A federal law promising an easier process for raising capital has energized entrepreneurs and investors, but many experts are pointing to the caveats.
The provision was part of last year's bipartisan Jumpstart Our Business Startups Act, which was designed to help businesses grow and hire.
One facet of the JOBS Act, in particular, was created to make it easier for startups and small businesses to gather small amounts of money from nonaccredited investors through online funding portals, a process known as crowdfunding. In return, business owners give the investors small equity stakes in the company.
Previously, businesses could take on only “accredited investors,” who, under the law, had a certain net worth, income or personal relationship to the entrepreneur.
And if they went the crowdfunding route, using services such as KickStarter and Indiegogo, a business owner couldn't give investors equity in the company, only a product — such as a copy of a movie, if that was the project.
Some critics worry the new rules could cause small, inexperienced investors to lose money or be exposed to fraud. That's why the Securities and Exchange Commission recently released nearly 600 pages of rules dictating the new provisions, open for public comment for about two more months.
Can the crowdfunding legislation work for your small business or startup venture? Charlotte, N.C., attorney Benjamin Baldwin, who specializes in equity investments and capital structures, said that while the new federal legislation doesn't directly address jobs or employment, growth in the small-business ecosystem could lead to more jobs. And if small businesses are able to raise capital more easily, that growth might happen faster.
Here, Baldwin explains how investments would work and why many businesses should consider hiring a securities lawyer to walk them through the process.
Q: Who is affected by the JOBS Act's new crowdfunding legislation?
A: The Internet has long been used for charitable purchases, disaster relief, that sort of thing. Now, if the SEC finalizes its regulation, it will be expanded to a corporate capital-raising context. Basically, it's available for companies that don't want to raise more than $1 million for a 12-month period.
Q: Who can invest?
A: There is a sliding scale, depending on the net worth or the amount of money that investor makes. That's so people don't get taken advantage of. If the investor has a net worth of less than $100,000, then the amount sold to that investor could not be more than the greater of $2,000 or 5 percent of their annual income or net worth.
If their net worth is over $100,000, then the limit is 10 percent of their annual income or net worth, with a hard cap of $100,000 per investor.
Q: What if an owner of a successful brick-and-mortar small business, like a cafe, wants to use crowdfunding to raise money for another location. Would it work?
A: If they are very patient and are willing to hire a good securities lawyer who can walk them through the process. You don't want to wind up on the wrong side of securities (laws).
Q: What are some of the drawbacks?
A: One of the biggest drawbacks is (the law) will require a company to produce audited financial statements if they're trying to raise more than $500,000. It's an intrusive and expensive process, like going to the doctor and having an unpleasant procedure done every year.
You're inviting a CPA into your offices to do a very thorough exam of your finances. It could cost anywhere from $10,000 to $50,000, or more. Depending on how much money you're raising, you'd have to submit information about the directors and officers, shareholders who hold more than a $20,000 stake in the business. You'd need to file a description of the company's business, business plan, financial (documents), copies of tax returns.
And it becomes public record. That can be sensitive information a company might not want to part with.
Q: How do you advertise that you're looking for investors?
A: (What's changed is) now you can put an ad in the paper and you can do something on television or radio. But they loaded it up with a lot of conditions.
There's lots of paperwork involved — bank statements, appraisals, statements from brokers who manage their money.
Q: So what are your thoughts on the new law overall?
A: Really, all of these changes are a result of balancing interest of a) supporting the economy and promoting job growth and b) protecting the interest of investors and public. There's a constant tension there.
On the one hand, it seems like Congress was very generous in opening the door to crowdfunding. But they didn't do it without taking a pound of flesh in the process.