This is Part 2 of a two-part series. Click here for Part 1.

On April 5, 2012, President Barack Obama signed The JOBS Act (“Act”) into law and Title III of the Act empowers the SEC to set rules for companies to raise capital through crowdfunding. Crowdfunding will permit entrepreneurs to advertise and seek financing from the general public in relatively small amounts in exchange for an interest in their company. These provisions present great opportunity for new companies and investors alike because start-ups can seek capital from a broad pool of investors and investors can seek financial return through the internet from a company that resonates with them. Permitting a diverse group of unaccredited investors as a shareholder base in a company is a large change in securities regulation.

However, there are significant concerns as to whether the SEC will set rules providing adequate flexibility. Currently, Title III of the Act substantially burdens both issuers and funding portals. Regarding issuers, a sweeping scope of individuals in the company must sacrifice limited liability: directors, partners, principal executive officers, principal financial officers, controller, or any person who offers or sells the security in the offering.  Regarding funding portals, there will be financial costs in providing administrative aid to investors and registering with the SEC. Finally, the language in the Act provides for much disclosure and many regulations that do not significantly depart from current requirements for companies at the IPO stage. For both issuers and funding portals, the regulatory costs may be too great.

Additionally, companies will face uncertainties surrounding later rounds of financing and subsequent restructuring if they decide to crowdfund. It will be vitally important for a company to consider the impact that crowdfunding will have on its projected funding model and its ultimate exit strategy. First, companies should consider whether they plan to seek funding from angel investors, venture capitalists, or other traditional sources because such sources might balk at getting involved with a broad base of unaccredited investors. Second, companies should consider that many restructuring plans require a degree of shareholder approval and such shareholder approval could prove difficult and expensive with a crowdfunded shareholder base. Although speculative, these concerns should be contemplated with each client.

Crowdfunding is an exciting legal development that attorneys should monitor as they advise their business clients. The interest surrounding this funding model is justified because crowdfunding has the potential to change the capital raising landscape for start-up companies overlooked by traditional funding sources. Yet, it remains to be seen whether the SEC will implement rules that address current concerns regarding financial costs and issuer liability. Additionally, companies who seek angel or venture capital funding need to be aware of the pragmatic consequences from accepting funds from the general public. In sum, when the rules are promulgated by the SEC crowdfunding should be considered as a potential funding source for start-up companies, but careful scrutiny should be paid to clients’ future plans.

This is the first part of a two-part series. Stay tuned for Part 2.

Between the Colorado Business Law Institute and Denver Startup Week, October was ripe with exciting events for attorneys in Denver interested in the entrepreneurial community. After speaking with attorneys and entrepreneurs alike, it is clear that great interest exists surrounding the forthcoming federal regulations in The JOBS Act (“Act”) pertaining to “crowdfunding.”  Although there is hope that this funding model will be a great source of capital for wanting entrepreneurs, legitimate concerns exist that regulations will be too strict when implemented at the Federal level.  This two-part piece will briefly introduce the idea of crowdfunding, explore how it fits with traditional start-up financing options, and identify potential issues.

Crowdfunding will enable companies to raise capital by seeking funding from a large number of unaccredited investors in relatively small amounts without violating SEC registration and solicitation rules. Title III of the Act specifically permits companies to leverage the internet for this purpose through “funding portals.” At its core, crowdfunding is a simple idea. By way of example, it will enable entrepreneurs from various geographic locations to advertise the efficacy of their start-up entity through social media outlets to individuals in Denver, among other locations, and an interested Denverite could then invest limited funds with that start-up entity. As a result, a wider base of capital will exist for start-up companies to tap into, thereby complementing traditional funding avenues. This is important because less than two percent of start-up companies are ultimately funded by traditional angel investors or venture capitalists.

Crowdfunding rules and regulations are currently being debated and will be issued by the SEC in 2013 – nothing is final yet. As it stands, Title III of the Act will permit participating companies to sell up to $1 million in securities while remaining exempt from the requirements of Section 5 of the Securities Act. In addition to this cap, proposed restrictions on investors will limit crowdfunding investing to an amount tied to their annual income or net worth. Despite these restrictions, this is an exciting shift in the investment paradigm for entrepreneurs because the new rules will remove the strict restrictions on companies advertising and selling securities to unaccredited investors. Instead, companies will be able to solicit investments directly from unaccredited investors through an intermediary funding portal.

Crowdfunding is not a new idea. Rewards-based crowdfunding has been in existence for years without violating SEC rules and is popular for philanthropic and entrepreneurial causes. In this model, individuals invest money with a company or individual, but only as a donation or for some type of reward – there is no expectation of financial profit. Additionally, some companies are beginning to use existing state securities laws which exist in many states, including Colorado, to setup investment crowdfunding platforms that carefully work within the federal framework. This is a detailed topic beyond the scope of this entry.

This is Part 1 of a two-part series. Stay tuned for Part 2.