Crowd-fundamentals: Balancing Rapidly Advancing Crowdfunding Innovation With Protections for Consumers

• Publication year: 2017

Crowd-Fundamentals: Balancing Rapidly Advancing Crowdfunding Innovation with Protections for Consumers

Zachary Fialkow

CROWD-FUNDAMENTALS: BALANCING RAPIDLY ADVANCING CROWDFUNDING INNOVATION WITH PROTECTIONS FOR CONSUMERS

Introduction

The future of America is online. The Internet's ability to connect people across large distances has allowed for new ideas to prosper. But the Internet has also allowed for old ideas to find a renewed use. Enter crowdfunding, a method of fundraising with roots stretching back hundreds of years.¹ Recently, crowdfunding has gained new significance on the Internet. For those less tech-savvy, crowdfunding is a method of fundraising by using "small amounts of capital from a large number of individuals to finance a new business venture . . . mak[ing] use of the easy accessibility of vast networks of people through social media and crowdfunding websites to bring [donors] together."² Though crowdfunding has been successful in seeing new ideas, charities, and ventures comes to fruition, it also requires that users be wary of substantial legal issues. In fact, the intersection of law and crowdfunding is so rife with legal landmines that some have called it a "legal disaster waiting to happen."³ This paper posits that while crowdfunding has the ability to revolutionize American markets and the economy, it also can be used to harm people. Looking at both equity crowdfunding and crowdfunding fraud, this paper concludes that developers have moved too fast in innovating and must take a step back to fix crowdfunding's issues. Developers and the government must find a way to incentivize this kind of innovation, but also balance protections to vulnerable consumers.

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I. Crowdfunding History

Though the crowdfunding concept has been around for a long time, it only recently took off in America in its online form.⁴ The first popular crowdfunding site, ArtistShare, launched in 2003.⁵ ArtistShare focused on facilitating crowdfunding for musicians and consequently popularized the idea of offering rewards for donations, which could increase based on how much money donors spent on the project.⁶ In the wake of ArtistShare's success, other rewards-based crowdfunding sites were created—Indiegogo launched in 2008 and Kickstarter launched in 2009—and made reward-based crowdfunding huge.⁷ For example, in the six years between its launch and 2015, Kickstarted has acted as facilitator for over 265,000 crowdfunding campaigns and 95,200 of the successful campaigns have raised $1.76 billion.⁸ To remain viable in the rewards-based market, crowdfunding sites have had to offer more specific types of projects. For instance, Teespring offers custom t-shirts while Experiment.com focuses on funding scientific research.⁹

Seeing the success of the rewards-based system, types of crowdfunding have begun to split as well. Now, crowdfunding types include debt-based crowdfunding, which "lets individual borrowers apply for unsecured loans . . . then pay it back with interest," and donation-based crowdfunding, in which platforms act as hubs for charity donations.¹⁰ These other crowdfunding forms have become equally popular to rewards-based crowdfunding, as evidenced by GoFundMe donation totals reaching $1 billion between its 2010 launch and 2015.¹¹

Lastly, crowdfunding types have further expanded to include equity crowdfunding, which is regulated by the United States Government through the Securities and Exchange Commission (SEC). 2009 marked the beta launch of the first equity crowdfunding platform, Grow VC Group.¹² Grow VC Group

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was followed by ProFounder in 2011, but SEC regulations eventually forced the platform to shut down.¹³ Equity crowdfunding is the next large leap in crowdfunding innovation, but it took until 2016 for the United States to begin providing ways for it to grow in the country. The United States' actions regarding equity crowdfunding are discussed below.

II. Equity Crowdfunding

A. JOBS Act Background

In April 2012, Congress enacted, and President Obama signed into law, the Jumpstart Our Business Startups Act, also known as the JOBS Act.¹⁴ The new law, cleverly named, was meant to "facilitate access to capital for startups and small businesses, give more people the ability to participate in investment opportunities, and ultimately, create more jobs and stimulate economic growth."¹⁵ In other words, the JOBS Act took a bottom-up approach to strengthening the United States' economy and business. The Act was meant to increase and benefit small businesses, giving them the opportunity to flourish and grow, instead of the common tactic of solely focusing the already-large and successful businesses.¹⁶ The bill consists of four main "titles," each aimed at benefiting small businesses, including giving various benefits to "emerging growth companies," companies with less than $1 billion before going public; ending a ban on general solicitation and advertising in private offerings; increasing the amount of assets to qualify as a company mandated to report to the SEC;¹⁷ and amending other SEC regulations "to facilitate intrastate and regional securities offerings."¹⁸

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However, the flagship section of the JOBS Act was Title III, which allowed equity crowdfunding for small businesses.¹⁹ Equity crowdfunding is the act of "issuers . . . rais[ing] funds online from ordinary people for investment purposes."²⁰ This act is significant because it marks the first time United States' "securities laws will be updated to recognize modern modes of online capital raising."²¹

Before the JOBS Act, the Securities Act of 1933 covered all issuance of stock for companies. The over 80 year-old law prohibited companies from "offering or selling securities to the public unless (a) the offering is registered with the SEC, or (b) there is an available exemption from registration."²² Now, after the SEC and drafters of the JOBS Act recognized that "crowdfunding is an evolving method of raising capital that has been used to raise funds through the Internet for a variety of projects," they wrote Title III to apply this innovation to selling securities.²³ Title III of the JOBS Act works as a new exemption to the Securities Act of 1933, permitting "companies to offer and sell securities through crowdfunding."²⁴

B. Title III Effect

Economic and crowdfunding experts say that allowing equity crowdfunding "will open up the investor pool to over 300 million potential investors," thus making small business growth significantly attainable.²⁵ Yet, there are many rules that companies and investors will have to follow to use the new equity crowdfunding opportunities. In general, the rules impose restrictions on how much money can be made through equity crowdfunding, limit ways to receives funds and increase disclosure requirements relating to

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equity crowdfunding.²⁶ Specifically, the rules can be broken up into three categories: fundraising, disclosure, and platforms used.²⁷

First, the rules limit equity fundraising and investing to different amounts depending on whether the participant is a company looking for funds or an individual looking to invest.²⁸ A company is only allowed to crowdfund $1million maximum in aggregate throughout the course of 12 months.²⁹ In contrast, rules for investors are more restrictive and more complicated: If an individual's "annual income or net worth is less than $100,000," then the maximum aggregate that person can invest is "the greater of . . . $2,000 or . . . 5 percent of the lesser of their annual income or net worth.³⁰ But, if an individual's net worth and annual income are both greater than or equal to $100,000, then they can only invest in aggregate a maximum of "10 percent of the lesser of their annual income or net worth."³¹

However, this system is complicated and onerous. It is a chore to both parse out the statute's language and to actually follow its instructions. First, an individual will have to find out his annual income, or net worth. If both are $100,000 or more, then he may only spend 10 percent annual income or net worth, whichever is the lesser, on equity crowdfunding. However, if either his net worth or annual income is less than $100,000, then he must find out which is the lesser. If 5 percent of the lesser number is greater than $2,000, then he may invest up to that 5 percent within a 12-month period. If that 5 percent is less than $2,0000, then he may only invest up to $2,000 in a 12-month period. The final rule covering investors is that "the aggregate amount of securities sold to an investor through all crowdfunding offerings may not exceed $100,000" in a 12-month period.³² These rules are likely aimed at preserving the JOBS Act's goal to help small businesses, rather than allowing a large company to raise money which it is able to receive in other ways.

The rules regarding disclosure and platforms are, thankfully, less complex. Companies making an equity crowdfunding offering must disclose standard information to the SEC like price of securities, target amount, whether the company will accept investments over said target amount, financial statements,

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and descriptions of the business itself and its financial condition.³³ Then, Title III both allows websites to be created to act as portals for equity crowdfunding and mandates equity crowdfunding only occur through those portals.³⁴ To become legitimate, a portal must "register with the [SEC] on new Form Funding Portal, and become a member of a national securities association."³⁵ Other portal rules require the service to provide "educational material" explaining how to equity crowdfund on its website as well as, vaguely, "take certain measures to reduce the risk of fraud."³⁶

C. Issues with Title III

The JOBS Act and Title III clearly have good intentions, but the law's implementation and execution leave much to be desired. Reportedly, SEC regulators were "scrambling" to write and release the final rules...