CROWDFUNDING – A Source of Capital for Small Business Financing and Project Funding.
Report Date: 03.18.2011
Q: Could this herald the beginning of a revolution in the traditional capital markets? Is this new idea going to create a needed redistribution of significant operating and growth capital and liquidity into the Emerging Enterprise and Small Business Sectors? What might be the potential impact on the domestic and global economies, employment and the future distribution of wealth?
A: One thing is certain: CrowdFunding is a flexible and innovative solution for fundraising in relatively small amounts. It is worth exploring.
CROWDFUNDING
Preface: Here is a basic definition of Crowdfunding from Wikipedia, the free encyclopedia:
“Crowd Funding (sometimes called crowd financing or crowd sourced capital) describes the collective cooperation, attention and trust by people who network and pool their money and other resources together, usually via the Internet, to support efforts initiated by other people or organizations. Crowdfunding occurs for any variety of purposes, from disaster relief to citizen journalism to artists seeking support from fans, to political campaigns, to funding a startup company or small business.”
This article was inspired through a letter which I received from a Linked In colleague and co-member in a group about CrowdSourcing.
CrowdFunding is a rapidly-emerging phenomenon based upon the leveraging of the Internet and social media to solicit funds for projects, causes and for smaller companies (or start-up enterprises). It is a logical and innovative entrepreneurial response to the growing problem of obtaining relatively small amounts of financing for private enterprises. The principle is similar to that which is employed by not-for-profit, cause-based organizations which raise small contributions from a relatively large donor audience via their mass e-mailings, newsletter and their presence on the web.
At present, most CrowdFunding efforts yield relatively small sums of capital (i.e., anywhere from US$5,000.00 to US$150,000.00) in very small increments (i.e., anywhere from US$100.00 to US$5,000.00) from any number of investors or patrons. It is, if properly planned and implemented, a means for an ambitious company to raise a small early-stage round of financing without having to: 1) approach and engage in an elaborate and often time-consuming courtship (sales cycle) with angel investors, venture capitalists, investment bankers, government agencies or commercial banks; 2) spend large sums of money -- principally legal fees, compliance fees and production costs) on preparing Private Placement Memoranda (for private offerings to a limited number of specially qualified, “accredited” investors) or Sales Prospectuses (for initial public offerings); or 3) sacrifice a tremendous share of the company’s ownership and control to outside parties at an early, vulnerable stage in the company’s life cycle.
Most participants in CrowdFunding campaigns are non-wealthy, non-institutional individuals who simply believe in the management, objectives or intentions of the offering entity. Many of them are, in fact, entrepreneurial individuals who would like to participate in other entrepreneurial companies for either altruistic reasons, or to obtain a direct return on investment from a private company, assuming that the company is successful.
It is a very straightforward approach which allows adventurous private sector investors or participants an opportunity to directly participate in the bootstrapping and profitability of potentially successful ventures. There are virtually no price barriers to entry (small sums are invested per participant), catastrophic risks (while there are risks inherent in every investment, if the amount being invested is less than the cost of dinner and a show, a loss of the entire investment would probably not have significant adverse consequences to the investor.
The mechanism is incredibly simple. An entrepreneur, executive or spokesperson of an emerging enterprise or growing business makes an offer (generally in the form of a brief request or polite solicitation followed by some additional information to those parties who indicate that they may be interested in participating) to the public through postings on various social media groups, opt-in subscriber lists, business networks, blogs, websites and other internet-based communications forums to raise money for some specified purpose. If the purpose is to raise funds specifically for investment in the issuing entity, and if the investor is not involved in the management or affairs of the company, one potential complication might be the need for compliance with federal regulations and state laws governing offerings of securities. If you are, in fact, making an offering of securities, you must make the necessary regulatory and state (“Blue Sky”) filings.
While I have heard numerous offline discussions about the SEC and other similar regulatory agencies in other countries regarding the possibility of creating a separate, less cumbersome status for CrowdFunding offerings, and about numerous petitions to three of these agencies toward that noble effort, I remain highly skeptical that any significant change in the securities laws governing CrowdFunding will come soon. Both the regulatory agencies and the expert securities lawyers have too much financially and politically at stake to create an exemption or exception for any “special” class of securities offering – especially one which I believe is going to increase tremendously in popularity within the next 24 months to the extent that it could become a capital markets game-changer.
It has long been the position of securities regulators that their primary role was to keep “order” in the capital markets (note: to some cynical folks that merely means keeping Wall Street investing as close as possible to casino gambling for the large numbers of small, independent investors, while simultaneously keeping the select, elite “too big to fail” powerhouses effectively in charge of the game, as the “house’s favored insiders”… but I digress…), and to protect investors from abuse and fraud – like the occasional Enron, Madoff or market collapse which vaporized many a pension and retirement fund.
For the time being, it would seem prudent to avoid using any method of CrowdFunding that could be construed as a securities offering. The mere compliance and filing fees involved would make a small capital raise far too expensive for serious consideration. You should consult competent legal counsel to find out A) if you are making a securities offering, and B) what your most viable alternatives to this might be.
One way to determine whether or not you are making an offer of securities and may be subject to the applicable regulations and laws, at least in the United States is by the Howey Test.
The Howey Test says that a transaction constitutes an investment contract (therefore a security) if there is (1) an exchange of money (2) with an expectation of profits arising (3) from a common enterprise (4) which depends solely on the efforts of a promoter or third party. Clearly, under this standard, any crowd sourcing arrangement in which people are asked to contribute money in exchange for potential profits based on the work of others would be considered a security. As such, the applicable investment contract would have to be registered with a regulatory agency (such as the S.E.C.) unless it qualified for one of several rule-laden exemptions (e.g. Regulation A or Rule 506 of Regulation D of the Securities Act of 1933, or the California Limited Offering Exemption - Rule 1001 (also known as S.E.C. Rule 1001)). The penalties for a securities violation can vary greatly and depend in large part on the amount of profit obtained by the "promoter," the damage done to the investors, and whether a violation is a first time offense. However, a violation may result in both civil and criminal penalties, a return of any profit made and sometimes a lifetime ban from work in the securities industry. According to Section 5 of the 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. You will have to check with an expert in the jurisdiction in which you reside, and in any jurisdiction in which your prospective offerees may reside, as well.
While I cannot and do not recommend or guarantee the efficacy or legality of any particular approach to any CrowdFunding venture, I will state definitively that the structure of what is offered, and the way in which the marketing is conducted are two very critical components essential to getting the optimal CrowdFunding advantage with the minimum likelihood of being in the position as an offeror or promoter of any type of securities.
I predict that some of the more spirited entrepreneurs and other innovative financial engineers looking into using the CrowdSourcing approach will be delving into the following types of possible workarounds, although I do not express an opinion or offer advice on the viability or legality any one of them. I can, however, safely forecast, as a Futurist, that the following approaches or variations on them will be tried by requesters of CrowdSourced capital. In each case, depending upon the specific nature of the structure of a transaction, there can be tax consequences (for example, where the “contributions” will be treated as taxable income to the company receiving them). Get advice from competent tax counsel prior to finalizing the details of any CrowdFunding campaign:
1. ADVERTISING AND PROMOTION - Offering contributors permanent ads, promotional spots, or endorsements in exchange for contributions of funds. In these cases, any stake in the company would merely be given to the contributors as a perquisite;
2. HONORING EARLY ADOPTERS – Similar to the above approach, contributors would be honored as “early adopters” or “charter members” in special postings on the company’s website, newsletters and other applicable e-media. In these cases, any stake in the company would merely be given to the contributors as a perquisite;
3. SPECIFIC PROJECT FUNDS – In this approach, the company would create a special fundraising campaign (with a segregated account for received proceeds) with contributions for a specific purpose, such as contributions to a charity, a community development project, an educational opportunity, or something of humanitarian or civic interest. In these cases, any stake in the company would merely be given to the contributors as a perquisite. An important issue here is the judicious application of the funds collected; the bulk of funds collected must be allocated for the specific purpose set forth in the project description or campaign plan, with minimal expenses deducted for company purposes;
4. CLUB-TYPE MEMBERSHIPS – In this approach, contributors would be given certain privileges or access to resources of value (like club memberships) in exchange for their contributions. In these cases, any stake in the company would be given to these “charter members” as a perquisite;
5. A COOPERATIVE OR COLLABORATIVE CO-VENTURE – In this approach, contributors would be actively rendering services to the company, or through the company, in consideration of their contributions, and each of these contributors would have some significant element of “say” in the company’s financial and business affairs. In effect, the contributors would each and all be acting as the co-founders of the company, or could be regarded as such;
6. AN EMPLOYEE OWNERSHIP PROGRAM – In this approach, employees would be issued options (as bonuses) to purchase stakes in the company (generally at some bargain price) which they could earn and vest as a function of performance and/or seniority. These options might be considered and treated for taxation purposes as employee income, so due consideration must be exercised in how they are earned, issued, priced and exercised;
7. BARTER – In this approach, the company might issue ownership stakes in lieu of cash payments to creditors, vendors and suppliers. Once again, seek professional advice on the tax consequences, if any, to both the company and to the recipients in this type of trade so as not to be unpleasantly surprised.
There will certainly be pioneers, who, at great risk to themselves (and others) will just go out and directly or indirectly sell stakes to large numbers of small-ticket investors via the Internet and social media. While this approach is certainly straightforward, with honest and honorable intentions, a significant volume of successes, especially involving larger amounts raised, will invite regulatory oversight and numerous legal “test cases” and arguments as to the legality of this type of fundraising. It may well force some changes in securities regulations and laws – but these types of changes generally take time and involve a number of legal and regulatory actions.
A CROWDFUNDING CHECKLIST
If you should select CrowdFunding as a solution to bridging a capital gap or for financing a special project, mission, event or cause, you must have certain information in place before you commence your campaign. Following is a brief, basic checklist of items which you will need to be certain about prior to the commencement of your CrowdFunding adventure. The experts at TNNWC Group (http://www.tnnwc.com/) can assist you in creating and launching a successful campaign:
1. The exact nature of your business, distilled into a concise, descriptive paragraph;
2. The amount of funds that you are seeking to raise at minimum and at maximum (your goal);
3. The anticipated application of the funds;
4. The timeframe associated with the campaign;
5. The size of the smallest and largest contribution amount per participant;
6. The maximum total number of participants whom you will permit to participate;
7. What you are offering for each dollar amount (level) of participation. This can be a certain type of advertisement for a certain period of time, or a membership in a special committee – it does not necessarily require any offering of any ownership stakes. There are other ways of rewarding participants something of value in exchange for their confidence in your organization;
8. A list of media through which you are going to present your proposal. Generally speaking, you should identify and target the groups of individuals who would most likely see a synergistic, vanity-based or a cause-based motivation to become participants. Then, you must present your written “CROWDFUNDING CAMPAIGN SUMMARY” to as many groups as possible with the desirable demographic or psychographic profile.
9. You’ll need to distill all of the above information into a concise but powerful document consisting of not more than two typewritten pages.
10. You will need to set up a means of collecting payment (via PayPal or some other safe and familiar means, and identifying the specifics of which participants provided which sums in exchange for what offered benefit. You will be sending out Thank You notes!
To give you an example of a professionally prepared “opening statement” from a CrowdFunding Campaign Summary, an illustration is provided. Bear in mind that the illustration provided hereinafter does not contain or constitute investment, legal or financial advice under any circumstances, and it must not be construed by the reader as such. It is provided solely for the purposes of illustration:
“Note: During Phase I, RAVENSWOOD NUTRITIONALS, Inc. (the “Company”), an e-commerce based retailer of anti-aging nutritional supplements compounded in proprietary formulas will be seeking up to fifty Members to join its Founders’ Advisory Committee. In addition to having any suitable combination of expertise, resources, contacts, passion or other synergistic assets to bring to the Company, each qualified prospective participant will be required to purchase a one-year advertisement (i.e., personal, corporate or brand name and live hyperlink) on the Company’s website for the minimum sum of US $500.00. Interested parties wishing to advertise for longer periods, not to exceed five years, may participate in amounts of up to a maximum per individual participant of US $10,000.00. The Company is seeking an aggregate financial participation of US $50,000.00 (at minimum) and US $150,000.00 at the maximum. The Company reserves the right to accept or reject any participant’s offer to become a Member of its Founders’ Advisory Committee. The Company also reserves the right to terminate or extend the time period of this campaign in its discretion and without prior notice.”
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Expect to hear and see a great deal more about CrowdFunding during the next two years as it becomes much more widely-known through increased experimentation and some newsworthy entrepreneurial successes.
Faithfully,
Douglas Castle
http://www.tnnwc.com/
http://aboutdouglascastle.blogspot.com/
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