Crowdfunding: Do’s and Don’ts for New Business Owners
Under new SEC rules, crowdfunding continues to be a complex financing vehicle that buyers should evaluate carefully before committing.
Over the past several years, there’s been a lot of talk about crowdfunding as a financing mechanism for entrepreneurs interested in acquiring or expanding their businesses. Recently, the SEC enacted new rules that allow entrepreneurs to raise up to $1 million through crowdfunding.
That’s good news for business buyers, right? Maybe … and maybe not.
Under the new SEC rules, crowdfunding continues to be a complex financing vehicle with pros and cons for small business owners. If you’re seriously considering crowdfunding your business, you’ll need to tread carefully and know what you’re getting into before you commit.
The SEC’s New Crowdfunding Rules for Small Businesses
In October 2015, the SEC established new rules for crowdfunding a small business. Known as Title III, these rules created a framework for entrepreneurs to offer equity to non-accredited investors.
Key elements of Title III rules include:
- Funding Cap: Unlike other forms of financing and investment, entrepreneurs cannot use crowdfunding to raise an unlimited amount of capital. Under the new rules, small businesses are allowed to raise no more than $1 million in a 12-month period through crowdfunding.
- Transaction Procedures: Crowdfunding transactions must be executed through accredited third parties such as broker-dealers or approved funding portals that are accountable to the SEC.
- Investor Limits: Individual investors who earn less than $100k per year can invest $2,000 or up to 5 percent of their annual income. Those who earn more than $100k can invest up to 10 percent of their income, with a maximum investment of $10k during a 12-month period.
- Reporting Requirements: Small businesses that engage in crowdfunding are subject to additional disclosure, reporting and audit requirements.
The SEC’s Title III rules went into effect in May, clearing the way for business owners to begin using crowdfunding as a tool to grow their companies. For business buyers, that means crowdfunding is now an option for expanding or improving a business acquisition.
The Do’s and Don’ts of Crowdfunding
Although the SEC’s Title III rules allow business buyers to tap into crowdfunding as a source of capital for business growth, crowdfunding is not an advisable funding vehicle for all business owners.
If you’re testing the waters and leaning toward launching a crowdfunding initiative, there are several proactive steps that you will need to take as you move forward.
DO explore all of your options.
A lack of financing opportunities helped propel crowdfunding into the spotlight. But most business owners have more financing options available to them now than they did during the lending crisis. Before you commit to crowdfunding, explore commercial financing, SBA loans and other funding options.
DO find the right platform.
Equity crowdfunding is much different than rewards-based crowdfunding, an arrangement in which the business offers investors a tangible reward rather than a piece of the business. To comply with SEC rules and to protect the integrity of your investment vehicle, it’s important to identify a reputable platform that can attract the right kinds of investors and provide a registered funding portal for transactions
DO consult an attorney.
Even though the amounts individuals invest can be relatively small, equity crowdfunding is a serious funding vehicle – and it can have serious consequences for business owners who fail to adequately protect themselves. Before you launch a crowdfunding initiative, consult an attorney to make sure you’re in compliance with Title III and that your business structure will protect you from personal liability should the arrangement go south. In some cases, Title III requires owners to publicly file annual financial statements that have been reviewed by an independent accountant or audited.
In addition to proactively structuring your crowdsourcing opportunity to attract investors and mitigate risks, there are several things you’ll want to avoid before and after you launch your initiative.
DON’T neglect the costs.
It’s a myth that crowdfunding is more cost-efficient than other types of funding. Funding portals and broker-dealers charge fees for their services, and the cost of complying with SEC regulations add up. Fees vary in structure. For example, NextSeed Inc. charges between 5 percent and 10 percent of the amount raised, while SeedInvest LLC will charge a fee that is 5 percent of the amount raised and then also take a 5 percent equity stake. More importantly, equity crowdfunding requires you to give investors a piece of your business – a cost that you won’t incur with traditional debt financing.
DON’T make unrealistic promises.
It’s tempting to promise the moon to attract a high volume of investors. But overpromising often leads to a mass exodus of investors and causes lasting damage to your business. When promoting your business to potential investors, it’s okay to be positive, but be realistic about what they can expect in terms of timelines and yields.
DON’T ignore SEC requirements.
Title III rules aren’t guidelines or suggestions. They are legally enforceable regulations that the SEC has enacted to protect investors from fraudulent investment activities. Educate yourself about Title III rules and comply with all SEC regulations to avoid fines and other penalties.
Title III crowdfunding is still in its infancy. Finding sources of capital to grow or expand recent acquisitions will always be a concern for business buyers and new business owners and ultimately, crowdfunding may prove to be a viable funding channel for small operations.
Until then, entrepreneurs and business buyers should be cautious. Include equity crowdfunding in the mix of potential funding sources, but do your homework and carefully consider whether the amount you can reasonably expect to raise through crowdfunding will be worth the cost.