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What You Need to Know About the New Equity-Crowdfunding Model

In her book Cash From the Crowd, Sally Outlaw, founder and CEO of crowdfunding website peerbackers, reveals the secrets of funding your business with help from colleagues, peers, family, friends and even perfect strangers through a crowdfunding campaign. In this edited excerpt, the author provides information on the new equity-crowdfunding model that was authorized by the JOBS Act of 2012.

Until now, crowdfunding has come from backers who donate money with no expectation of a financial return, but that's about to change. The JOBS Act, which offers the first changes to securities law in more than 80 years, enables a new equity-crowdfunding model that allows backers to buy shares in posted ventures. Entrepreneurs who list on equity-crowdfunding platforms will have an opportunity to raise serious capital and must also manage new expectations, responsibilities and obligations to regulators and shareholders.

Under the new law, a company seeking money from "the crowd" may sell up to $1 million in securities in any 12-month period to an unlimited number of investors via a Securities and Exchange Commission-approved crowdfunding platform. Although right now, only accredited investors can purchase these securities, the general public will have the same opportunity when the SEC implements its new "Crowdfund Investing" rules in 2014.

Related: The Basics of Crowdfunding

One of the toughest aspects of this new direction for crowdfunding may be the work involved with managing the expectations of hundreds of new investors. Most of the public, who have never had the chance to invest in a private company, may expect a financial return faster than is the norm in the startup world. Many backers involved in the current donation model of crowdfunding can be demanding as they wait for overdue "rewards" to be shipped; that persistence may be magnified if they're awaiting a dividend check. Even if backers fully understand the risks of investing in crowdfunded startups, they'll certainly be expecting -- and entitled to receive -- frequent updates and financial reports. The investor-management piece of this equity equation will be a challenge for entrepreneurs.

First, the Facts
The good news is entrepreneurs will be allowed to sell up to $1 million in securities through this crowdfunding method. The bad news is there are numerous requirements, restrictions, and liabilities.

Although the rules and requirements weren't yet finalized as of this writing, it looks like entrepreneurs looking to crowdfund via the equity model will be required to make at least the following information available to the SEC, to the platform through which they raise funds, and to potential investors:

  • The name, legal status and addresses of the business, along with the names of directors, officers and key shareholders
  • A business plan and description of the business
  • Financial information that may include income tax returns, officer-certified financial statements, and audited financial statements if raising $500,000 or more.
  • A description of the purpose and intended use of the funds, the target offering amount and the price of the securities they're offering
  • The ownership and capital structure of the business, including the terms of each class of the issuer's securities and methods of valuation for the securities
  • Annual reports and financial statements

The process isn't for the faint of heart or for entities that may not have a legal structure or much financial history. Although the costs aren't yet known, there will certainly be some legal or accounting expenses involved.

Related: How Established Businesses Can Benefit From Crowdfunding

There are also liabilities and restrictions to keep in mind:

  • An issuer (the entrepreneur offering the securities), including its officers, directors or partners, can be liable for any material misstatements or omissions.
  • Issuers cannot advertise the securities, except to provide a notice that directs investors to the crowdfunding platform.
  • Issuers cannot compensate others to promote its offerings through communication channels provided by a broker or funding portal
  • Securities are restricted and subject to a one-year holding period, except when transferred under certain limited circumstances.

While they wait for the rules to be finalized, more and more crowdfunding platforms are opening up to accredited investors. So although you can't yet invite your community to invest, there are two viable forms of equity crowdfunding in action:

  • Equity websites using registered brokers/dealers that are open only to accredited investors.
  • Equity websites using an intrastate exemption under the Federal Securities Act, which allows companies to offer securities to state residents, whether they are accredited investors or not.

Despite the requirements, equity crowdfunding is an exciting proposition for both entrepreneurs and investors as it has the potential to bring billions of dollars into the world of small business. The issue is that venture capitalists may balk at investing in companies that have hundreds of small and unsophisticated backers amassed from the "crowd round," so you may want to consider this consequence before deciding to post on an equity portal. Some platforms try to alleviate this concern by pooling the investors into one unit or LLC that holds the shares, so future investors will have to deal with only one entity. Be sure to research how the equity portal you choose handles this element.

Some pros of equity crowdfunding include:

  • Opportunity to raise more substantial funds -- up to $1 million a year.
  • A potentially larger pool of backers who are searching for investments.
  • Allows you to tap your customers, employees, vendors and so on to invest.
  • Helps overall business planning because of rigorous posting requirements.

Some cons include:

  • Cumbersome and costly preparation process (legal and accounting fees).
  • Managing backers' expectations and reporting requirements to the SEC.
  • Liability. If backers feel you didn't properly disclose something, you could be sued.
  • Possible complications for further funding from venture capitalists.

Related: New Crowdfunding Platform Gives Hardware Innovators Realistic Production Sources

The author is an Entrepreneur contributor. The opinions expressed are those of the writer.

Sally Outlaw, a crowdfund junkie, is the co-founder and CEO of fundraising platform peerbackers.com and crowdfunding media company Crowdcast Network. She's the author of Cash From the Crowd (Entrepreneur Press, 2013) and speaks nationally on the topic of crowdfinance and the JOBS Act.

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