So What is Crowdfunding Anyway?

IMGCAP(1)]The trendy new term in the high-tech arena is “crowdfunding.” Both the President and Congress jumped on the crowdfunding bandwagon as a way to show they are doing something about the economy by passing the JOBS Act. What exactly is crowdfunding? Here’s one introduction through the eyes of a professional accountant and auditor.

Essentially, crowdfunding is the ability for a large group of people to band together and make small investments that collectively are enough to fund a startup company. Prior to the act, that wasn’t feasible because the limit on the number of shareholders before having to report as a public company was 500. The legislation not only raises that limit to 2,000, but also excludes investors in crowdfunding transactions from the calculation of shareholders of record. What that means is that there is no limit on the number of investors in a crowdfunding transaction.

Naturally, this will be done over the Internet, through what the legislation terms “funding portals.”

It’s a hot topic for businesses because they are always looking to raise capital. The hard part is figuring out a way to get investors together. Without some kind of exchange, only tech-savvy companies that had a Web-based business could raise money that way. Now several funding portal Web sites have risen to fill the crowdfunding void. Anyone, even if not incorporated, will be able to use crowdfunding. It is only limited by the attractiveness of your idea and your ability to present it.

Kickstarter, CircleUp and Fundable
The remarkable thing about crowdfunding is how successful it’s been even though the SEC hasn’t created rules for it; they are not due until the end of 2012. The appetite for small investments in companies is proven by the report that the Web site Kickstarter has raised more than $200 million for 22,000 product offerings. Two million people have supported these products, receiving nothing more than what amounts to a digital “attaboy” and maybe a sample of the product. Investors are termed “supporters” because they don’t currently receive any ownership in or financial information about the retail product startups. In April, the SEC reminded issuers that “any offers or sales of securities purporting to rely on the crowdfunding exemption would be unlawful under the federal securities laws.”

Kickstarter started all this three years ago. Co-founder Yancey Stricker was quoted as saying that only 5 percent of the projects appealing for funding are rejected, while 56 percent of them fail to meet their fundraising goals. Film fundings are the most successful projects on the site, with 12 Kickstarter films showing in the Tribeca Film Festival this year. Company officials say they won’t switch to equity shares, even when the SEC rules are out.

Here’s a typical reward for supporters of ReAct Theater in Seattle: For $10, you get admission to a play in the theater; for only $30, you receive invitations to cast events and backstage passes; for $250, you can have dinner with the theater’s board; and for $1,000 or more get a special VIP night with a pre-show dinner, front-row seats and drinks after with cast members.

CircleUp, on the other hand, offers direct share ownership in consumer product startups in return for your financial support. According to the company’s website, “Your ownership will be proportional to the amount you invest. As the company grows, so will your equity investment. This ownership will allow you to receive distributions when the business is sold or if dividends are paid.” The site does not offer a rewards model. CircleUp is able to offer equity because they currently only accept “accredited investors,” who must have $200,000 of annual income or $1 million in net worth.

Fundable attempts a combination of both methods. The company said that it will—as required by the new law—register with the SEC and a yet-to-be decided self-regulatory body as a broker-dealer before it can sell shares of companies. CircleUp will have to do the same in order to offer shares to the public. Fundable charges companies 5 percent of every dollar raised. One of its successful products was an elevation training mask that simulates training at elevation for runners and cyclists. The product goal was to raise $10,000, and it had raised $14,000 a month before its deadline. The most popular “reward” level was $75. For that you got a mask, a beanie and a t-shirt.

To the trained eye, there are some obvious challenges to crowdfunding. The first and most obvious is the probability that it could be used for fraudulent activity. The second is that even if investors receive actual shares of the company once the SEC rules are set, these shares are private and illiquid, meaning that once you’ve bought them, there’s little chance that you will be able to sell them to someone else. The crowdfunding sites are not exchanges, just angel investment collectors. The third is that there are few requirements—if any—to inform investors about what’s happening with the company. SEC chairwoman Mary Schapiro has already said that the JOBS Act would weaken investor protection.

SEC attorney John Eckstein of Fairfield & Woods in Denver noted that crowdfunded shares, according to the JOBS Act, are to be sold in a transaction that is exempt from registration under the 1933 Act (new Section 4(a)(6)).

“We are all assuming that the shares, once they have come to rest in the hands of an investor, will be 'restricted' stock which cannot be resold unless they are subsequently registered under the 1934 Act or exempt (e.g. Rule 144 or "Section 4(a)(1 1/2)" type transactions,” Eckstein said. “The SEC has a lot of regulation writing to do to make the rules for this new exemption clear and facile for the use by issuers, intermediaries, investors and service providers such as accountants and lawyers. Many things are yet to be determined.”

Eckstein said there is a political battle for the right to be the self-regulatory agency over portals.

“FINRA [Financial Industry Regulatory Authority] would certainly like the job, but there is at least one new portal trade association [Crowdfund Intermediary Regulatory Association] trying to form to do the job. My bet is on FINRA, which is also trying to get the job of regulating registered investment advisers after Dodd-Frank, but there are reasons why FINRA may not be the best public policy choice,” Eckstein said.

Crowdfunded companies that raise more than $1 million during one 12-month period or have more than 500 shareholders will have to register as public companies and begin public reporting. Until then, these new looser regulations will no doubt allow some winning companies to emerge. They will probably be in the minority, however, as some real stinkers emerge a year or two after they receive funding. Of course, that’s the nature of venture investing.

James Brendel, CPA, CFE, is the national director of audit and accounting for Hein & Associates LLP, a full-service public accounting and advisory firm with offices in Denver, Houston, Dallas and Orange County. He specializes in SEC reporting and assists companies with public offerings and complex accounting issues. Brendel can be reached at jbrendel@heincpa.com or (303) 298-9600.