What is Crowdfunding & How Does it Work?

Given a lot of my time is spent in the lower and middle market private equity arena, I am currently getting a lot of questions about crowdfunding.  Many of our client executives are asking me – What is crowdfunding and how does it really work?  Whether you are a Summit Executive Resources executive client, or one of our relationships in the marketplace, I hope the following helps to clarify what crowdfunding is all about.

Crowdfunding Defined

Crowdfunding is a fairly new and evolving vehicle of using the Internet to raise capital in order to support a broad range of new ideas and new ventures.  An individual or an entity who is raising capital through crowdfunding usually seeks smaller contributions from a larger number of people – essentially ordinary people. Those that are interested in crowdfunding, or also known as member of the “crowd”, can share information about the venture, idea, business model, cause or project with each other.  They can then decide whether to fund the venture based on the “crowd’s” collective expertise and opinion.

In April 2012, the “JOBS Act”, established a regulatory structure for small businesses and startups to raise capital using the Internet through crowdfunding via securities. This was originally intended to help small businesses and startups with capital through low dollar securities offerings.  In an effort to protect investors who engage in these transactions, Congress included a number of provisions that included things like investment limits, required disclosures, and required use of intermediaries. This also allows Internet-based platforms to handle the offer and sale of securities in these transactions without having to register as brokers. Small businesses and startups can raise up to $1M every twelve months from non-accredited investors.

How Crowdfunding Works

In general, here in the United States, crowdfunding has not involved an offer of a share in financial profits or returns, that the fundraiser might expect to generate, otherwise this would refer more to a “equity mode” of crowdfunding which in case could trigger federal securities laws.  Regulatory limitations have made private placement exemptions essentially unavailable for crowdfunding transactions. In addition, if someone operates a website to affect the sale and purchase of securities on the account of others would generally be required to register as a broker-dealer. Also, if someone operates a website solely for the purchase of securities of small businesses and startups, they may find that it is impractical due to the limited nature of that individual’s activities to register as broker-dealer and operate under those regulations.

In regards to “regulation crowdfunding”, it allows individuals to invest in securities-based crowdfunding transactions that are subject to certain thresholds.  This limits the amount of money that raised, requires disclosures, and establishes a regulatory framework for the intermediaries that facilitate crowdfunding transactions.   Securities purchased in a crowdfunding transactions typically cannot be resold for a period of one year. Under “regulation crowdfunding’, offerings must be conducted through a platform operated by a registered broker or a funding portal.

Alternatives to Crowdfunding

Small businesses and startups can alternatively raise capital from sources that could be fairly close substitutes for or compliments crowdfunding transactions. This type if capital raising is typically conducted through unregistered securities offerings, lending from financial institutes or from friends and family. With the alternative of friends and family, small businesses and startups can raise capital which is available earlier in the lifecycle of a small business and before more formal funding options.

Small businesses and startups might also seek loans from financial institutions, although the rate of banks lending to small business has fallen over the last ten years. Another source of financial is peer-to-peer lending. There are also various loan guarantee programs through the Small Business Administration (SBA), which can make credit more accessible. At the other end of the spectrum are angel investors and venture capitalists from which small businesses and start-ups might seek funding.

Crowdfunding Good or Bad

Technology and innovation have driven the growth of alternative models of small business and startup fund raising.  Studies have shown that online lenders have doubled every year and several models have emerged.  Crowdfunding in the US is an array of lending, donation, reward, royalty, equity and hybrid-based. Regardless, small business and startups still have a very high rate of failure. The JOBS Act was designed to help drive the formation of online capital. Unfortunately, so far,  many say the results have been disappointing.