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What is Crowdfunding Anyway?

    Client Alerts
  • July 31, 2015

Rarely has a capital markets concept been more ambiguous, and potentially more confusing, than crowdfunding. It seems that everyone has his or her own definition, which sometimes varies depending on the circumstances. Now a recent Federal Trade Commission order, as well as widespread fascination with start-ups of all shapes and sizes, has generated another round of media coverage and perhaps another round of misinformation. So, although crowdfunding is not really relevant to public companies, I thought it would be interesting to consider: what is crowdfunding anyway?

In its broadest sense, crowdfunding is the process of obtaining money in small amounts from a large number of people, almost always via some sort of internet or social media platform or solicitation. Generally, crowdfunding efforts can be divided into two categories:

  • Donations/rewards crowdfunding, and
  • Investment crowdfunding.

The first category is a now prevalent technique for start-ups and individuals to raise money for charitable causes or to obtain seed funding to launch a product. The second category, to the surprise of many people, does not actually exist except in very narrow circumstances.

Donations/Rewards Crowdfunding.

It has become commonplace for product-driven business startups to seek seed capital to move a new product from concept to production, the scope of which depends on the success of the crowdfunding campaign and management’s ability to execute. In essence, a company accesses the internet or social media to solicit small amounts of money from individuals in exchange for a reward in the form of the product it proposes to develop (for example, an espresso machine or a surfboard).

The individual contributors tend to think of this type of crowdfunding as a fun way to help get an interesting product off the ground and then to be first in line to receive it. The amount contributed is often, though not always, substantially less that the anticipated retail price of the product. Various internet sites have been created to bring such companies and contributors together, perhaps the most well-known of which is Kickstarter.

Also, as online charitable giving has exploded in recent years, so has the practice of using crowdfunding for charitable purposes. It has become common for individuals or groups to solicit small donations from large numbers of donors on behalf of local, sometimes personal, causes.

In both cases, the key is that no one is being asked to “invest” in a company in exchange for an equity or debt interest. Therefore, there is no offer or sale of a security, and the SEC does not get involved.

Donations/rewards crowdfunding is not completely unregulated, however, as evidenced by the FTC’s recent enforcement action against Erik Chevalier. Mr. Chevalier used Kickstarter to raise approximately $122,000 from over a thousand persons to produce a board game (with the wonderfully evocative title of “The Doom That Came To Atlantic City!”), which was supposed to then be delivered to the contributors as a reward for their financing. Instead, according to the FTC, he used a substantial portion of the funds to pay for his personal expenses, including his apartment rent, and to fund other projects.

As the FTC pointed out, Section 5(a) of the FTC Act prohibits “unfair or deceptive acts or practices in or affecting commerce.” The defendant was, therefore, fined $112,000 and hit with the FTC’s version of a cease and desist order.

Investment Crowdfunding.

Interestingly, many people seem to believe that crowdfunding in small amounts from legends of financially unsophisticated individuals is currently a permissible method for raising capital through the sale of equity or debt interests in companies. This is, however, not the case (yet). Some of the confusion is, no doubt, due to the media’s extensive, breathless coverage of the SEC’s proposed crowdfunding rules, which were issued back in October 2013 in response to the JOBS Act’s mandate. However, those proposed rules have never been finalized and, therefore, are not effective.

While online funding portals for soliciting investment funds now exist in the wake of the JOBS Act, offerings through such portals still must be limited to accredited investors and are subject to limitations and parameters of Rule 506 of Regulation D. This is essentially an electronic version of angel investor financing.

The timing and content of the SEC’s final crowdfunding rules, which would provide an alternative to Rule 506, are anyone’s guess right now. Furthermore, absent major modifications to the proposal, compliance with the final rules appears to be so burdensome and expensive that most start-ups will likely find them to be unhelpful.

The media has also recently noted that a few states have begun to adopt their own investment crowdfunding statutes and regulations in an effort to get out in front of the need for start-up investment capital. However, most of those state statutes rely on the federal intrastate registration exception, which has numerous restrictions that severely limit their effectiveness.

So, the bottom line is that crowdfunding, however you define it, is still a niche technique for raising money in very narrow circumstances.