Crowdfunding: What is it, and is it right for my business?
Many individuals and business owners have heard of crowdfunding, but may not know if or how they could benefit from it as a funding option. Crowdfunding is the process of raising money (from a large number of people) for a project, venture, or business. It is typically done over the internet. In essence, crowdfunding consists of a business looking to raise money, a group willing to invest in the business idea, and a portal (funding platform) to bring those groups together.
Crowdfunding has taken off globally because of the opportunities it provides individuals or businesses looking to raise awareness and funds for their ideas and products. It has increased the pool of potential idea-backers from a select few investors with experience and capital to anybody with internet access across the world.
How does crowdfunding work?
In order for a company to sell interest in the business (referred to as a security) to the public, the security must either be (i) registered with the Securities and Exchange Commission (SEC) or (ii) qualify for an exemption from registration.
The Jumpstart Our Business Startups (JOBS) Act, which was signed into law in 2012 to ease regulations, introduced the crowdfunding exemption. Effective in May 2016, the SEC adopted Regulation Crowdfunding (Regulation CF), which provides the framework for businesses to raise money through securities-based crowdfunding while offering an exemption from SEC registration requirements.
What are the different types of crowdfunding?
There are different kinds of crowdfunding platforms with different expectations of the investors. These include:
- Rewards-based Crowdfunding
Investors contribute funds in exchange for a type of reward. The entrepreneur explains their project or business idea, typically on a social media (internet-based) platform. The reward received by the investor is often the product that is being produced. Two of the first, IndieGoGo and Kickstarter, provided entrepreneurs a method of raising capital and support in an ever-growing socially minded global community. The popular perception in the crowdfunding community has been that reward-based platforms are more likely to attract individuals who invest because they are interested in an initiative and want to support it.
- Equity-based Crowdfunding
Investors contribute funds in exchange for a piece of equity in the company. This is typically used to fund the launch or growth of a company. Equity-based platforms are seen as attracting people who are largely interested in backing projects for a return on their investment.
- Donation-based crowdfunding
Investors contribute funds without anything granted in return. Donation-based crowdfunding platforms are often used for charitable causes. GoFundMe is a popular example.
What are requirements and limitations in crowdfunding?
While crowdfunding opens up funding options to a number of individuals and businesses, it is not without limitations. Those include limits on the size of the offering, limits on the amount each investor can invest, the avenue for investing, and the type of investor.
- Maximum Offering Raised in Crowdfunding
A business selling equity under Regulation CF is allowed to raise a maximum aggregate amount of $1.07 million in a 12-month period.
Each 12-month period is determined by counting: (i) the amount it has already sold under Regulation CF during the 12-month period before the expected date of sale; plus (ii) the intended amount to be raised under Regulation CF in the current offering. However, amounts sold in other exempt (non-crowdfunding) offerings (Regulation D, for example) during the preceding 12-month period are not included for purposes of determining the amount that may be sold in a particular Regulation CF offering.
- Investor Limits in Regulation CF
In order to balance risk that is typically found in start-ups, individual investors are limited in the amounts they are allowed to invest in all Regulation CF offerings over the course of a 12-month period. The limits are determined by looking at an investor’s income and net worth.
- If the investor’s annual income or net worth is less than $107,000, then an investor may invest the greater of:
- $2,200 across all securities offered under Regulation CF over the trailing 12-month period; or
- 5% of the lesser of their annual income or net worth.
- If both annual income and net worth are equal to or more than $107,000, then the investor’s limit is 10 percent of the lesser of his/her annual income or net worth.
Regardless of the income and net worth, an investor, during any 12-month period, may invest a total of $107,000 through crowdfunding offerings.
- Platform/Intermediary Requirements in Regulation CF
Any crowdfunding offering must only be conducted through one online platform. This platform acts as an intermediary, and it must be either a registered broker-dealer or a registered funding portal. Further, companies selling securities through the platform may rely on the efforts of the intermediary to determine that the aggregate amount of securities purchased by an investor does not cause the investor to exceed the investment limits.
- Excluded Companies from the Crowdfunding Exemption
Not all companies are able to use the crowdfunding exemption. These companies include:
- Foreign (non-U.S.) companies
- Exchange Act reporting companies and certain investment companies
- Companies that are disqualified under the crowdfunding’s disqualification rules (convicted of or subject to sanctions for securities fraud or other violations of specified laws)
- Companies that have failed to comply with the annual reporting requirements during the two (2) years immediately preceding the filing of the offering statement
- Companies that have no specific business plan or have indicated their business plan is to engage in a merger or acquisition with an unidentified company or companies
How are crowdfunding dollars taxed?
The receipt of crowdfunding dollars is treated the same as any funds or property by a taxpayer. Contributions a taxpayer receives through crowdfunding contributions is presumed to be gross income and, thus, shall be reported as income on a taxpayer’s tax return. To avoid taxability, the taxpayer must demonstrate that the income fits into one of the narrowly construed exclusions. A more in-depth article about potential tax traps in crowdfunding, as well as income and sales tax considerations in crowdfunding, is forthcoming.
Crowdfunding for your business, in summary
Crowdfunding is a viable option for many businesses to gain investors for an idea or product. It can be highly successful in getting a business off the ground. However, it’s not foolproof. While the JOBS Act was intended to lessen restrictions and regulations on raising capital, entrepreneurs who seek crowdfunding must be on top of the rules that apply to the crowdfunding process. Limitations on money raised, restrictions on investor contributions, SEC fees and rules are just some of the possible disadvantages to crowdfunding. A business attorney with experience in helping crowdfunded clients can advise you in your decision.
For questions about crowdfunding for your business, contact members of our Business Law group or Business Start-Up team in Wisconsin. Murphy Desmond has lawyers in Madison, Janesville, Appleton, and Dodgeville to help you with your business at all stages.
Published February 22, 2019