posted Apr 3, 2013, 11:00 AM by Andrew Manzo
updated Apr 5, 2013, 4:05 PM by David Khorram
Crowdfund investing (CFI) is a revolutionary financial technology that offers individuals an opportunity to engage with small businesses and startups and participate in their growth. In order to build understanding in the crowdfund investing ecosystem, we present a “Crash Course in CFI” that can be used by investors, entrepreneurs, and other interested parties who are interested in crowdfund investing.
On this page you’ll find:
- A very brief history of crowdfund investing in the US.
- Key Concepts and Definitions Related to CFI.
- The Basic Legal Framework for CFI in the United States.
- How CFI Impacts Small Businesses.
- Some of the Reasons that CFI is Good for the World.
- How to Link Up with Our Current Endeavor, Crowdfund Capital Advisors.
The History of Crowdfund Investing in the US
How Beer Changed the Financial System in the United States The crowdfund investing narrative begins in 2008, when the American beer company Pabst Blue Ribbon put itself up for sale for $300 million. One clever social media marketer named Mike Migliozzi saw how the power of social media had changed politics and business, so he decided to use the Pabst Blue Ribbon sale as an opportunity to run a sort of social experiment. With a partner, he started a website to collect small commitments from many individuals in order to buy Pabst Blue Ribbon with money raised from the “crowd.” The site they set up to buy out Pabst generated commitments of $282 million from investors before the SEC intervened. The investors funding the Pabst buy out attempt were regular investors, not accredited investors, and at the time, US law prohibited regular investors from participating in these kind of deals.
The Pioneers of Crowdfund Investing As Mr. Migliozzi’s funding experiment took place, our Startup Exemption team was frustrated with outdated securities laws in the US. These frustrations were the foundation of our drive to create a framework to change small business funding practices in the US. We found broad support for our ideas so they took we case to the government. Upon attending meetings with the SEC they were told it would never happen – that it would take an “ACT OF CONGRESS” for crowdfund investing to be permitted in the US, even though it was clearly a compelling alternative for small business funding. Undeterred, the Startup Exemption team decided it was time to take our ideas directly to US legislators.
Our first step was to create a comprehensive regulatory framework that could be easily used by lawmakers to craft legislation that would allow for crowdfund investing in the future. The result of our work was called the Startup Exemption Framework which you can find on this site. Our framework merges the principles of collective donations made via the Internet and early stage business funding.
When the Wall Street Journal began to follow the story about the legalization of crowdfund investing, businesspeople and policymakers started to look at the issue more seriously. Discussions among policy makers and businesspeople began, and ultimately, significant momentum was created that would later ensure the passage of legislation based on our Startup Exemption framework as a part of the JOBS Act.
List of Key CFI Concepts
Crowdfunding is an Umbrella Term
- The word crowdfunding can be thought of as an umbrella term that describes multiple different funding relationships between individuals and organizations connected via the Internet. The three key terms you need to know are token crowdfunding, crowdfund investing, and regulation D crowdfunding.
- Token crowdfunding is the act of raising non-equity capital for creative projects and or charity causes in exchange for “tokens” like early access to a product or service, public recognition, or a feeling of doing something good. This activity is does not involve the sale of securities.
- Crowdfund investing refers to the new exemption that was created under Section 4(6) of the US Securities Act by the JOBS Act, which provides an exemption from the registration requirements of the Securities Act for offerings of securities by US Company made through an SEC registered Crowdfunding Platform. Under this new US Crowdfunding exemption investors do not have to be U.S. Accredited Investors and do not count toward the 2,000 investor threshold.
- Regulation D crowdfunding is the act of raising equity and debt-capital on the internet by private US and foreign companies under the amended exemption provided by Rule 506 of Regulation D under the U.S. Securities Act. Rule 506 of Regulation D was amended by the JOBS Act to allow for companies to raise money from investors using publicity and other media like the internet (I would refer to this activity as Rule 506 Crowndfunding). However all investors under Rule 506 Crowdfunding offerings are required to be Accredited Investors (as defined in Regulation D under the US Securities Act) (this will normally require having each investor sign an accredited investor certificate that certifies that they meet such criteria). You should note that investors in a Rule 506 Crowdfunding offerings WILL COUNT toward the new higher 2,000 investor registration threshold established under the amended Rule 12(g) under U.S. Exchange Act of 1934.
- A security is a stock, bond, or other financial instrument designed to give someone claim over the future assets owned by some company.
Seed Funding vs. Series A Funding
- Seed round funding is used to finance a company or an idea through the “proof of concept” phase to the beginning of the stage when they actually begin to generate revenue. In most cases, a seed round is raised pre-revenue–that is, companies that are no more than a business plan and perhaps a proof of concept. Companies at this stage tend to be the highest risk because there is no revenue or market proof. Supporters of these types of businesses tend to be those closest to the entrepreneur–“friends & family,” so sometimes this is informally called the “friends and family” round of funding.
- Series A funding describes the first time that professional financiers (like banks, angel investors and venture capitalists) invest money in a company. Usually, Series A funding will be used to grow a business that has already proved that it can make money. These professional financiers are in the business of making money by investing in entrepreneurs and growing businesses.
Venture Capitalists, Private Equity Funds, and Angel Investors
- A venture capitalist in the US is someone who is in the business of making relatively large investments in growing businesses that have proven they are likely to make money. Generally, a venture capitalist (or a venture capital firm) will only make investments greater than $1mm (one million dollars), which is more capital than is needed by most starting businesses
- Venture capital is not the same thing as a private equity fund. Private equity funds usually “buy-out” well-established businesses that the fund feels are undervalued by the marketplace.
The Concepts Behind the CFI Investment Transaction
- An angel investor is usually a wealthy individual that is interested in investing in very small businesses or start-ups. Generally, an angel investor will want to invest in the seed round or the Series A round of a business. An angel investor will usually want to make an investment of between $10,000 – $50,000 and will want to provide development advice to the entrepreneur or the entrepreneurial team. There are some extremely wealthy angel investors who are capable of investing much larger sums of money and sometimes these individuals are called “super angels.” Also, some angel investors like to invest as a group so they create “angel clubs” or “angel groups.”
- A private share is a unit of ownership in a private company. When you think of a private company, think of a company that is not traded on any public market, like the NASDAQ or NYSE. So, when an angel investor, a venture capitalist, or someone in “the crowd” invests in projects using CFI, they are investing in private shares.
- When people invest in private shares, they will receive an Offering Memorandum (OM) (sometimes called a “Private Placement Memorandum” or “PPM”) that includes the company’s business plan, financial information about the company and a Term Sheet. The term sheet is important because it summarizes the most important details of the investment opportunity.
- For example, a term sheet for company who is starting a new line of running shoes would tell investors details like:
- What percentage of her company she is selling.
- What kind of security investors will get in return for their money.
- How she will use the investment money to grow her business.
- What rights investors will have over the way her company runs.
- What information investors will receive to keep track of the company’s progress.
- An equity security is an ownership claim on all of a business’ assets. Sometimes but not always, equity securities can pledge to give investors a dividend. A dividend is a payment (in cash or in kind) from the company to the investors in the company. It is usually up to the company to decide whether to give investors a dividend or to re-invest money they make back into the company so that the company can continue to grow or pay bills.
- A debt security is a contractual promise between a company and investors. With a debt security, the company agrees to pay investors a set amount (determined by an agreed interest rate) over a pre-determined length of time.
- A revenue-based security is an agreed split of future revenues of a company in exchange for an investment today. Also, there is usually a time limit on revenue-based financing deals. For example, a movie production company might agree to give 20 percent of all revenues made for the next three years, paid monthly, in exchange for a $100,000 investment made today. So, if the movie is a success and the production company is paid $1,000,000 of licensing revenue in some month, $200,000 of that licensing fee will go to investors per the revenue sharing agreement.
- Other types of securities may be offered by companies and as a rule of thumb, Crowdfund Capital Advisors recommends that investors do not invest in these securities until they understand them well and perhaps, have spoken to a securities lawyer.
The Basic Legal Framework for CFI in the US (Source)
- The Issuance Limitation is $1mm Annually - A company seeking money from “the crowd” may sell up to $1 million of securities in any 12month period to an unlimited number of investors.
- The Law is Designed to Facilitate Small Investments by Many People - The SEC limits investment amounts by individuals based on annual income or net worth, because the idea is for a lot of people to contribute small amounts of capital and to collectively create a larger pool of cash for use by entrepreneurs. So…
- The System Facilitates Funding for Startups and Community Businesses - CFI is about funding startups and community businesses. This is important because there is a huge mismatch: though small businesses create over half of the jobs in our economies (see Figure 1), it has been impossible to invest in them–until now.So, CFI creates a new kind of asset class that enables people to invest in startups and businesses in their community that issue shares via CFI. Note that certain businesses can’t use CFI: public companies, investment companies, and companies with bad histories.
- CFI Platforms (Think: CFI Websites) Are Registered with the SEC - Offerings under the crowdfunding exemption must be conducted through an intermediary registered with the S.E.C. as a broker or “funding portal.” However, a broker is not the same thing as a funding portal. Generally speaking, brokers are permitted to promote securities and allowed to solicit investors while funding portals are prohibited from those activities.
- Advertising a CFI Issuance is Restricted - Advertising of crowdfunded offerings is not permitted, except for notices directing potential investors to the intermediary’s platform. This law will be clarified by the SEC in due time.
- Companies Using CFI Must Publicly Disclose a lot of Information - An issuer of a crowdfunded security must disclose a lot of information, including its business plan, capital structure, planned use of proceeds, background checks on directors and key shareholders, and (depending on the target offering amount) income tax returns and officer certified financial statements, unaudited financial statements reviewed by an independent accountant, or audited financial statements.
- If the Full Amount Isn’t Reached, Crowdfunders Get their Money Back - Issuers must disclose the target offering amount, and investors may rescind their commitments until this amount is reached. If the security is not fully funded, initial backers’ money is returned to them.
- Investors Have to Hold on to their Securities for at Least a Year, Usually - Securities issued under the crowdfunding exemption must be held for at least one year before they can be transferred, with limited exceptions.
CFI Frameworks Have Major Implications for Small Business
- It Lowers the Personal Financial Involved in Entrepreneurship - Entrepreneurship is currently very risky thing, so that means that people with great ideas stray away from starting businesses because they’re scared of the risks of personal failure. CFI spreads the risk of starting a business to a larger community of people, effectively lowering the risk of starting a business for the entrepreneur.
- It Lowers the Failure Rate of Small Businesses - When businesses use crowdfund investing, they have hundreds or thousands of investors. Many of these individuals are willing to participate in business development and crowdfunded companies might be able to use investors to augment company strategies. This is likely to reduce the failure rate of small because the wider knowledge base and human network is an obvious advantage for a small business–particularly in the age of social media.
CFI is Good for Society
- It Augments Capital Formation for Small Businesses - It’s pretty well accepted that small businesses create a lot of American jobs. CFI builds a new funding system where investors can invest in small businesses in addition to the traditional stock market. Recent research shows that increasingly, savers do not trust traditional public markets, so they keep their money in savings accounts which generally offer very low interest rates–thereby serving only to make them poorer and make the economy more inefficient.
- The Funding Mechanism Does Not Socioeconomically Discriminate - It’s generally pretty well accepted that people who already have money generally have more access to business loans. This means that smart people who don’t already have money (like recent college graduates from poor families) have no way to get money to start a business even if they have a great idea or they’re capable of running a business. This isn’t fair and it’s not efficient.
- Meritocratic Funding Mechanisms Support Economic Growth - Today, almost half of all businesses that start will fail within two years.
- With crowdfund investing, this will change because:
- Crowdfund investors augment a small business’ strategies
- “The crowd” is very good a filtering out bad ideas and vetting entrepreneurs