Crowd-Funding Draws New Attention

Why a new format for raising seed rounds is in the news -- and on the SEC's agenda.
Alix StuartSeptember 22, 2011

This past summer, Thomas Young raised more than $60,000 for his nascent ear-bud business, with no dilution to his company or bad blood between him and his relatives. The magic ingredient? Raising a little money from a lot of people, via an online “crowd-funding” platform.

Young collected $61,000 over three months, thanks to 1,078 donations of between $21 and $57. In return, sponsors got one of three different types of ear-buds, transactions calculated to include a 25% margin above what the buds cost to make.

His next step? Young says he “would love” to raise more money by offering a financial reward, like shares of future revenue, in return. “If I could do that, I would never have to worry about second- or third-stage funding,” he says.  

While such transactions are legal right now, there are some serious restrictions on them, thanks to the Securities and Exchange Commission’s watchful oversight of anything resembling an investment. The agency shut down a Website trying to raise $300 million to buy Pabst Brewing Co. through crowd-funding last year, for example, because the proposed deal wasn’t registered with the SEC. And that was before any money changed hands, according to press reports.  

In the past week, however, Rep. Patrick McHenry (R-N.C.) has introduced a bill that would exempt some crowd-funded deals of up to $5,000,000 from the need to register with the SEC, and two separate committees of the House of Representatives have held hearings on the concept, as well as on other ways of improving the flow of capital to growth companies. (See the agendas and written testimony here and here.)

Yesterday, SEC director of corporation finance Meredith Cross spoke about some of the broader steps the agency is considering to streamline capital raising, many of which could be useful in crowd-funding. Currently under consideration at the agency, she said, are the following ideas: (1) increasing the number of shareholders a company can have before it must publicly file its financial information, up from the current limit of 500; (2) loosening up current “general solicitation” bans on marketing smaller deals widely; (3) relaxing some of the rules on communications during the IPO process, especially regarding prospectuses; and (4) making changes to Regulation A, which allows companies to raise up to $5 million per year with minimal reporting requirements but is not commonly used.

Dana Mauriello, co-founder of Profounder, one of the leading platforms for crowd-funding deals involving financial incentives, testified at both hearings, and says she came away “encouraged.” Profounder has so far helped coordinate deals for 19 companies, involving a total of $612,000 and 356 investors, most of whom have received shares of future revenue.

Others, however, are not very optimistic. “It’s going to be hard for the SEC to be more accommodating without making it even easier for unscrupulous people to commit even more fraud on the Internet,” says Thomas J. Murphy, a securities lawyer with Mcdermott, Will & Emery in Chicago.

Murphy notes that the SEC previously lifted many of the restrictions for offerings under $1 million, including allowing for general solicitation and the trading of securities. In response to Internet fraud, the agency then reversed itself in the late 1990s to again impose limits on such activities.

The set of options currently being discussed are “a little bit too much Wild West for them to be signing off on it anytime soon,” he says.

Crowd-funding deals involving financial returns can happen now under the auspices of Section 504 of Regulation D, which allows a company to raise up to $1 million in a year, but only from existing friends and family, and with other restrictions. All but one of the 19 companies that have raised funds through 504 on Profounder have offered investors a share of future revenues, which is considered a debt security rather than equity, says Mauriello. When equity is offered, Profounder suggests using nonvoting shares. “If you try to apply the same principles to the crowd as you do to VCs, it gets too complicated,” she says.

Mauriello says that her business could expand — and that client businesses could increase the size of their deals — if the SEC were to loosen some restrictions. Among the investor protections she has suggested is limiting deals to people who either know the founders or who live within 100 miles of the business, to keep it accountable. She envisions the platform being especially helpful for local consumer-oriented businesses, like restaurants and retail stores.

According to yesterday’s testimony, some of the questions the SEC will consider with regard to crowd-funding in particular include:  

• What information about the business should be required to be available to investors?

• What restrictions should there be on participation by individuals or firms that have been convicted or sanctioned in connection with prior securities fraud?

• Should an SEC filing or notice be required so that activities in these offerings could be observed?

• Should securities purchased be freely tradable?

• Should Websites that facilitate crowd-funding investing be subject to regulatory oversight?

For his part, Young says he understands the SEC is “being prudent,” but wishes “they would light a fire under it” to make things easier faster.  

The process he already completed was fast and easy, and gave him more than the money. His campaign on Kickstarter, perhaps the oldest crowd-funding site, was also a bit of market research to test interest in his product, says Young. Plus, about 20 of his more enthusiastic supporters are now helping build the company, from naming it to building a Website for it – for free. If he could find a few more enthusiasts who were wealthier than his current group, he says, “I’d be set.”