What’s Up with Crowdfunding?

So you’re ready to expand your business or operationalize your idea. That’s great news!

Do you have the funds? If you are like a lot of smaller businesses, the answer is probably no. Larger banks and some smaller ones have cut back dramatically. As much as half of small businesses lending over the past five years, since the phase-in of the Dodd-Frank act.

The Dodd-Frank act is meant to curb risky behavior of the largest financial institutions. Since the phase-in of the Dodd-Frank act, larger banks and some smaller ones have cut back on loans to small businesses by as much as one half over the past five years a simple matter of spreading lending costs. Banks incur the same overhead for each loan. A small business loan makes less profit than one for a large business. And since costs are going up for banks because of the rules, fewer small businesses get loans.

The question is then, who do you go to for financing? Angel and venture capital are possible sources. But the price of this capital is steep and includes your autonomy.

These investors expect to gain control of an investee. If that is not what you want, then you need to look elsewhere.

The Securities and Exchange Commission (SEC) released Title III crowdfunding rules. These regulations permit, for the first time, “non-accredited” investors to purchase equity or debt in unregistered securities.

Why is this important to you? Because there are a lot more non-accredited investors than accredited.

What is an accredited investor?

It is an individual with high net worth in accordance with SEC rules. Accredited investors are permitted to invest in some riskier companies than other investors.

As we all know, wealth tends to accumulate in relatively few individuals. This is not a value judgement, just a fact. So the math just works out that there are fewer accredited investors than non-accredited investor.

Who is a non-accredited investor?

Basically, anyone! Your potential investor base has just exploded by orders of magnitude.

Is this a good thing? It could be. But also it might not be. It depends.

Pros

The most obvious benefit to Title III is that the universe of investors is huge.

  • Any US citizen can invest up to the greater of $2,000 or 5% of their net worth. If a potential investor’s net worth and income are over $100,000, they can invest up to 10% of the lower of their income or net worth (capped at $100,000).
  • This limit applies to all investments this person makes in unregistered securities (in your company or others). However, you don’t have to verify this. The total investors cannot exceed 500.
  • You can issue debt or equity, or any other legal financial instruments. But get legal advice.
  • An internet “portal” is used (and required) to sell your securities. So you do not need to be schooled in or hire counsel for the process of selling your stocks or bonds.
  • The cost of issuing and maintaining the reporting requirements of unregistered securities is hundreds of thousands of dollars less than that of registered securities (but it can still cost quite a bit of money).

Cons

  • How do you get the word out to all these investors? Advertising, which costs money. There are certain rules you must follow as well or you could get into trouble with the feds.
  • Dealing with stakeholders. Are you ready for this? Even though the reporting requirements are not frequent or difficult, that does not mean these investors won’t harangue you for information.
  • Your financial statements must be in US GAAP format. US GAAP encompasses not just a few schedules like an income statement and balance sheet, but pages of foot notes. You will need a CPA for this. As a CPA myself, I can tell you it takes years to understand the nuances of disclosure, as footnotes are referred to. If your statements are currently prepared by a bookkeeper, I can assure you that there is something that is not accounted for as it should be under US GAAP.
  • You will need to engage two CPA’s. If you want to raise more than $500,000 your first time, your financial statements need to be reviewed by an independent CPA, not the one who prepared the financial statements. Also, a second round over $500,000 requires audited financial statements.
  • You will need to disclose risks. Take some time to do a little reading on one of your favorite public companies. Go to the “business risks” section of their form 10-K. While your disclosures need not be that long since presumably your company is less complex, this will give you a flavor of what you will need to disclose and monitor. The rules require fundraisers to update investors about risks and progress of raising funds.
  • Investor must hold the security for one year before selling. There are a few exceptions, but this will make an investment less attractive than one that can be sold at any time.
  • You must disclose transactions or arrangements with related parties (a relative) as well as any advantages you or other present investors have now or as additional securities are issued. For example, some equity structures give the first profits of a company to a single person or group of investors while other investors must wait to collect dividends or benefit from growth until profits accumulate past a certain number.

Do I Crowdfund?

Well, there is no conclusion because the decision to use this vehicle for fundraising is based on many factors. This includes your present access to funds to finance an offering, your desire to deal with many investors, your other financing choices, and the competitiveness of you company or idea. Investors will have many choices and your venture needs to compel them to invest in your securities over others.

So unfortunately, I will have to leave you with an “it depends.”

SHAMROCK vCFO Services in Naperville, IL specializes in helping small and medium size businesses with strategy, taxes, accounting, and financial performance management. Steve Shamrock left big companies to help smaller ones energize the economy.