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Benefits and Limitations of Investment Crowdfunding

*co-authored by Elizabeth L. Carter, Esq.

Lack of access to financial capital is a barrier for many entrepreneurs who seek to grow their business ventures. Congress and the Obama Administration enacted the Jumpstart Our Business Startups Act (JOBS) Act to help solve this lack of access to financial capital by democratizing the entrepreneurial ecosystem through investment crowdfunding. The JOBS Act established crowdfunding provisions that allow early-stage businesses to offer and sell securities up to a certain dollar limit, adjusted for inflation every five years, without having to register this offer with the U.S. Securities Exchange Commission (SEC).

The main idea behind the JOBS Act was to remove certain restrictions on small business capital raising. This includes making it easier to raise money from both accredited and non-accredited investors through online registers crowdfunding portals. These portals are required to register with both the SEC and Financial Industry Regulatory Authority (FINRA.) The role of the Financial Industry Regulatory Authority (FINRA) is to oversee the registration of crowdfunding portals and ensure that they comply with the federal securities laws and registration FINRA rules.

Crowdfunding essentially means using the internet to pool financial contributions (usually small individual amounts) from several people (i.e., the crowd) for a common purpose. The practice is widespread in facilitating person-to-person lending and launching creative ventures. In addition, crowdfunding aligns with the phenomena of social networking and viral marketing. As such, crowdfunding functions most effectively when many people connect through social media, membership-based websites, email lists, and other online mediums. The democratic nature of crowdfunding includes both the ability to raise capital through public advertisement and general solicitation without having to register with the SEC. This resulted in a more cost-effective and accessible capital raising strategy for small businesses throughout the U.S.

Before the JOBS Act, start-up businesses relied overwhelmingly on Rule 506(b) of Regulation D in order to avoid registration with the SEC. Under this exemption, these companies could only offer their securities to accredited investors and up to 35 non-accredited investors that whom they already had a pre-existing relationship. This excluded the general public from having the opportunity to invest in potentially successful companies. Now, even low-income investors can invest in businesses that they admire, shop, and consume with. For instance, Reg CF allows non-accredited investors who have an annual income or net worth of less than $107,000 to invest up to the greater of 5 percent of their annual income or $2,200, whichever is greater, across all crowdfunding portals (effective March 15, 2021). These same non-accredited investors are able to invest up to 10 percent of their annual income or net worth, whichever is greater, in a Reg CF campaign if the investor's annual income and net worth are equal to or more than $107,000. Therefore, the Jobs Act represents a unique democratic milestone in securities regulation that should prove to be beneficial for more startups, small businesses, and investors alike.

Similar to stocks and bonds, anyone can invest in crowdfunding offerings. However, as shown, there are limits to how much one can invest during any 12-month period. The inflation-adjusted investment limits depend on an investor’s net worth and annual income. In addition to investment limits, other requirements and procedures have been put in place to protect and inform those who invest in crowdfunding offerings. This includes the regulated funding portal, a new type of broker-intermediary also created by the JOBS Act. Under this rule, companies may not offer crowdfunding investments to investors directly. Instead, they must use a broker-dealer or a registered funding portal. Eligible broker-dealer or funding portal must be registered with the SEC and be a member of FINRA.

It is also important to note that investing in early-stage businesses also carries significant risks. There is a real possibility of a loss of investment due to the fact that Start-ups and early-stage businesses often fail. Some ways for a crowdfunding investor to lower their investment risk in any campaign is to seek information about a crowdfunding platform’s communication channels, ask the issuer direct questions about the investment, including worst-case scenarios, and read through the offering disclosures very carefully. As with all investment opportunities, the possibility of fraud is real with crowdfunding offers.

In addition, crowdfunding has several barriers to entry for many businesses. These include transaction costs, disclosure requirements, portal registration, and the capital limitations previously mentioned. The cost of assembling and submitting all of the necessary disclosures for a crowdfunding offer could be very high relative to the amounts raised. This incudes legal, marketing, and accounting preliminary costs. As such, it is important to find professional support that is not only knowledgeable but also sensitive to your unique funding challenges. This is especially true for underrepresented entrepreneurs. Despite the disadvantages, the number of start-ups relying on crowdfunding to raise funds and grow their businesses continues to rise. This is especially true for Black women entrepreneurs. This is because the visibility of crowdfunding campaigns can help fill the gaps and fund worthy start-ups that were traditionally overlooked or ignored, including Black women-owned businesses. Investment crowdfunding can also help boost sales and the consumer base of these entrepreneurs.

Crowdfunding is a unique industry that allows entrepreneurs to gain widespread media coverage and funding support, especially as the campaign gains momentum. Understanding the strengths and weaknesses of Investment Crowdfunding can maximize your chances of success. Schedule a consultation with us to help you strategically raise capital through investment crowdfunding.

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