or “Backers”

The Issuer’s Dilemma

Reconnecting with Prospective Investors and Backers

Investor Relations: Are You Ready to Walk Down the Aisle?

Crowd Communications Checklist

Chapter 9: Alternatives to Crowdfunding

Basic Types of Finance

Choice of Entity

Overview of Securities Laws

Private Placements and Regulation D

Initial Public Offerings

Small Business Administration Loans

Other Sources of Capital

A Note Regarding Finders and Business Brokers

Part III: Understanding the Framework of Rules and Regulations

Chapter 10: The Legal Aspects of Crowdfunding and U.S. Law

Crowdfunding and Securities Regulation

Crowdfunding Interests in Business Associations

Contracts in Crowdfunding

Other Potential Legal Issues

Conclusion

Chapter 11: Crowdfunding Laws Based on Global Jurisdiction

The Emergence of Equity Investing in Europe

Where Investing Emerges, Regulation Follows

Crowdfunding Is Born in Europe

European Platforms in Practice

Looking Ahead

Chapter 12: Living with the New Reg D and Its Impact on Pitch Events and Demo Days

Key Securities Law Concepts

Structuring Your Event

Afterword

About the Author

About the Contributors

Author’s Disclaimer

Index

Advertisement

End User License Agreement

List of Illustrations

FIGURE 1.1 A Timeline Leading to Crowdfund Investing: Regulation that Didn’t Scale Down. . .

FIGURE 3.1 Global Crowdfunding Volumes; The Crowdfunding World Map

FIGURE 3.2 Growth by Crowdfunding Model

FIGURE 3.3 Crowdfunding Platform Activity across the 10 Most Active Categories

FIGURE 3.4 Financial versus Nonfinancial Crowdfunding Activities

FIGURE 3.5 Donation-Based Crowdfunding Activity

FIGURE 3.6 Rewards-Based Crowdfunding Activity

FIGURE 3.7 Lending-Based Crowdfunding Activity

FIGURE 3.8 Equity-Based Crowdfunding Activity

FIGURE 3.9 Global Distribution of Launched and Prelaunched Crowdfunding Platforms

List of Tables

TABLE 9.1 Basic Types of Equity Interests

TABLE 10.1 Comparative Attributes of Business Entities

Pages

ii

iii

iv

v

vi

ix

x

xi

xii

xiii

xiv

1

2

3

4

5

6

7

8

9

10

11

12

13

14

15

16

17

18

19

20

21

22

23

24

25

26

27

28

29

30

31

32

33

34

35

36

37

38

39

40

41

42

43

44

45

46

47

48

49

50

51

52

53

54

55

56

57

58

59

60

61

62

63

64

65

66

67

68

69

70

71

72

73

74

75

76

77

78

79

80

81

82

83

84

85

86

87

88

89

90

91

92

93

94

95

96

97

98

99

100

101

102

103

104

105

106

107

108

109

110

111

112

113

114

115

116

117

118

119

120

121

122

123

124

125

126

127

128

129

130

131

132

133

134

135

136

137

138

139

140

141

142

143

144

145

146

147

148

149

150

151

152

153

154

155

156

157

158

159

160

161

162

163

164

165

166

167

168

169

170

171

172

173

174

175

176

177

178

179

180

181

182

183

184

185

186

187

188

189

190

191

192

193

194

195

196

197

198

199

200

201

202

203

204

205

206

207

208

209

210

211

212

213

214

215

216

217

218

219

220

221

222

223

224

225

226

227

228

229

230

231

232

233

234

235

236

237

238

239

240

241

242

243

244

245

246

247

248

249

250

251

252

253

254

255

256

257

258

Guide

Cover

Table of Contents

Begin Reading

Since 1996, Bloomberg Press has published books for financial professionals on investing, economics, and policy affecting investors. Titles are written by leading practitioners and authorities, and have been translated into more than 20 languages.

The Bloomberg Financial Series provides both core reference knowledge and actionable information for financial professionals. The books are written by experts familiar with the work flows, challenges, and demands of investment professionals who trade the markets, manage money, and analyze investments in their capacity of growing and protecting wealth, hedging risk, and generating revenue.

For a list of available titles, please visit our website at www.wiley.com/go/bloombergpress.

CROWDFUNDING

A Guide to Raising Capital on the Internet

Steven Dresner

Cover image: Digital News © iStockphoto/Bet_Noire, Energy © iStockphoto/karelin

Cover design: C. Wallace

Copyright © 2014 by Steven Dresner. All rights reserved.

Published by John Wiley & Sons, Inc., Hoboken, New Jersey.

Published simultaneously in Canada.

No part of this publication may be reproduced, stored in a retrieval system, or transmitted in any form or by any means, electronic, mechanical, photocopying, recording, scanning, or otherwise, except as permitted under Section 107 or 108 of the 1976 United States Copyright Act, without either the prior written permission of the Publisher, or authorization through payment of the appropriate per-copy fee to the Copyright Clearance Center, Inc., 222 Rosewood Drive, Danvers, MA 01923, [phone], fax [phone], or on the Web at www.copyright.com. Requests to the Publisher for permission should be addressed to the Permissions Department, John Wiley & Sons, Inc., 111 River Street, Hoboken, NJ 07030, [phone], fax [phone], or online at www.wiley.com/go/permissions.

Limit of Liability/Disclaimer of Warranty: While the publisher and author have used their best efforts in preparing this book, they make no representations or warranties with respect to the accuracy or completeness of the contents of this book and specifically disclaim any implied warranties of merchantability or fitness for a particular purpose. No warranty may be created or extended by sales representatives or written sales materials. The advice and strategies contained herein may not be suitable for your situation. You should consult with a professional where appropriate. Neither the publisher nor author shall be liable for any loss of profit or any other commercial damages, including but not limited to special, incidental, consequential, or other damages.

For general information on our other products and services or for technical support, please contact our Customer Care Department within the United States at [phone], outside the United States at [phone] or fax [phone].

Wiley publishes in a variety of print and electronic formats and by print-on-demand. Some material included with standard print versions of this book may not be included in e-books or in print-on-demand. If this book refers to media such as a CD or DVD that is not included in the version you purchased, you may download this material at http://booksupport.wiley.com. For more information about Wiley products, visit www.wiley.com.

Library of Congress Cataloging-in-Publication Data:

ISBN 978-1-118-49297-0 (cloth)

ISBN 978-1-118-74685-1 (ePDF)

ISBN 978-1-118-74686-8 (ePub)

To Max, Joshua, and Harry

Acknowledgments

It is my hope that this book accurately reflects the present state of crowdfunding and the nascent business of raising capital on the Internet. My coauthors and I began this project long ago with the idea that we’d be writing mostly about the deal-making aspects of crowdfunding. That is, writing about investment crowdfunding as our priority with other topics such as rewards-based crowdfunding as a secondary—and distant—interest. However, as the project developed (and as rules from the Securities and Exchange Commission were slow to materialize) we began to contemplate a book that captured a more well-rounded perspective on crowdfunding with a view toward what comes next.

Because of the rapidly changing industry we aimed to depict in the pages of this book, my coauthors and I were faced with a challenging task. I offer my coauthors gratitude for rising to the occasion and putting up with all the changes I requested as the project evolved. As with all collaborative texts (of which I’ve done a handful), it is only because of the hard work put forth by everyone involved in the project that this book went from idea to reality. So to my collaborators, thank you for participating and in the process, helping to define an exciting topic.

Although he is not officially listed as an editorial contributor to this book, I’d like to especially thank Todd Anderson. Todd had been our primary researcher on this topic at DealFlow Media. And because of this, I dragged him into the project to help coordinate the massive amount of not-so-glamorous work that’s involved in making a book. Fortunately, Todd was excited to help out. He overdelivered every step of the way.

Many others have added to the quality of this book through their involvement with DealFlow Media, my publishing company. I thank everyone who worked with me prior to the sale of DealFlow Media/PrivateRaise, and I thank everyone who still works with me at Dealflow.com, our successor company. For those of you who’ve put up with my relentless pursuit of the next big idea, I applaud you. You are my friends and family, but most importantly, you have become my primary source of inspiration.

Worthy of recognition is also Meg Freeborn, my editor at Wiley, and Bill Falloon, who brought this project into the fold after Wiley acquired Bloomberg Press.

Thanks also go to my father, who continues to be my biggest advocate and most trusted adviser. Since my last book, and during an especially rough time, he’s kept me steadfast in pursuing my goals by himself living to fight another day. He’ll always be my hero. Thanks also go to mom for helping guide me toward doing startups by teaching me to count cash at an early age.

And in the tradition of saving the best for last, I send all of my love to my boys, Max, Joshua, and Harry. Words aren’t enough to express my gratitude. You guys have sacrificed more than anyone else. For you I want nothing but peace, love, and happiness.

Steven Dresner

Introduction

Crowdfunding, sometimes called crowd financing or crowd investing, is generally defined as the collective cooperation by people who pool their funds, usually via the Internet, to support efforts initiated by other people or organizations. Crowdfunding supports a variety of purposes, from disaster relief to publishing books, to artists seeking support from fans to political campaigns, to funding a startup or small business.

This book addresses the market dynamics now catapulting crowdfunding into the mainstream. It should be distinguished from the many crowdfunding white papers, how-to guides, and promotional materials on the Internet in that our cast of contributors—who were carefully selected to represent a variety of market participants—went about this project without bias. We intended to make a professional text accurately reflecting the present state of crowdfunding with a view toward what’s coming next. In this regard, we hope you find value in these pages.

Whether you’re an entrepreneur seeking capital for your first startup or a corporate development pro at a large company, an angel investor or a hedge fund manager, a securities attorney, tax accountant or consultant, you’ll definitely need to understand the crowdfunding phenomenon. So the sooner you delve into this topic, the better off you’ll be. Fortunately, my coauthors and I are presenting you with the first professional book of its kind—a comprehensive treatment on the topic of raising capital on the Internet.

The book comprises three sections. “The Business of Crowdfunding” offers historical context along with a snapshot of the present market. “Preparing for Your Crowdfunding Campaign” provides business planning suggestions. “Understanding the Framework of Rules and Regulations” offers a discussion of legal and other technical issues. While the book can serve as a guide while you jump around from topic to topic, it was designed to read from front to back and offers a considerable amount of foundational material at the beginning. So with this in mind, let’s start at the start and take a quick tour through the sections that follow.

Historically, crowdfunding is well known for helping to raise charitable donations. But now crowdfunding serves much more than just nonprofits. It’s receiving very mainstream attention from both commercial and social entrepreneurs now that social media, online communities, and micropayment technology make it straightforward for sourcing donations from a group of potentially interested supporters, or for raising capital from investors at very low cost for new business opportunities. Jason Best and Sherwood Neiss do a fantastic job of exploring the roots of crowdfunding in the first chapter, “Crowdfunding: A Historical Perspective.”

Whether crowdfunding is directed at profit-oriented investment opportunities, charitable purposes, or artistic efforts, it is at its core a pooling of resources at the grassroots level with a framework for rewards and for the purpose of initiating an investment—and where common desire and trust are the most important driving forces for participation. Karen Kerrigan, in “Understanding the ‘Crowd’,” provides a backdrop for the discussions in this book covering the importance of social media in this new area of finance.

An entrepreneur seeking to use crowdfunding for something such as seed financing typically makes use of online communities to solicit pledges of small amounts of money from individuals who are not professional financiers. A range of variations are possible.

The solicitation could call for backing an idea with no direct material return for those making a pledge. This is common in artistic patronage and the activities of charity fundraising. Sometimes a threshold pledge approach is used, in which all pledges are voided unless the threshold amount is reached before a deadline. Another approach invites a display of sponsorship in return for the cash pledged. The solicitation could involve offering a non-interest-bearing loan as in microfinance. Or some kind of quasi-equity investment could be offered, although any such arrangement would need to avoid falling under any applicable financial regulations governing public offerings of securities. In “A Statistical View of Crowdfunding,” Carl Esposti gives a 360-degree view of the marketplace with special attention to the geographical considerations and demographics of popular crowdfunding models. Andrew Dix and Charles Luzar also round out a comprehensive view of the modern crowdfunding market in “Current Market Dynamics.”

Crowdfunding allows good ideas (which do not always fit the pattern required for conventional financing) to attract cash through an approach to “the crowd.” If the appeal to the crowd is successful, an enterprise can not only secure seed funding to begin its project, but also obtain evidence of backing from potential customers and benefit from word-of-mouth promotion. Joy Schoffler gives an overview of building and maintaining online relationships in “Communicating with your Investors or ‘Backers’.”

One theme covered in several areas of this book includes unique aspects of business planning since crowdfunding can entail disclosing an idea in public when the idea might be at a very early stage—thus vulnerable to poaching by competitors. The promoter needs to consider the risk of the idea being copied and developed by better financed competitors who can get a quicker start. David Feldman in “Business Planning in Preparation for a Crowdfunding Campaign” and Michael Allan in “Protecting Your Intellectual Property” kick off the second section with a comprehensive look at the planning that should take place prior to launching a crowdfunding campaign. Reginald Chambers’s “Understanding Your Investor Options” and “Alternatives to Crowdfunding” by David Burton complete the section with discussions covering other approaches to financing a fledgling business or new idea.

Other important concerns related to crowdfunding are the limitations imposed by securities laws, since soliciting investments from the general public is most often illegal unless the security for sale has been filed with an appropriate regulatory authority, such as the Securities and Exchange Commission in the United States or similar agencies in other countries. According to Section 5 of the U.S. Securities Act, it is illegal to sell any security unless such a sale is accompanied or preceded by a prospectus that meets the requirements of the Securities Act.

While debate continues as to whether a particular activity constitutes a sale of a security, any crowdfunding arrangement in which people are asked to contribute money in exchange for a share of potential revenue or profits based on the work of others, or that involves some kind of ownership in the work of others, or contemplates a financial incentive such as an interest-bearing loan, would likely be considered a security. Consequently, the solicitation of the investment would have to be registered with a regulatory agency unless it qualified for one of several exemptions (e.g., Regulation D of the Securities Act of 1933). As this book was going to press, the SEC was soliciting comments on its equity crowdfunding rule proposals, which were introduced in late 2013. These rules contemplate a number of possible amendments to the securities laws to permit investment crowdfunding, with certain safeguard limitations that would allow for raising limited amounts of money through crowdfunding while using such mass communication techniques as social media without the usual regulatory filing requirements. In the last section of this book, Joan MacLeod Heminway provides a comprehensive discussion of relevant securities rules in her chapter, “The Legal Aspects of Crowdfunding and U.S. Law.” Jeff Lynn and Kristof De Buysere follow with “Crowdfunding Laws Based on Global Jurisdiction,” which covers the more flexible regulatory framework in Europe.

In “Living with the New Reg D and Its Impact on Pitch Events and Demo Days,” Kiran Lingam, Trent Dykes, and Megan Muir round out the most technical section of the book with a timely discussion of how the SEC’s new rules on general solicitation and advertising affect what’s commonly referred to as “pitch events,” where companies solicit investment from a group of qualified investors.

Crowdfunding, like crowd sourcing (which is the act of sourcing tasks to a group of people), is very much related to online communities and social networks. The crowd can already exist as a community but it can also suddenly form from disparate groups around the world who happen to share an interest in funding a person, project, event, campaign, or business enterprise. The Internet allows for information to flow around the world, increasing awareness in such situations. In the book’s afterword, Jon Medved and Zack Miller provide some forward-thinking considerations relating to making investments in globally based crowdfunded companies.

In the same way that social networking changed how we allocate time, crowdfunding will change how we allocate capital. Crowdfunding, generally speaking, is simply the merger of group funding and social networking. While group funding dates back millennia, the social networking aspects of crowdfunding are quite new and are a major driving force behind this revolutionary form of financing.

Building on social networking, crowdfunding creates a vehicle for people to invest or pledge money to projects for which they have an interest, a passion, or some other kind of attachment. In doing so, it creates a marketplace opportunity for a diversity of players. Whether financing a new movie, a fashion line, a sailing adventure, a startup business, or the next Olympic athlete, crowdfunding is in play everywhere. It is my hope that this book serves as a catalyst to begin your exploration of this fascinating area of finance.

Part IThe Business of Crowdfunding

Chapter 1Crowdfunding: A Historical Perspective

Jason Best and Sherwood Neiss

Crowdfund Capital Advisors

Crowdfunding, simply put, is pooling the financial resources of many individuals to convert an idea into a project or business. Instead of relying on a few large donors, it requires many small ones. This chapter steps back in time to understand what happened to this form of financing, why it’s “new all over again,” and why it’s emerging as one of the hottest topics in global business financing. It reviews the risks that led to changes in U.S. financial laws in the early twentieth century and how these laws had the unintended consequence of shutting off capital markets to many startups and small businesses. It discusses how advances in the Internet and technology have allowed us to safely go back to where we started. Today’s crowdfunding enables anyone to use the Internet to gauge the value of people’s ideas and use online reputations and their own judgment and experience to make their own decisions about which ideas have the best chance for success.

Crowdfunding Isn’t New

Crowdfunding is a new way to do something old. It uses the Internet to facilitate capital formation in much the same way that communities financed transactions as far back as 3000 B.C. Prior to the advent of banks and other financial institutions, wealthy families and rulers provided loans to individuals in communities to finance everything from businesses to infrastructure. Financial instruments not unlike simple loan documents used today were created as promissory notes. Interest rates were determined based on how well individuals knew each other and how much capital was needed. Risk was a function of relationship and ability to execute. Default came with a heavy toll.

While difficult to relate the experiences of 5,000 years ago to today, life in the United States in the late nineteenth and early twentieth centuries offer some examples of American institutions and icons that emerged from the crowd. In the 1930s, before the Great Depression, banks existed primarily to finance infrastructure and the activities of governments. This was ushered in by the Industrial Revolution that led to a change in farming techniques. In order to adapt, farmers were forced to take loans for equipment. Other businesses faced similar technology shifts and access to capital was the same challenge.

Building and loan associations were one of the answers to how to provide capital to businesses and individuals. Groups of people deposited their savings into an association. When the association gained enough money, it financed activities for its members, mainly through mortgages. This system helped many working-class people buy homes. Unlike banks, these associations made their investments based primarily on the interests of their members instead of on the promise of the greatest returns and security. Associations, however, tended to serve small groups or communities and didn’t offer many of the services that banks did.

In 1876, crowdfunding was used to finance one of the United States’ most iconic monuments, the Statue of Liberty. The citizens of France paid for the statue, and the citizens of the United States paid for the pedestal. Citizens in both countries held meetings, theater performances, art auctions, prizefights, and rallies to raise money. Frédéric Auguste Bartholdi, the Statue of Liberty’s architect, offered a miniature version of the statue with the name of the buyer engraved on it in exchange for a donation—a “perk” when compared to today’s crowdfunding.

Despite being $250,000 short, newspaper publisher Joseph Pulitzer used The World, a New York City daily newspaper, to mount a fund drive, promising to print the name of each donor. Pulitzer’s plan worked and millions of people around the country began donating whatever they could including a kindergarten class in Iowa that sent $1.35.

Why? Because these people believed in the project and wanted to give back; they wanted to be a part of history and be a part of something bigger than themselves. These are the same reasons people give to crowdfunding today. Times might have changed but core beliefs have not.

Why Crowdfunding Disappeared

In the early 1900s, the main role of investing in startups and small businesses fell into the hands of wealthy families like the Morgans, the Vanderbilts, and the Rockefellers. Starting in 1911, the process of raising capital from the public was enforced by each state under so-called blue sky laws. With these laws, states regulated the offering and sale of stocks to protect the public from fraud. The specific provisions of these laws varied among states, but they all required the registration of all securities offerings and sales, as well as the registration of every stockbroker and brokerage firm. Providing a structure was a benefit; lacking an infrastructure to monitor, police, and hold people accountable opened the doorway to fraud.

In 1915, the Investment Bankers Association told its members that they could ignore blue sky laws by making securities offerings across state lines through the mail. Allowing solicitation via a mechanism as opaque at the mail opened up the floodgates to fraud. Because the markets weren’t regulated at the federal level, shady stockbrokers started to issue stocks in dubious, fictitious, or worthless companies and sell them to people in other states, using the mail as their means of communication.

This ushered in a period replete with snake oil salesmen and grifters moving from one opportunity to the next and debunking Americans out of their savings. During the 1920s leading up to the Great Depression, which began in 1929, the marketplace was full of exuberance. Stock prices kept going up, reinforced by shady brokers. Tempted by promises of riches and easy credit, many investors started to borrow money to buy essentially worthless stocks. Greed drove them to neglect the risks and believe unreliable information about the securities in which they invested.

During the 1920s approximately 20 million large and small shareholders set out to make their fortunes in the stock market. Of the $50 billion in new securities offered during this period, approximately half became worthless as a result of the stock market crash in October 1929.

When the stock market crashed, public confidence in the markets collapsed. Investors large and small, as well as the banks that had loaned to them, lost great sums of money in the ensuing Great Depression. For the economy to recover, the public’s faith in the capital markets needed to be restored, so Congress held hearings to identify the problems and search for solutions.

Congress passed the Securities Act of 1933. This law and the Securities Exchange Act of 1934—which created the U.S. Securities and Exchange Commission (SEC)—were designed to increase public trust in the capital markets by requiring uniform disclosure of information about public securities and establishing rules for honest dealings. The main purposes of these laws can be reduced to two common-sense notions:

Companies publicly offering securities for investment must tell the public the truth about their businesses, the securities they’re selling, and the risks involved in investing.

People who sell and trade securities—brokers, dealers, and exchanges—must treat investors fairly and honestly, putting investors’ interests first.

Congress established the SEC to enforce the newly passed securities laws, to promote stability in the markets, and, most important, to protect investors. The Securities Exchange Act of 1934 requires that issuing companies register distributions of securities, such as stocks, with the SEC prior to interstate sales of these securities. This way, investors have access to basic financial information about issuing companies and risks involved in investing in the securities in question.

The SEC was founded in an era that was ripe for reform. The 1933 and 1934 laws set the way in which the capital markets would function for the next 50 years. Having a mechanism where information was centrally stored and accessed by the public was required; today, this is facilitated by the Internet.

Regulation D, Sarbanes-Oxley, and Regulatory Reform

From 1933 to 1982, the way business was conducted in the U.S. capital markets stayed relatively unchanged. In 1982, the SEC adopted Regulation D, which established three exemptions from the registration requirements under the Securities Act of 1933. An exemption enables some companies, in certain situations, to issue securities without the requirement to register them with the SEC provided they follow all the rules. Included within Regulation D’s definitions was the notion of an accredited investor. The SEC adopted two definitions of an accredited investor, one based on net worth and the other based on income:

Net worth criteria

. Under the net worth definition, an accredited investor is someone who, at the time when he purchases a security, has a net worth of $1 million or more, not including the value of his primary residence. (Note that net worth could be the individual’s net worth alone or that of himself and his spouse.)

Income criteria

. Under the income-based definition, an accredited investor is someone with individual income above $200,000 during the two most recent years or with joint income (with a spouse) above $300,000 in each of the two most recent years. This person also should expect to achieve a similar income in the current year.

Prior to the 2012 Jumpstart Our Business Startups (JOBS) Act, a company issuing stock to investors had to restrict the number of unaccredited investors it included in a securities offering. If you were starting a small business raising less than $5 million in securities in 2010 and wanted equity investors, you could have only 35 unaccredited investors. (You could have an unlimited number of accredited investors.) This structure allowed your closest supporters, such as friends and family, to become equity owners in your business while preventing you from reaching larger numbers of your network to ask them if they would like to invest in a business that might carry significant risk. This was one of the measures that attempted to address the pumping-and-dumping schemes leading up to the Great Depression.

Unfortunately, the side effect of this regulation was that small investors found themselves largely shut out of some of the most lucrative, albeit risky, investments such as technology startups. As a result, small businesses and startups found themselves fairly restricted when trying to raise funds. Plus, the underlying implication of the definition is that small investors are, by virtue of their smallness, less educated, sophisticated, or knowledgeable about risk than larger investors—a notion that is flawed when considering scandals such as the one involving Bernie Madoff.

The 1990s and early 2000s saw the rise of a whole new level of financial engineering. That was the creation of financial structures and instruments that allowed corporations greater flexibility (and much greater risk) in their investments. Most of the time, the “flexibility” was really code for “leverage,” or the practice of betting on the direction of a stock’s or other financial instrument’s movement. The larger the bet on the direction, the larger the risk if the stock moved in the opposite direction. When corporate bets worked as planned, companies showed significant gains. However, when these bets soured, the results could be disastrous. Two examples follow.

Enron was an energy, commodities, and services company based in Houston, Texas. Between 1995 and 2000, it was called one of America’s most innovative companies. It filed for bankruptcy in December 2001, and several of its top corporate officers were later convicted of financial crimes. These executives were hiding huge losses in offshore accounts that were not reported in Enron’s financial statements, and their financial “engineering” ultimately caused the company to collapse. Thousands of employees lost their jobs, and millions of Enron shareholders lost billions of dollars. At the time, it was the largest corporate failure in U.S. history, and it was all due to a handful of executives playing fast and loose with company money to enrich themselves.

In July 2002, just seven months after Enron’s demise, WorldCom also declared bankruptcy after using fraudulent accounting and aggressive finance practices to hide losses and inflate revenues. Again, the company’s collapse led to thousands of lost jobs and the elimination of billions of dollars of stockholder value.

With back-to-back, multi-billion-dollar business failures that were based on accounting and finance fraud, the federal government was pressed to enact significantly enhanced financial regulations. As a result, the Sarbanes-Oxley Act of 2002 (commonly referred to as SOX) was the largest overhaul of federal securities laws since the 1930s. It covered a wide range of corporate governance, accounting, industry analyst relations, and financial reporting issues.

Although well intentioned, SOX had enormous unintended negative consequences for businesses in the public capital markets. These negative consequences were most profound for small businesses that were interested in going public to raise capital. Because SOX treated all companies (regardless of size, industry, geography, or market) exactly the same, all companies faced a similar burden related to regulatory costs. This setup may seem reasonable at first blush, but imagine a mom-and-pop store trying to achieve the same reporting and accounting standards followed by a Fortune 500 company. It can’t be done.

Effectively, SOX ensured that if your business was worth less than $100 million, it made zero financial sense to go public because in order to execute an initial public offering (IPO), you’d spend millions of dollars on accounting and administration, and your annual compliance fees would be well over $1 million. SOX effectively closed the IPO market for all but the largest corporations and dramatically reduced small businesses’ access to capital. Startups and small businesses were restricted to seeking funding from an elite group of wealthy venture capital investors who for the past decade have determined who among America’s businesses were worthy of funding. This, of course, left out the other 27.5 million businesses that needed access to capital as well, the majority of which are not high-tech startups but local mom-and-pop businesses that are profitable, yet still find it difficult to gain access to capital.

The Modern Era

With the rise of the Internet and e-commerce, the foundational tools were in place for nonprofits to begin raising money online as well as offline. As individuals gained experience and trust in completing transactions online, it enabled them to save time, save money, and extend their reach into more geographies, sectors, and interests across the globe.

In 2005, an organization named Kiva was founded to use the Internet to source microloans from people in the United States to entrepreneurs in the developing world. Individuals in the United States were able to visit the Kiva web site and directly interact with individuals in the developing world and participate in loans as small as $100 to $1,000 that would enable those entrepreneurs to purchase a cow, a motorbike, an oven—some means by which they could build a business to lift their families out of poverty. Lenders in the United States knew the names of the people they were lending to, as well as their circumstances, and received a photo and a way to monitor their progress, via the Kiva web site, as they built their business and repaid the loan. This allowed people who wanted to feel directly connected to other people they were helping to satisfy that deeper human need of being part of something larger than you are on your own.

Then, in 2008, the United States and every other country were hit with the global financial crisis, causing substantial financial damage to individuals and businesses. Among the many negative outcomes of this crisis, the loss of investment capital in small and medium-sized business was deep and profound. Raising capital or being accepted for a bank loan always was a challenge, but in the wake of the financial crisis, it became virtually impossible. Banks were generally not even lending to profitable, successful businesses. Most of the time, the business needed to have the amount of the loan (or greater) in assets before the bank would consider lending to the business. In other words, banks were only lending money to people who did not need it. Unfortunately, due to the SEC regulations written in 1933 and 1934, there were very few avenues for businesses to gain access to capital.

Shortly after the modern financial crisis began, in 2009, the web site Kickstarter was begun by Perry Chen out of a desire to help musicians and artists raise money for their projects. Perry had a band, so he understood what it was like to need money to tour or record music and that if these artists and musicians were able to tap into their fan base and supporters to each pitch in small amounts of money, they could help artists to reach their goal, and they could provide something back (a perk or thank you gift) for their contribution. This usually took the form of the output of the artists such as a CD, a DVD of the film being produced, a T-shirt, and so on. This was the rise of the “micro-patron of the arts.”

The third technology element that led to the rapid adoption of crowdfunding was the rise of the social Web, otherwise known as “Web 2.0.” Web 1.0 was consuming information and completing transactions. With Friendster, MySpace, and later LinkedIn, Facebook, Twitter, and Instagram, the Web became a place to not only consume information and complete transactions, but also a place to share interests, communicate with friends, and build relationships with people that you may not have initially known in person, but with whom you could create a relationship online.

The rise of the social Web was crucial to the success of perks-based crowdfunding. It enabled people to not only make their donations, but also amplify the power of those donations by making it very easy to spread the word to friends and family via social networks about a project they believed in and encourage their networks to participate as well. This not only increased the success of campaigns, but it also increased the scale and utilization rates of perks-based crowdfunding platforms like Kickstarter.

In August 2010, a group of successful entrepreneurs were talking about how frustrating it was for small—sometimes even profitable—businesses in the United States and around the world to access capital. To them, it seemed crazy that people could give away money on web sites like Kickstarter to artists and musicians and lend money to entrepreneurs in the developing world on web sites like Kiva, but it was illegal to use the Internet to raise investment capital for entrepreneurs and business owners in the United States. It didn’t make sense that the securities laws had not advanced to the Internet Age and the same tools such as the Web and social media, which were a daily part of our lives, could not be used to raise money from their communities. It didn’t make sense that the Regulation D exemptions excluded crowdfund investing online because this would require raising money with public solicitation from unaccredited investors. Investors were asking themselves the same question, “Why can’t I invest in businesses in my community or entrepreneurs I believe in?”

This marked the creation of Web 3.0 where the social Web meets capital formation. This was also the creation of the term crowdfund investing so as to make a clear distinction between perks-based crowdfunding and securities-based crowdfunding. That was the jumping off point for the team of entrepreneurs to create the Startup Exemption Framework that would form the basis of the crowdfunding legislation in the 2012 JOBS Act. Sitting at a dining room table with the Regulation D language, they created the framework that would enable entrepreneurs and small businesses to raise up to $1 million per year from an unlimited number of investors.

From there, this group of entrepreneurs talked with securities attorneys who told them not to waste their time—the laws had not changed in 77 years and there was nothing they could do about it. But they pushed forward anyway and met with the Small Business Division of the SEC, who said, “We don’t make those kinds of changes, you’ll need an Act of Congress.” Instead of quitting or just complaining about the problem, they took an entrepreneurial approach and took their solution, the Startup Exemption Framework, to Capitol Hill to advocate for its passage. By putting a stake in the ground, they were able to engage the White House and both Democrats and Republicans in the House of Representatives and Senate in debate and discussion on how to create legislation to pass crowdfunding to help address the critical needs facing the United States at that time—increasing jobs, innovation, and entrepreneurship. With good timing, teamwork from many people, and amazing amount of luck, this legislation was able to pass both houses of Congress with wide, bipartisan majorities, and on April 5, 2012, 460 days after they began walking the halls of Congress, these entrepreneurs (including the authors of this chapter), attended the Rose Garden ceremony at the White House to watch President Obama sign the JOBS Act. Their work was embodied in the third part of the JOBS Act, otherwise known as “Title III.”

Obviously, in creating a new asset class and a new industry that would be regulated by the SEC, a trade association needed to be formed. So this same group of entrepreneurs cofounded the Crowdfunding Regulatory Intermediary Advocates so that the industry could engage with the SEC and the Financial Industry Regulatory Authority (FINRA, the organization responsible for securities regulation in the United States), with a unified voice and so that crowdfunding platforms could work together to create an orderly market for crowdfund investing. They also formed the Crowdfunding Professional Association to provide networking, education, and collaboration among startups, small businesses, and investors.

The SEC took the first step to regulating crowdfunding during the summer of 2012, when it released the final rules relating to Title II of the JOBS Act. Title II of the JOBS Act required the SEC to lift the ban on general solicitation to accredited investors. The final rules allow entrepreneurs to use public means like the Internet or even an aerial banner to solicit investments in their businesses provided that they prove the investor is accredited. Prior to this, the burden of proof was on the investor, and self-certification of one’s accreditation was all that was needed. Now the burden has shifted to the issuer. While some opponents say that that the forced disclosure will deter investments, proponents see third-party providers like accountants certifying forms for investors in order to keep personal information confidential.

FIGURE 1.1 A Timeline Leading to Crowdfund Investing: Regulation that Didn’t Scale Down . . .

The final rules also included a class of individuals otherwise known as “bad actors” from partaking in these offerings. The intent is to reduce fraud in the marketplace. All offerings must be submitted 15 days before they go public with the SEC. The specifics regarding these latest changes are covered later in this book.

The elimination of the ban on general solicitation went into effect at the end of September 2013. It is yet to be determined the impact this will have on both investments and investors.

As of the writing of this book, the SEC has not yet released draft rules for comment related to Title III, Crowdfunding, and so the history is still unfinished. The crowdfund investing industry has been actively engaged with both the SEC and FINRA to provide comment and perspective as those bodies contemplate rules for the crowdfunding legislation.

In the meantime, the world has not waited on U.S. regulation. The United Kingdom has equity- and debt-based crowdfunding platforms in operation, and Italy has passed crowdfund investing legislation and has final rules that restrict the types of issuers to technology-related companies and require a lead angel investor. While seen as a first mover, Italy has also been critiqued for leaving behind those most in need of capital: mom-and-pop businesses. Many other countries are also looking at how they will institute crowdfund investing for the benefit of their citizens. Also, development organizations including the World Bank are actively working on models for crowdfunding that will fit in the developing world. Are there ways for developing countries to leapfrog the developed world in this new asset class? An often-cited example of this from the past would be the way in which cell phones came to China and connected vast numbers of people who never had telephone service via landline before.

Another issue that development organizations are attempting to solve is “the last mile problem” for delivering resources and capital to businesses and entrepreneurs. In many countries around the world, leaders of governments face the same challenge. That is, how to use funds that have been earmarked for entrepreneurship, innovation, or jobs and deliver funding to the “right entrepreneurs” that will be successful. While there is no way to do that with anything approaching 100 percent accuracy, the question becomes whether these organizations can leverage crowdfund investing and/or crowdfunding to create “signals” from the crowd that an entrepreneur is worthy of greater investment. The World Bank and national governments are exploring how this might take shape. One example of a government that is already moving forward is in the United Kingdom, where the government has created a £20 million (US$30 million) fund to coinvest with debt-based crowdfunding site Funding Circle.

Could this provide another opportunity for a new technology or business process to fix inefficiencies in a market? And if it does, what is the opportunity to create an entire ecosystem for crowdfunding? At the beginning of the social Web, there were only the social networks themselves. Once Facebook opened its application programming interfaces to developers and encouraged companies to create applications that could be used with Facebook, a massive ecosystem was created that has formed thousands of companies that has yielded hundreds of exits for entrepreneurs that created value in the ecosystem. It is our belief that we are already seeing the birth of the Web 3.0 ecosystem and we are excited to watch it grow.

One could say that the history of crowdfunding is measured in hundreds, if not thousands, of years. Crowdfund investing, however, has a very brief history and interesting prospects for success with potential risks that the industry and governments must work together to address. It creates new challenges for entrepreneurs, business owners, investors, and regulators. Those challenges also create business opportunity for savvy entrepreneurs, who can bring new technology solutions to address these market opportunities both here in the United States and globally. This is the birth of a new asset class, and we believe that if the industry can get it right, it will unlock significant opportunity for innovation, entrepreneurship, and economic growth.

Chapter 2Understanding the “Crowd”

Karen Kerrigan

SBE Council

Access to startup and growth capital has remained a central challenge for entrepreneurs for the two decades that I have been advocating for their interests. Yes, capital has flowed a little more freely during healthy economic periods, but for the most part, the inability to tap into growth capital—even in good economic times—has hindered many promising enterprises. The past five years or more, in particular, have not been kind to entrepreneurs. The financial crisis followed by the Great Recession, lingering policy uncertainties, and a fragile economic recovery have made it more difficult for entrepreneurs to finance their businesses. However, tremendous change and innovation are emerging in the financing space, which makes this a very exciting time to be an entrepreneur.

Heeding the cries of entrepreneurs and the startup community about the lack of available capital, Congress and President Barack Obama came together to advance a policy solution in 2012—the Jumpstart our Business Startups (JOBS) Act—which allows entrepreneurs to raise investment capital via crowdfunding. President Obama signed the JOBS Act in April 2012, and as of this writing, entrepreneurs and investors are eagerly waiting for the SEC to approve Title III regulations associated with the law that finalize the ground rules for crowdinvesting.

Positive headway was made by the SEC with respect to Title II of the JOBS Act, which lifts the antiquated ban on general solicitation. As of September 23, 2013, entrepreneurs seeking investment capital were given the green light to publicly market their offerings to raise capital to accredited investors. This is a significant change in the startup ecosystem, as entrepreneurs can communicate their financing needs more openly to access capital. There are 258,000 active accredited investors in the United States, and another 8.5 million Americans qualify as such according to a July 2013 study by the Government Accountability Office. Entrepreneurs can reach more investors, and investors can reach more deal flow. So while it has been frustrating to watch the SEC dither over the rules for an extended period of time, ongoing publicity generated by the JOBS Act delay, along with robust advocacy efforts to get it implemented, come with a silver lining. This activity has sparked a major interest in crowd financing, and there has been a significant increase in gift- and rewards-based crowdfunding. In addition, crowd investing among accredited investors is beginning to take shape, and with the rule change on general solicitation taking effect, the market will continue to develop nicely. Hopefully, the SEC will not disrupt the pace and development of crowd investing with new or onerous rules that work against the intent of the JOBS Act. Complex and burdensome rules will undermine the efficiency and accessibility of crowd financing for entrepreneurs and startups.

According to The 2013 Crowdfunding Industry Report by research firm Massolution, crowdfunding has raised $2.7 billion globally in 2012, an increase of 81 percent over 2011. The firm estimates that $5.1 billion will be raised in 2013, with a greater share of these raises going to entrepreneurial endeavors and businesses. So the good news is even with the delay in the implementation of the JOBS Act, businesses are increasingly raising funds through crowdfunding. The experiences of these entrepreneurs who have successfully raised capital through gift-, donation-, and rewards-based crowdfunding provide a wealth of information and “how to” strategies for successfully raising capital via this method. Best practices are emerging. In addition, as noted earlier, various crowdfunding platforms are currently connecting promising businesses with accredited investors, which will create more opportunities, more knowledge, and more options for entrepreneurs.

Quality Entrepreneurs and Ideas

Raising money via crowdfunding is not a walk in the park. Kickstarter reports that 44 percent of projects using its platform reach their full funding goal, while the percentage is considerably lower on other platforms. Kickstarter requires you to raise 100 percent of your goal in order to receive the funds. (This is a JOBS Act requirement for equity-based crowdfunding as well.) About 33 percent of technology projects are funded. So there is no guarantee that your business or innovative idea will acquire the capital it needs simply because you have posted your need and a profile on a crowdfunding platform. However, the benefits and opportunities presented by crowdfunding are abundantly clear in terms of exposure and access to a greater pool of investors, which has made it a very exciting development for entrepreneurs. The crowd just has to believe in you, your idea, or your plan for business growth.