You may have heard that crowdfunding is already on its feet and on its way to becoming the next big thing. In fact, the crowdfunding you may think already exists… doesn’t. Not yet, anyway. The average investor and the small business owner are both standing by, like participants waiting to jump into a game of double dutch, but the time has not quite come. Here’s a quick primer.
Businesses need to raise capital. One of the main ways they do so is by selling equity, or shares of ownership (also known as “securities”). As a general rule, if a business wants to sell securities, it has to register on the federal level with the SEC (Securities and Exchange Commission) and often on the State level, too. Registration is time consuming and expensive. Businesses, especially small businesses (which employ half of the private workforce in America), often need to raise capital for growth but don’t want to deal with registration. These businesses can raise capital from accredited investors (primarily people who make more than $200,000 per year or have more than $1 million in assets) without having to register, but they cannot currently raise capital from non-accredited investors without registration. This is an issue for a couple of reasons.
According to the New York Times, the median household income in the United States is about $52,000 per year. That means that most Americans are non-accredited investors. With certain exceptions, small businesses cannot sell to these non-accredited investors without first registering. Accredited investors, who make up a relatively small minority of the population, may be more difficult to find (though perhaps easier to find now that the ban on general solicitation has been lifted (see Facebook Friend Seeks Funds: Title II of the Jobs Act (part 1)). This cuts off a major potential source of funding for small businesses. The system is designed to protect unsophisticated investors from risky investments. After all, according to the Wall Street Journal, three out of every four start-ups will likely fail, and about three quarters of them never return investors’ capital. On the other hand, many small investors feel that it is fundamentally unfair that the law deprives them of many opportunities to invest in local businesses or benefit from successful non-registered start-ups in the way that “rich people” can. All of this may cause you to wonder, “Well how can a business “crowdfund” if it cannot raise equity capital from the majority of people… from the crowd?” That’s a great question, and that’s why the crowdfunding you think exists, doesn’t (yet).
Crowdfunding, at its core, is the ability to raise money directly from a large pool of everyday investors with minimal hurdles, using technology and social media to facilitate the fundraising. Crowdfunding became law in 2012 through Title III of the Jobs Act, with the purpose of providing a relatively simple way for entrepreneurs and small businesses to gain access to more capital in order to grow the economy. Although crowdfunding is now legal, for the most part, it doesn’t yet exist. The reason is that while the Jobs Act tells us what the law is, the SEC must then promulgate rules to tell us how the law works in practice. The SEC hasn’t yet issued final rules to inform us how Title III will be implemented, but the SEC has recently issued proposed rules, which is a first big step (see Crowdfunding – SEC Proposes Rules on Title III of the Jobs Act). So, we still wait, but we are getting closer!
As it stands, under federal law, businesses cannot yet raise equity capital from the majority of Americans (from the “crowd”). This may confuse you, and you may be thinking, “Well what about Kickstarter, that’s crowdfunding, right?” Good question. There is an important distinction between equity-based funding and rewards or donation-based funding. This distinction is explored in detail in part 2 of this post.