Intrastate Crowdfunding in Alaska: Is There Security in Following the Crowd?

• Publication year: 2017

§ 34 Alaska L. Rev. 293. INTRASTATE CROWDFUNDING IN ALASKA: IS THERE SECURITY IN FOLLOWING THE CROWD?

Alaska Law Review
Volume 34, No. 1, June 2017
Cited: 34 Alaska L. Rev. 293

INTRASTATE CROWDFUNDING IN ALASKA: IS THERE SECURITY IN FOLLOWING THE CROWD?

Evan Glustrom ^[*]

ABSTRACT

This Note analyzes the potential of crowdfunding for the State of Alaska. Crowdfunding can open up new sources of revenue for small businesses while simultaneously providing an avenue for Alaskans to invest in their own communities. The potential, however, must be weighed against the risk of fraud, poorly run businesses, and the lack of protection for investors. It is the responsibility of the Alaska legislature, the State's securities administrators, and the Securities and Exchange Commission to ensure that investors are adequately protected. This Note discusses Alaska's crowdfunding legislation, the Alaska Intrastate Crowdfunding Exemption, and recommends changes to the legislation that account for the risks involved in crowdfunding while still capturing its potential.

INTRODUCTION

Kyle DeWitt and Tim Schmidt are residents of Tecumseh, Michigan, passionate about brewing beer, and young entrepreneurs. ^[1] Shortly after meeting, they developed a plan to open their own brewery, Tecumseh Brewing Company. ^[2] Kyle would be the General Manager and Tim the Head Brewer. ^[3] As is common with many young entrepreneurs, they could not acquire sufficient financing and were repeatedly denied a bank loan. ^[4]

Their prospects were looking bleak until a friend told them about the Michigan Invests Locally Exemption (MILE) Act. ^[5] The premise of the law is simple: Companies in Michigan can sell up to $1 million worth of equity to Michigan residents without registering with the Securities and Exchange Commission (SEC), ^[6] so long as the company and its investors meet a relatively straightforward set of requirements. These include, for instance, how much each investor can contribute. ^[7] Imagine a campaign similar to what one would see on Kickstarter or GoFundMe, but instead of receiving a reward based on the amount contributed, the investor receives equity and a share of the profits.

Kyle and Tim developed a plan to raise between $150,000 and $175,000 in ninety days through a local funding portal called Localstake. ^[8] They promised investors a 150% return distributed through seven percent of monthly sales revenue with expected payback within five years. ^[9]

It only took forty-five days for Kyle and Tim to raise the full $175,000, and when they showed their newfound capital to one of the same banks that previously turned them down, Kyle and Tim received a $200,000 loan. ^[10] Two years later, Tecumseh Brewing Company is located in downtown Tecumseh and open for business. ^[11]

The MILE Act is part of a nationwide trend of state-level intrastate crowdfunding exemptions following the federal Jumpstart Our Business Startups (JOBS) Act ^[12] in 2012. As of October 2017, there are thirty-six states with an intrastate crowdfunding exemption, and Alaska recently joined the crowd. ^[13] The Alaska Intrastate Crowdfunding Exemption (AICE) functions similarly to the MILE Act in Michigan and is intended to open new avenues of local capital to Alaskan entrepreneurs and businesses. ^[14]

It is often difficult for new businesses to acquire capital in their early stages. Rural environments, where "angel investors" seldom venture, amplify this difficulty. ^[15] Alaska's sizeable rural population and its struggling economy have made capital acquisition especially difficult for entrepreneurs.

It is easy, however, to point to stories such as Tecumseh Brewing Company and declare equity crowdfunding a success. Though there is enormous potential in equity crowdfunding to open up new avenues of capital and increase community involvement, there are also numerous reasons for Alaska to proceed with caution. For instance, many securities law experts have concluded that equity crowdfunding is ripe for fraud. ^[16] Equity crowdfunding creates a dangerous situation because it allows businesses to obtain funding from unsophisticated investors, ^[17] while requiring only minimal financial disclosures. Even setting aside the risks of fraud, the unfortunate truth is that about one-third of small businesses in the United States fail within the first three years. ^[18] These investments appear even more unsound considering that businesses are only likely to resort to equity crowdfunding when they have exhausted other sources for raising capital (e.g., the inability to obtain a bank loan). As one critic has put it, "[W]hat kinds of companies would ever want to use non-accredited investor crowdfunding? Desperate ones." ^[19] In addition, crowdfunding investors often do not receive the same level of investor protection that venture capital firms receive because the former are not typically sophisticated enough to seek protections-such as dilution protection, control, or rights-and furthermore lack the necessary bargaining power to attain them.

Regardless of the risks, equity crowdfunding is available in two forms. Alaskan small businesses conducting an equity crowdfunding offering can use either AICE or Regulation Crowdfunding, another method of crowdfunding implemented by Congress in the JOBS Act. Though having two avenues for equity crowdfunding can complicate compliance, both options offer advantages and disadvantages for businesses and investors. While Regulation Crowdfunding will not change unless done so by Congress, there are ways the State of Alaska can improve AICE and protect investors.

This Note introduces crowdfunding, explains the options available in Alaska today, provides a summary of the advantages and disadvantages of each type of crowdfunding, as well as crowdfunding generally, and recommends ways the State of Alaska can modify AICE to make it more accessible for businesses while protecting investors.

Part I introduces securities law, including the registration of securities and exemptions from registration. Part II gives the history of crowdfunding and highlights the types of crowdfunding options available. This part also considers reasons one might be wary or optimistic about crowdfunding, especially in Alaska where the current recession and the state's rural geography exacerbate issues that already make it difficult for small businesses to raise capital. Part III delves into the state of equity crowdfunding today. It begins with a summary of the JOBS Act and its implementation of Regulation Crowdfunding. It then discusses Rule 147 and Rule 147A (the SEC's federal intrastate crowdfunding rules) and their applicability to equity crowdfunding. This part includes a summary of the limitations and restrictions on Regulation Crowdfunding and AICE. Lastly, this part discusses AICE and its connection to Rule 147. Part IV compares Regulation Crowdfunding and AICE, including a discussion of the benefits and drawbacks of each option and how they compare. Part V proposes amendments to AICE including modifying the exemption to utilize Rule 147A, increasing the investment cap, and requiring the use of a funding portal. A brief conclusion follows.

I. SECURITIES REGULATION AND EXEMPTIONS

The SEC was established in response to the stock market crash of 1929 and was given its authority through the Securities Exchange Act of 1934. ^[20] The mission of the SEC "is to protect investors, maintain fair, orderly, and efficient markets, and facilitate capital formation." ^[21] While the SEC serves numerous purposes in the economy, the focus of this Note is the SEC's role in the registration, or rather exemption, of intrastate securities prior to sale. ^[22]

Generally, if a company wants to sell a security, ^[23] the company must register that security or sale with the SEC. ^[24] Alternatively, the security or sale must fit within an exemption. ^[25] Registration is often prohibitively expensive and time-consuming for small companies in need of capital. ^[26] Thus, the exemptions become important. While there are numerous exemptions available for these companies, each exemption comes with requirements and restrictions that still make raising capital difficult, especially for capital-strapped companies. ^[27]

When funding is difficult to acquire for small businesses, the first source that entrepreneurs often turn to for capital is their local bank. ^[28] Nearly half of all money lent to small businesses comes from community banks. ^[29] However, one-third of small businesses fail within the first three years, making many banks and lending institutions wary of making such loans because companies frequently lack sufficient collateral and a proven record of accomplishment. ^[30] In addition, regulations ^[31] and collateral requirements ^[32] hinder the ability of banks to lend to individuals and small companies. Moreover, these loans are becoming more difficult to obtain as community banks consolidate into larger banks. ^[33] Larger banks prefer to lend to larger, more established companies because of the lower risk and higher profitability of larger loans. ^[34] For these reasons, small business borrowers spend an average of 25 hours filling out paperwork for a single bank loan, often must approach multiple banks, and wait weeks or months for approval. ^[35] As such, while bank loans are undeniably an essential source of capital for small businesses, they are often effectively...