Crowdfunding: Good for the Crowd, or Just an Elite Few?

As we detailed in Crowdfunding: an Alternative to “Traditional” Fundraising, crowdfunding has grown tremendously in recent years, tripling since 2011 to more than $5.1 billion in 2013. This growth and success continued in 2014.

For example, Oculus Rift, a technology company that created a virtual reality headset for immersive gaming, was purchased by Facebook for $2 billion only 18 months after raising $2.4 million using crowdfunding. Lending Club, a crowdfunding lender, successfully raised over $1 billion in an initial public offering. The success stories go on, but so do the less publicized failures.

Though social media has provided the enabling force, crowdfunding as an industry has been constrained by restrictive securities laws, particularly with respect to equity crowdfunding. Although the SEC loosened some of these restrictions in 2013 by allowing general solicitation over social media, because it was only open to accredited investors, equity crowdfunding remained limited. Since then, only wealthy investors and institutions have been able to invest this way. However, once the SEC issues its long awaited Title III regulations, equity crowdfunding may become available to a much broader range of investors.

Participating in Equity Crowdfunding

Currently, in order to participate in equity crowdfunding offerings, an individual must be an Accredited Investor under the Securities Act of 1933. An Accredited Investor is defined as one having a minimum net worth of $1 million (exclusive of primary home equity) or meeting a minimum income requirement ($200,000 earned in each of the last two years or $300,000 combined with a spouse, and an expectation of income at that level in the current year). Unlike traditional private placements, crowdfunded offering issuers must take steps to verify an investor’s accredited status, which may require a potential investor to divulge sensitive information such as tax returns or bank statements.

To expand the range of investors who could participate in equity crowdfunding, as part of Title III of the Jumpstart Our Business Startups Act (JOBS Act), the SEC has proposed new rules that would allow non-accredited investors to invest in limited amounts. Under the regulations, investors with annual income or net worth of less than $100,000 could invest the greater of $2,000 or 5% of their annual income or net worth. In addition, investors with annual income or net worth more than $100,000 could invest up to 10% of annual income or net worth, not to exceed $100,000 per year. Among other requirements, the issuers of such offerings would be limited to raising $1 million per year, must offer through a registered funding portal or broker-dealer and would have to disclose financial and certain other information.

While these rules do reduce some restrictions, many commentators have said that the SEC’s proposed rules do not go far enough and will hinder small businesses from raising capital successfully through crowdfunding. It remains to be seen if the SEC will loosen its final rules. Meanwhile, several states are also promulgating their own crowdfunding rules, so there may be separate requirements or limitations for investors to navigate as well. 

Equity Crowdfunding Advantages and Disadvantages

Equity crowdfunding platforms change the market for investors and start-up companies alike in two significant ways. First, crowdfunding gives greater access to startup investments. In addition, it also typically permits lower minimum investments. The crowdfunding format connects startups to more investors than ever before, and connects investors to thousands of startups. Non-accredited investors can now invest in startups by giving small amounts to multiple companies with potentially lower transaction costs to the investor and the startup. Lower entry costs and greater access to companies raising funds enable more of the estimated nine million Accredited Investors in the United States (according to Crowdfunder) to invest in companies in earlier phases of growth.

Though the potential reward is great, investing in startups is highly risky. For every Oculus Rift success story, there are many more crowdfunded projects that have failed to deliver promised goods or failed to even raise enough capital to get started. Because companies do not have to provide as much information about their business as they would in an initial public offering, there is more room for error, inaccurate data, misleading facts or even fraud. Additionally, when concepts are pitched to investors earlier in the process, entrepreneurs may have invested less money and time in their own unproven idea, potentially creating a less refined business model or a substandard product. Also, because crowdfunded investments have no secondary market, they are illiquid and could be problematic if investors have cash needs.

Finally, be careful when you invest with a relative’s business, even if you do it through a crowdfunding vehicle. You want to make sure that your investment is documented and treated as such, so that IRS does not recast it as a gift.

Conclusion

Although equity crowdfunding and relaxed SEC rules have created new investment opportunities for many individuals, investors should proceed with caution. Given some of the risk inherent with this type of investing, prudent investors should study their options, consider their risk tolerance, and seek professional advice regarding the implications of their investment. If you have questions about your crowdfunding activity, please contact your Andersen Tax advisor.