by Victoria Burke
Remember in the movie Field of Dreams when Ray Kinsella hears a voice whispering to him, “If you build it, he will come?” For the entrepreneur, the concept of crowdfunding is built on a similar premise: If you dream it, they will fund it. Raising capital is not easy for any venture. This is especially true in today’s market, where securing investors for a project can be downright impossible. Furthermore, some people just feel that dealing with banks or pitching to sophisticated investors isn’t their cup of tea. Perhaps they fear making a Faust-like contract to finance a dream. For all of these reasons and more, innovative funding can often be the defibrillator needed to resurrect a dying project.
Crowdfunding involves raising a delineated amount of money from a large pool of investors (often via small increments) for a common effort. The idea relies on the “it takes a village” approach to succeeding at fundraising for a project, cause, or business enterprise. The fundraising takes place through an internet campaign hosted by a funding portal. The campaign has a set deadline, and ideally donors pledge money. Crowdfunding web sites charge the principal an administrative fee based on a percentage of the money raised.
But crowdfunding can be tricky – avoiding Securities and Exchange Commission (SEC) entanglements while crowdfunding is like navigating around the Minotaur in the labyrinth. Where there is profit on investment, there is likely a security. And where there is a security, a ton of SEC regulations always follow. Section 2(1) of the Securities Act of 1933 includes an “investment contract” within its definition of a security. To determine if an investment contract exists, the United States Supreme Court developed the Howey Test. SEC v. W.J. Howey Co., 328 U.S. 293, 299 (1946). Under this test, an investment contract exists when “a person invests his money in a common enterprise and is led to expect profits solely from the efforts of the promoter or a third-party.” What exactly equals a “profit” is not always clear.
Several varieties of crowdfunding exist. One type utilizes debt capital. The crowd of investors extends money that will ultimately be paid back. Business owners who feel it is better to be indebted than owned often prefer this method. However, one possible issue is “crowdfunding sites organized on the lending model probably are offering securities if the lender is promised interest.” C. Steven Bradford, Crowdfunding and the Federal Securities Laws, 2012 Colum. Bus. L. Rev. 1, 31 (2012). In these situations, interest acts as profit.
Another popular crowdfunding format is raising donations for projects or causes. Many users implement the donor/reward model to attract funding. Under this methodology, the donor will get something of value as consideration for his or her funding donation. Principals utilizing this format are typically indie filmmakers, musicians, fashion designers, inventors, artists, and humanitarians. They might draw from a pool of investors comprised of film buffs, fans, philanthropists, techies, etc. In exchange for the funding donations, they often reward donors with a copy of the finished product (film DVD/band CD/invention itself), a mention in the credits, having a character named for them, receiving a personal phone call, a simple t-shirt, etc. Yet, in these situations, the reward itself may prove to be a liability.
Speculation continues as to whether this kind of reward system constitutes an investment contract. This concern mainly arises when a reward is not necessarily nominal. Notably, many jurisdictions have adopted the “Hawaii Market Test” to determine if an investment contract exists. State v. Hawaii Mkt Ctr, Inc., 485 P.2d 105, 109 (Haw. 1971). This test is similar to the Howey Test, however, under the language of this test, the donor/reward relationship could be open to interpretation as to whether it constitutes an investment contract. The waters turn murky in the third prong where the test states “the furnishing of the initial value is induced by the offeror’s promises or representations which give rise to a reasonable understanding that a valuable benefit of some kind, over and above the initial value, will accrue to the offeree as a result of the operation of the enterprise.” Does a reward constitute a “valuable benefit of some kind” when it is “above the initial value?” For example, let’s say a person donates $100 for the development of a gadget. As a reward, the person is guaranteed one of these gadgets. If the gadget receives a market value of $500, is this now an investment contract because the benefit rises above the initial value?
The final crowdfunding format is one in which an Average Joe gains an equity stake in a start-up business or project by connecting with the issuer through a third-party funding portal. Currently, this method is illegal. However, on April 5, 2012, the President signed into law the Jumpstart Our Business Startup Act (the “JOBS Act”). This law contains the important Capital Raising Online While Deterring Fraud and Unethical Non-Disclosure Act of 2012 (the “CROWDFUND Act”). The CROWDFUND Act contains exemptions to current federal securities laws. Additionally, as per this new law, funding portals dealing with the sale of securities must register with the SEC.
Some of the significant CROWDFUND Act exemptions are:
(1) Issuer can offer or sell securities to raise up to $1,000,000 over twelve months.
(2) If an investor’s annual income or net worth is less than $100,000, he or she can invest the greater of $2,000 or 5% of his or her annual income or net worth.
(3) If an investor’s annual income is equal to or more than $100,000, then he or she can invest 10% of his or her annual income or net worth, not to exceed a maximum investment of $100,000.
It’s best to proceed with caution and keep in mind that the ink is very wet on these changes. The SEC has 270 days from the time the law has been enacted to establish new governing rules and standards. Perhaps these rules will further address the public policy concern of protecting the unsophisticated buyer (such as retirees). Moreover, the SEC has emphasized that until these new rules are set, “any offers or sale of securities purporting to rely on the crowdfunding exemption would be unlawful under federal securities laws.”
Victoria Burke attained her juris doctor degree from Southwestern Law School and is admitted to practice in California. Her area of interest is intellectual property with an emphasis on trademarks, copyrights, and fashion law. She is a member of the executive committee of the Beverly Hills Bar Association IP/Internet & New Media Section.