Although the term “crowdfunding” has been around for a while, there is still confusion about what it entails and how it may be utilized. With the development and growth of the Internet and social media at its source, there are at least three different models of crowdfunding:
- Donation/rewards model
- Lending model
- Equity model
1. The Donation/Rewards Model
The most developed and well-known “crowdfunding” model is the donation/rewards model, also sometimes called “crowdsourcing”. See Jeff Howe, The Rise of Crowdsourcing, Wired (Jun. 2006) (“Crowdsourcing,” is the concept that “the power of the many can be leveraged to accomplish feats that were once the province of the specialized few.”). This model involves individuals providing financial support to an organization or project either as a donation or in exchange for a non-monetary reward. Examples of websites using this model include Indiegogo (founded in 2008) and Kickstarter (founded in 2009). Today, these platforms are two of the most popular crowdfunding platforms in the world.
2. The Lending Model
Under the lending model, also known as the “peer-to-peer” lending, individuals lend money to an organization or project in return for repayment of the loan, with interest on their investment. Notable examples of this model include online fundraising platforms Kiva and Lending Club.
3. The Equity Model
Finally, there is the equity model of crowdfunding, which can consist of: (1) traditional private placement under Rule 506(b) which has been around for some time, (2) the new “private issue/publicly raising” offerings now available under Rule 506(c), and (3) new crowdfunding rules emerging under the Jumpstart Our Business Startups Act (the “JOBS Act”) that are currently not available, but will be soon once the requisite regulations take effect later this year.
Traditional “Private-Placement” Funding Exemption under Rule 506(b)
Prior to Congress’s enactment of the JOBS Act in April 2012, venture and angel investors relied almost exclusively upon Rule 506(b) to avoid the costly registration and onerous reporting requirements that are otherwise required in the context of the sale of securities. Under a Rule 506(b) exemption, an issuer may sell its securities to an unlimited number of self-certifying “accredited investors,” and up to a total of 35 non-accredited but “sophisticated” investors, but cannot use “general solicitation” to do so. This approach to private placements has been used for traditional venture and angel financings. Additionally some online platforms such as AngelList (founded in 2010) and some others (including Portfolia and SeedInvest, discussed below) rely on this exemption, by using a closed password-protected system available to accredited investors only. Because a number of these online platforms have been growing rapidly since the passage JOBS Act, some people have the mistaken impression that the platforms are crowdfunding platforms under the JOBS Act.
New “Private Issue/Publicly Raising” Exemption under Rule 506(c)
In interpreting the JOBS Act, the Securities and Exchange Commission (SEC) added Rule 506(c), which allows an issuer to offer securities through general solicitations to the public. Although one step closer to a true “crowdfunding” model, this exemption requires that (i) all purchasers in the offering must be accredited investors, and (ii) the issuer must take “reasonable steps” to verify that this is the case. The SEC has provided a “safe harbor,” non-exclusive list of verification methods that an issuer may use to try to ensure that an individual investor is accredited:
- Income verification – by reviewing tax forms that report income, like the Form W-2, Form 1099, Schedule K-1 of Form 1065, and a filed Form 1040;
- Net worth verification – by reviewing prior three months’ financial documents, such as bank statements, brokerage statements, certificates of deposit, tax assessments and a credit report from at least one of the nationwide consumer reporting agencies, and obtaining a written representation from the investor;
- Third Party Written confirmation – a confirmation provided by a registered broker-dealer, investment adviser, attorney or certified public accountant, stating that he or she has taken reasonable steps to verify the purchaser’s accredited investor status within the last three months and has determined that such purchaser is an accredited investor;
- A method for verifying the accredited investor status of persons who had invested in the issuer’s Rule 506(b) offering as an accredited investor before September 23, 2013 and remain investors of the issuer.
Examples of crowdfunding portals that have taken advantage of Rule 506(c) include SeedInvest and Portfolia. On these portals, an issuer can opt to either proceed as a Rule 506(b) or Rule 506(c) offering, but not both.
Emerging Crowdfunding Provisions of the JOBS Act
A large part of the confusion around the current state of crowdfunding in the US stems from the fact that although the JOBS Act was passed in 2012, the “true” crowdfunding provisions of the statute (Titles III and IV) have not yet taken effect because they first require the SEC to adopt further rules. Title III would allow companies to solicit the general public for the purchase of their securities as well as to receive investment from the general public, non-accredited investors. The fundings would take place using special online portals that comply with the requirements of the law. The SEC has yet to adopt regulations to implement Title III of the JOBS Act, so this kind of crowdfunding is not yet available. These regulations are not anticipated to come into effect until the end of this year, or the beginning of 2016.
On March 25, 2015, the SEC finally voted and approved Regulation A+ (Title IV), which long-awaited rules are anticipated to take effect this summer. Under Regulation A+, a small or “emerging” business will for the first time be able to raise a limited amount of capital (up to $50,000,000) from “the crowd” (i.e., from the general public, both accredited and non-accredited investors) through a relatively inexpensive form of a public offering.