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Crowdfund Investing – Will 2013 be the Year of the Entrepreneur?

Posted by on December 20th, 2012

Despite controversy and delay, the Crowdfund provisions of the Jobs Act of 2012 promise a new funding paradigm for startup companies. But will we see final implementation in 2013?

In April 2012, President Obama signed the JOBS Act into law, a landmark piece of legislation with the potential to fundamentally change the way companies access and receive funding from the public markets. One of its most significant and controversial provisions creates an entirely new, online funding mechanism for entrepreneurs and small companies – the Crowdfund Act.

Originally introduced as bipartisan legislation by U.S. Senators Scott Brown (R-Mass.), Jeff Merkley (D-Oreg.) and Michael Bennet (D-Colo.), the Act was incorporated into the larger JOBS bill and makes it possible for “small-money” to participate in funding and capital raising platforms. It has been referred to as “Web 3.0, where the social Web meets small business financing.”

For entrepreneurs, crowdfund investing (CFI) has the potential to change the way startups get off the ground. It appears to be an ideal mechanism for raising seed capital (typically under $1 million) vital for early-stage companies. Startups are understandably excited, but delays in Federal rulemaking may hold up implementation beyond the Act’s statutory start date of January 1, 2013.

The Provisions
It is important to note that equity CFI, as regulated by the Act, is distinct from “token crowdfunding” popularized by sites such as Kickstarter , RocketHub , indiegogo and others. Under the CFI investing structure, the investor receives a claim on a business’ future assets in return for that investor’s capital. Under this form of crowdfunding, “crowds” of individuals donate to funding campaigns, prepay for yet-to-be-developed products or receive “token” rewards for their contributions.

This Act will allow entrepreneurs to solicit small investments directly from both accredited and non-accredited investors through a “crowdfunding intermediary,” a broker or a funding portal registered with the SEC.

A private company or entrepreneur may issue up to $1 million of restricted stock in any twelve-month period without triggering the registration requirements of the Securities Act of 1933. Small investors (annual income under $100,000) could invest up to $2,000, or 5% of their income, while large investors (annual income over $100,000) could invest up to 10% of their annual income up to a maximum of $100,000.

This is proving to be one of the more controversial provisions of the JOBS Act due to critics’ contention that it will raise the specter of online fraud against unsophisticated investors. Indeed the long title of the Act, “Capital Raising Online while Deterring Fraud and Unethical Non-Disclosure Act of 2012” speaks to this potential.

The Act proposes a number of provisions to guard against fraud, including: requirements to protect investor privacy; disclosures to investors regarding the risk of loss; requiring investors to answer questions demonstrating understanding of the risks; and obtaining background checks on the officers and directors of an issuer and anyone holding more than 20% of an issuer’s equity.

However, the Act would preempt state securities regulations (Blue Sky Laws) by making crowdfunded offerings “covered securities” and potentially limiting a layer of oversight. In addition, trading platforms for these crowdfunded securities would be exempt from a number of typical broker/dealer regulations.

The Potential
CFI, as envisioned under the Act, has the potential to fill a key gap in early stage capital formation, often the most important funding in an embryonic company’s existence.

Bank financing at favorable terms is a now a distant memory for startups and angel/venture capital has shifted from seed-stage rounds to larger more secure deals targeting companies much farther along in their evolution. This has resulted in a void for early-stage funding, which is particularly acute in the so-called “Valley of Death” for financing rounds of $1 to $4 million.

The opportunity to fill this void through a transparent, relatively simple and potentially rapid process has led to considerable interest on the part of U.S. investment banks, brokerage houses and law firms eager to tap into a new funding mechanism. And there has been an explosion of growth in non-equity, token crowdfunding platforms as well.

The most recent Crowdfunding Industry Report indicates that there were some 452 active crowdfunding platforms in early 2012, with more than 530 anticipated by the end of the year. Total funds raised in 2011 were more than $1.4 billion and this is expected to more than double by the end of 2012.

However, in order for entrepreneurs and small businesses to legally take advantage of equity crowdfund investing under the provisions of the Act, final rules need to be established by the SEC. And the rulemaking process to date has been slower than expected.

The Delays
All equity-based crowdfunding websites and organizations must be registered with the SEC and comply with its regulations before funds can be accepted. The JOBS Act gave the SEC 270 days (starting April 5, 2012) to draft its CFI rules, and the deadline expires on December 31, 2012. The SEC informed Congress that it will not meet this deadline, as regulations are still being drafted and likely will not to be released until early 2013.

A key delay to date has been the SEC’s rulemaking regarding Section 201 of the JOBS Act, which removes the ban on general solicitation and advertising for issuers of certain offerings. The lifting of the ban is critical for CFI, as well as other sections of the JOBS Act. The JOBS Act also requires FINRA to implement a new set of rules specifically for crowdfunding portals; however, the law set no deadline for FINRA to implement their rules.

Entrepreneurs, crowdfunding CEOs, VCs investing in or tracking the industry and others continue to speculate on when the regulatory authorities will finalize their rules and implement this game-changing legislation.

One positive development is that FINRA recently issued an Interim Form “to seek essential information from prospective funding portals intending to apply for membership with FINRA pursuant to the JOBS Act.” This is a first step for companies seeking to set up funding portals. Another potential positive indication is the generally supportive public remarks given by interim SEC Chairman Elisse Walters in November on the implementation of CFI.

Despite these small steps, rulemaking has been delayed to such an extent that many observers consider final implementation before Q1 of 2013 unlikely. Entrepreneurs and investors, eager to tap into this new method of startup funding, will no doubt continue to wait expectantly.