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A New Era in Crowdfunding

Under the JOBS (Jumpstart Our Business Startups) Act, raising money on the Internet through crowdfunding promises to be a tantalizing option for small businesses seeking capital. This new federal law stipulates that, for the first time, business owners will be able to offer shares of private stock to everyday investors.

Earlier, regulations had limited entrepreneurs, inventors, artists and others attempting to drum up capital using social media on Internet platforms such as Kickstarter and Indiegogo to a rewards-based model. It worked like this: The fledgling venture created a profile to build Internet buzz, pledged online backers a product, discount or other reward in exchange for seed money, and hoped for the best.

Sometimes results far exceeded expectations: Last May, an outfit called Pebble Technology eclipsed its $100,000 goal, raising a staggering $10 million on Kickstarter by offering early access to customizable watches that sync with smartphones, allowing them to view incoming texts and notifications on the watches. More often than not, however, fundraising has been modest. Consider Kult Kitchen Pickles, which in December used the site to secure more than $3,000 for its kraut and kimchee business, just over its $2,600 target.

Many entrepreneurs believe the JOBS Act will make the process more lucrative for (and more attractive to) crowdfunders. But no one will really know for sure until the act takes effect; Douglas Ellenoff, a securities lawyer who has closely studied the new legislation, expects that equity-based crowdfunding under the JOBS Act will begin later this year.

“The Securities and Exchange Commission has a lot going on,” says Ellenoff, noting the agency is busy interpreting an avalanche of new regulations under the Dodd-Frank Wall Street Reform and Consumer Protection Act. “Crowdfunding, while it’s important and on the agenda, is not going to get preferential treatment.”

Once all the details become known, entrepreneur Winston Ibrahim will consider offering stock in his privately held business—Philadelphia-based Hydros, which makes water bottles with built-in filters—to online backers based on opportunities spelled out under the new law. Those who purchase shares will probably be enthusiasts already sold on the filtered water bottle and its ability to deliver clean, portable water in the United States and abroad.

“You’re actually buying a piece of the company,” says Ibrahim, who co-founded Hydros in 2009 and has raised several million dollars under existing securities regulations. “It really galvanizes an evangelistic fan base.”

The JOBS Act, passed by Congress and signed into law by President Obama in April 2012, provides significant benefits to startups (like Ibrahim’s) and small businesses that are attempting to raise capital at a time when traditional lending sources remain difficult to tap.

Before the new law, the sale of private stock was restricted by SEC regulations to friends, family and so-called “accredited investors,” which are defined as institutions and high-net-worth individuals considered savvy enough to understand the potential risks of investing in nascent businesses.

Now, with certain limitations, businesses can raise up to $1 million in a 12-month period from mainstream investors. The law isn’t expected to fully take effect for a few months, when the SEC, which polices stock transactions, completes the regulations for crowdfunding that offers equity.

Among other conditions, the amount sold to a single investor cannot exceed the greater of $2,000 or 5 percent of that person’s annual income or net worth if his or her earnings are less than $100,000. For higher-earning investors, the amount may not exceed 10 percent of annual income or net worth, up to a maximum $100,000 investment in crowdfunding per person per year.

Supporters say lifting the equity restrictions on crowdfunding promises to democratize the investing process and foster what will probably be a boon to small business growth.

“This is for mainstream businesses, this is for consumer-related products, this is for people who do not historically qualify for funding from banks,” says Sherwood Neiss, an entrepreneur and crowdfunding enthusiast who helped draft the legislation and shepherd it through Congress, where it had bipartisan support.

Neiss, a principal in the Miami-based consulting firm Crowdfund Capital Advisors, expects that much of the fundraising facilitated by the new legislation will be amounts of $250,000 or less. “It’s the hardest capital to find,” he says.

Many websites already are gearing up to target small businesses seeking capital via crowdfunding. Among them are Fundable, Crowdfunder and Seed Invest.

Wil Schroter, founder and CEO of Fundable, said the ability to offer stock using crowdfunding sites will be welcomed by businesses that previously hit a wall trying to raise more than $50,000 using the rewards-based model.

“Once you go north of that, there are very few companies that even have a product or an offer… to accommodate that [level of support],” says Schroter, whose site currently charges small businesses a flat monthly fee of $99 to maintain business profiles and crowdfund under current regulations. “They almost inevitably have to use equity.”

To be sure, giving away shares in a business even when limited by law to small slices of the pie with no influence over company strategy could create additional headaches for owners and top management who already have their hands full trying to keep momentum going. Among other issues, they will face the burden of regular contact with shareholders.

“The concern and care that you’ll have to take in an investor that owns a part of your company is another level of management complexity,” says Nik Rokop, managing director of the Knapp Entrepreneurship Center at Illinois Institute of Technology in Chicago. In addition, traditional venture capitalists—the non-crowdfunding variety—potentially interested in buying a larger piece of the business might not appreciate having to acknowledge these smaller stakeholders. So they might be less likely to back you, something you should weigh before taking the plunge into crowdfunding.

Other complexities relate to the law itself, which places significant regulations on businesses offering stock through crowdfunding; it is designed to protect the general public from fraud and online scam artists. These regulations include requiring stock issuers to disclose detailed information about the company, its operations, performance and officers. In some cases, businesses will need to produce audited financial statements.

Fundable and the other crowdfunding sites that plan to facilitate equity offerings will be subject to oversight as well. The JOBS Act stipulates that crowdfunding websites must register with the SEC as well as do their part to ensure that potential investors review materials about the companies profiled on their sites.

Some supporters believe the extensive regulations for investor protection may be overblown. A significant percentage of the investment in a business soliciting crowdfunding capital comes from people who already know the principals, says Chris Tyrrell, manager of Princeton, N.J.-based Nehemiah Investments and a board member of the Crowdfund Intermediary Regulatory Advocates, which lobbies federal lawmakers on behalf of crowdfunders.

He expects the JOBS Act to foster a surge in local investing, enabling many community-based projects with few other financing options to raise capital. “The real strength of crowdfunding is that it’s really not ‘a’ crowd, it’s your crowd,” Tyrrell says.

Ibrahim, the water-bottle entrepreneur, is already trying to make a splash with supporters who might be persuaded to buy shares eventually. He has set up a profile on Fundable and has 35,000 Facebook fans following news of the business.

“It’s a new frontier, a new opportunity,” he says. “The equity model makes sense to me in a big way.”

 

 

Read more ways to creatively find funding for your small business on SUCCESS.com.

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