Crowdfunding Made Easy? Not So Much

I have always known that Silicon Valley is home to many innovative companies and has a lot of entrepreneurial talent, but I was still amazed to read that start-ups in Palo Alto, Mountain View, Redwood City, Sunnyvale and San Jose received a combined $980+ million in funding in Q2’13. [Source: Silicon Valley Business Journal, July 16, 2013]. As a business lawyer in San Jose, I have seen a number of attempts to make fundraising for start-up companies easier. Recently, a new technique has come into favor.

The new buzz word for start-ups looking for funding is crowdfunding (sometimes known as crowdsourcing). In this type of deal, a group or entrepreneur will receive contributions from a large number of people for a project. The process started with artists raising money for their projects. Their success led for-profit companies to look at crowdfunding to raise money. Websites like kickstarter.com and indiegogo.com are just a few that provide crowdfunding opportunities.

To encourage crowdfunding, Congress passed the JOBS Act a year ago last September. In response, the Securities and Exchange Commission (SEC) released new regulations intended to encourage crowdfunding. One of the new regulations relaxes the public solicitation limitations that had been imposed for certain types of private financing deals.

A little background may be helpful at this point. Because start-up fundraising involves selling stock, start-ups have to comply with federal securities laws. To avoid the formal and expensive registration process, companies comply by using an exemption, known as Regulation D. To be eligible to use Regulation D, you could not publicly solicit your stock. Here is where the SEC relaxed its requirements. For issuances involving only financially sophisticated persons who are accredited (meaning, rich) investors, you can publicly solicit your stock. Life is good!

Well, not so fast. The SEC said if you publicly solicit, you need to be sure the investor is actually accredited. So, what do you have to do?

In the past, most stock purchase documents merely have the purchaser state they are accredited. Under this new rule, that will not be enough. Instead, the issuer has to take “reasonable steps to verify that such purchasers are accredited investors.” The SEC did not want to dictate what has to be reviewed to verify accredited status, but did make some suggestions. For example, if you are using income as a basis for accredited status, you can look at tax returns. If you are looking at net worth as a basis, you can look at bank statement, brokerage statements, and a consumer report as to liabilities from a nationwide consumer reporting agency. You can also accept a written statement from a registered broker-dealer, registered investment advisor, or attorney.

Another set of regulations that is required under the JOBS Act governs the operation of funding portals, essentially companies that will enable investors to invest in start-up companies. The only problem with these regulations is that they do not yet exist. We are all waiting for these new regulations, and the latest rumors are that we should see something in the last quarter of this year.

What this all means is that if you want to use crowdfunding to sell stock, you will need to be a lot more invasive in investigating the financial status of your investors. Investors may not be comfortable releasing this information. As a result, this newest revision from the SEC may not open the floodgates of capital to start-ups. In addition, if you want to use a funding portal, you need to wait a little longer for the SEC to get its regulations together. Still, it all adds up to a new way of raising funds, and may prove to be useful in the right situation.

The information appearing in this article does not constitute legal advice or opinion. Such advice and opinion are provided by the firm only upon engagement with respect to specific factual situations. Specific questions relating to this article should be addressed directly to the author.

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