Getting Lost in the Crowd: Navigating Crowdfunding

October 2013

IN THIS ISSUE

— Bad Things Come in Small Packages: The Perils of Crowdfunding
— Is Three a Crowd? Crowdfunding, Investors and the SEC

GREETINGS!

Welcome to the October edition of our newsletter! In this issue, we’ll examine the processes (and lack thereof) regarding crowdfunding.

BAD THINGS COME IN SMALL PACKAGES: THE PERILS OF CROWDFUNDING

In recent years, as some traditional financing sources have struggled following the 2008 financial crisis, a more “open source” method known as crowdfunding — where companies can raise as much as $1 million via solicitations to multiple types of investors — has become increasingly popular. Yet this new method, driven primarily via companies like Kickstarter, poses challenges for both the companies raising money and the investors seeking to make investments.

Crowdfunding has been used to fund a wide variety of endeavors, from disaster relief to scientific research — both of which, it should be noted, are areas that can be ripe for fraudsters to prey on the hopes or sensitivities of investors. As traditional for-profit companies embrace crowdfunding as a tool, the same risks remain for investors: is the person or group developing this product or service legitimate? Have they had any failed ventures in the past, and have any past investors been stuck with significant losses? The addition of Internet-driven crowdfunding adds a new layer of accessibility to old models of private company fund-raising, which in turn can create more risk for fraud, not less. Similarly, companies seeking to raise capital must be diligent to make sure that investor funds are also legitimate, and not proceeds from illicit activity. The use of accepted banking methods can help deter this aspect of fraud (versus raising cash itself, as an entrepreneur might do among family and friends,) but basic diligence is still warranted to avoid the taint of having a disreputable person or group among your early investors.

IS THREE A CROWD? CROWDFUNDING, INVESTORS AND THE SEC

As part of the 2012 JOBS Act, the U.S,. Securities and Exchange Commission was tasked with developing reporting requirements for companies that raise funds via the relatively new crowdfunding method. Whereas privately-held companies are currently obligated to disclose little to no information about their revenues and other operational details, companies seeking to engage in crowdfunding would have to file reports that describe their business and what they intended to do with the raised funds, similar to offering documents for public companies. The proposed rule, submitted on October 23, 2013, remains open for comment for 90 days, meaning that final rules will arrive no earlier than January 2014, and possibly months after that date.

For a small company, or one seeking to grow, crowdfunding can be an attractive means of raising capital, and for investors looking to be part of something in the early stages, crowdfunding can present a vast array of new opportunities. But with all opportunities come risks, and through due diligence before investing funds — and during the process of raising such funds — can protect your client’s reputation, either as an investor or a nascent company.