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Crowdfunding: What investors and investment professionals need to know

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George C. Miller

In April 2012, Congress enacted the “Jumpstart Our Business Startups Act”—or JOBS Act—as part of the government’s ongoing efforts to stimulate the economy. Through the new “crowdfunding exemption” to the Securities Act of 1933, Title III of the JOBS Act gives startup companies permission to raise up to $1 million in investment capital per 12-month period from everyday (e.g., non-accredited) investors.

Crowdfunding regulation is a new and fluid area of the law. In fact, the SEC has not yet approved its proposed crowdfunding regulations. Until those regulations are adopted—which could take another year—this type of securities crowdfunding will remain illegal in California. It is a question of when, not if, crowdfunding will become legal, and investors and investment professionals must have a clear understanding of the rules and limitations governing crowdfunding before considering these inherently risky investments.

Crowdfunding Defined

Crowdfunding refers to the pooling of small capital investments from a large number of investors to finance a new or expanding business venture. In return, those investors receive a small stake in the company (usually shares of stock, but sometimes LLC units or a promissory note) and expect to earn a profit if the company succeeds.

The concept of crowdfunding is not new. Charities, social groups, churches and non-profit organizations have raised funds using similar methods for decades. Websites such as Kickstarter and Indiegogo brought crowdfunding to the internet by allowing startup companies and entrepreneurs to accept monetary “donations” from project “backers.” The difference between these crowdfunding platforms and crowdfunding under the JOBS Act, however, is that investors soon will be able to purchase a security interest in the company in which they are investing.

General Limitations and Rules Governing Crowdfunding

Crowdfunding is exempt from the formal registration and reporting requirements of the Securities Act. That means non-public/non-SEC reporting companies (referred to as “issuers”) may sell securities legally without meeting the stringent disclosure and reporting guidelines applicable to traditional public companies.

Under the SEC’s proposed regulations, there are strict limitations on the amount of money crowdfunding investors may invest each year. Those with an annual income or net worth of less than $100,000 may invest up to the greater of $2,000 or 5% of their annual income or net worth. The limitation includes all crowdfunding investments combined, and is not calculated on a company-by-company basis. Investors with more than $100,000 in annual income or net worth may invest up to 10% of their annual income or net worth, not to exceed $100,000 each 12-month period. Aside from these relatively minimal restrictions, any member of the general public will be eligible to make a crowdfunding investment. In fact, the SEC believes most investors who participate in crowdfunding offerings will be unsophisticated, lower to middle-income retail investors.

There are similar limitations for companies and countless other rules they must follow. Issuers cannot, for example, raise more than $1 million in capital during a 12-month period through crowdfunding. All crowdfunding transactions, moreover, must be conducted through a qualified intermediary—e.g., a traditional broker-dealer firm or “funding portal” that is registered with and subject to the oversight of FINRA. A company soliciting investments through any other entity or platform is a glaring sign of fraud.

Takeaway Tips

Through its proposed regulations, the SEC has attempted to strike a balance between protecting investors and allowing startup companies quicker and easier access to capital. Prospective issuers have criticized the proposed rules as being overly complex, particularly for young companies seeking to raise small amounts of capital. Some regulators, meanwhile, believe the rules do not go far enough to protect investors in what may become an area rife with fraud. Time will tell how well the regulations work after the crowdfunding floodgates open.

There is no question crowdfunding will make it easy for unsophisticated investors to invest in risky startup business ventures over the internet. The potential downfalls are obvious. Before considering a crowdfunding investment, investors and investment advisers should understand the inherently risky and illiquid nature of the investment, learn as much about the startup venture as possible and only invest an amount they are comfortable losing.

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About Shustak & Partners, P.C. – Business & Securities Lawyers: Shustak & Partners, P.C., is an AV-rated law firm with offices in San Diego, Irvine, San Francisco and New York. We represent broker-dealers, registered investment advisers, brokers, publicly traded companies, local businesses and high-net-worth individuals in a wide variety of business, securities and financial disputes. Call us today at (619) 696-9500 for a confidential analysis of your situation and visit our website, www.shufirm.com, to learn more about our firm’s accomplishments and credentials.

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