Crowdfunding

It's hard to raise capital. The regulatory restrictions imposed by securities laws make it harder to do so. As any bright-eyed entrepreneur with a dream project will tell you, the lawyers and the securities laws make it very expensive and time consuming to raise capital for a small project.

The central goal of the Securities and Exchange Commission is to facilitate companies' access to capital while at the same time protecting investors. More often than not, the securities laws and regulations are put in place due to some prior malfeasance. Limitations on the sale of securities are in place because there were (and still are) lots of shady characters trying to make a quick buck by de-frauding investors.

The Obama administration and the Congress think the regulatory burdens need to be removed to encourage small business capital formation. I'm going to guess that they are fans of Kickstarter, a website that allows entrepreneurs and artists to raise capital for their projects. (I'm also a fan and have contributed to some projects.)

SEC Rule 504 allows a public offering to investors (including non-accredited investors) for securities offerings of up to $1 million. There is no limit on the type of investors, so they need not be accredited investors.  There are no prescribed disclosures and no limitations on resales of the securities. The Rule generally does not allow companies to solicit or advertise their securities to the public.(Of course, the antifraud and other civil liability provisions of the federal securities laws are still applicable.)

However, these offerings are subject to state "blue sky" regulation. That means having to jump through the patchwork of state securities laws, depending where your target investors are located.

How does Kickstarter get around this? It doesn't. Capital for Kickstarter projects cannot be for securities or lending. As a patron, you do not get your capital returned. Often, you'll get the end product that the artist or entrepreneur was hoping to produce. (My son is patiently waiting for our pack of trebuchettes to arrive.)

Generally, the term "crowdfunding" is used to describe a form of capital raising whereby people pool money, generally as small individual contributions, to support a specific goal. Since the capital raising did not provide an opportunity for profit participation, initial crowdfunding efforts did not raise issues under the federal securities laws.

The Entrepreneur Access to Capital Act would create a new exemption for small companies, allowing them to raise up to $5 million. The limitation would be that investments are limited to the lesser of $10,000 or 10% of the investor's annual income.

President Obama cheered for crowdfunding as part of the American Jobs Act unveiling. I failed to find and proposed legislative changes in his proposed bill.

I'm for fueling entrepreneurial growth in this country. I'm concerned that the changes could lead to an onslaught of fraud. I think Kickstarter works well because you are funding the effort. You are not seeing dollars signs.

Sources:

• HR 2930: Entrepreneur Access to Capital Act
• The American Jobs Act (.pdf - 199 pages)
• House Legislation on Crowdfunding Elicits SEC Concerns in Jim Hamilton's World of Securities Regulation
• Testimony on "Legislative Proposals to Facilitate Small Business Capital Formation and Job Creation" by Meredith B. Cross, Director, Division of Corporation Finance and Lona Nallengara Deputy Director, Division of Corporation Finance Before the Subcommittee on Capital Markets and Government Sponsored Enterprises
• Video replay of Crowdfunding: Connecting Investors and Job Creators - House Oversight Committee - 2011-09-15 - House Committee on Oversight and Government Reform. Subcommittee on TARP, Financial Services and Bailouts of Public and Private Programs. Witnesses: Ms. Meredith B. Cross, Director, Division of Corporation Finance, Securities and Exchange Commission, Ms. Dana Mauriello, Founder and President, Profounder, Mr. Jeff Lynn, CEO, Seedrs, Mr. Sherwood Neiss, Cofounder, FLAVORx, Mr. Michael Migliozzi, Managing Partner, Forza Migliozzi, Professor Mercer E. Bullard, Associate Professor of Law, The University of Mississippi. Video provided by U.S. House of Representatives.

For additional commentary on developments in compliance and ethics, visit Compliance Building, a blog hosted by Doug Cornelius.

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