Part 1
THE BASICS OF CROWDFUNDING
CHAPTER 1
What Is Crowdfunding?
Most business start-ups have relied at some point on the friends-and-family offering to raise the capital needed to create new businessesâto make the products, provide the services, and launch the innovations that make the global economy exciting and dynamic and provide the foundation for human progress.
Since historically few other people (to say nothing of reluctant banks after the 2008 financial crisis) have been willing to risk their hard-earned money on speculative start-ups, most entrepreneurs and company founders, having exhausted their credit cards and personal savings, have been forced to borrow money or seek investment from their friends, college roommates, family members, teachers, mentors, and anyone else who would listen to their pitch. The near-universal popularity of friends-and-family offerings can be explained by two basic facts of human nature:
1.Friends and family members will frequently offer you money out of love and affection (or, less charitably, to get you out of their hair), not necessarily for the purely economic motive of seeking a return on their investment.
2.Friends and family members are less likely than other people to sue you and force you into bankruptcy if the you-know-what hits the fan and the start-up fails to achieve liftoff.
Historically, the pool of available capital from friends and family has been extremely limited for most entrepreneurs, and the success of these offerings often depended on who your friends and family were. If they were rich or well connected, you were more likely than not to get the capital you needed to launch your business. If your friends and family were poor, well . . .
But that is about to change. In a big way.
Taking the Friends-and-Family Offering to the Next Level
The past decade has seen an explosive growth in Internet-based social media platforms, such as Facebook, Twitter, Instagram, Pinterest, Snapchat, Google+, and LinkedIn. While these platforms are significantly different from each other, all have one basic thing in common: they are designed to help people exponentially expand their network of friends and family by building a personal network of followers, fans, hangers-on, groupies, posses, and significant others so that it becomes larger than the friends and family who share entrepreneursâ DNA or who actually know them in the flesh.
Thanks to these platforms, millions of people throughout the world have discovered that they have more in common with someone in a remote foreign country than they do with their next-door neighbors. The author himself, a relative novice on social media, has about four hundred friends on Facebook and almost two hundred on Twitter. I admit to knowing personally only a handful of them. Each week I receive invitations to friend other people on Facebook, and I wonder how in the devil these people found me, and why they care about my âfriendship.â I sometimes wonder whether the people who use cartoon caricatures or famous artwork as their Facebook photos are real people or computer algorithms.
It was only a matter of time before entrepreneurs, visionaries, and dreamers started thinking about tapping into these expanded social media networks to raise capital for their projects, their businesses, and other aspects of their lives.
But there was a problem.
Since the 1930s, the U.S. Securities and Exchange Commission (SEC) had imposed severe restrictions on an entrepreneurâs ability to raise capital using âgeneral solicitationâ or âgeneral advertising.â The idea was that you had to actually know people, and know them fairly well, before you hit them up for money.
I have had personal experience with these limitations. Back in the early 1990s, I and a couple of partners decided to produce a television show based on a novel idea: entrepreneurs from around the country would pitch their ideas before a panel of venture capitalists, lawyers, and industry experts and have their business plans critiqued before a live television audience.
Sound familiar? Fans of the popular network television show Shark Tank might be surprised to know that my show, MoneyHunt, ran on PBS for seven years before it folded when the Internet bubble burst in 2001 (to see some old episodes, search on YouTube for âCliff Ennicoâ or âMoneyHunt television showâ).
Because I was not only the host of the show but the legal expert on the management team, I spent countless hours speaking to securities lawyers, SEC staffers, and others trying to get the answer to a simple question: what can entrepreneurs say, and not say, on television about their efforts to raise capital? In the early 1990s, the answer was ânothing,â and each guest on MoneyHunt was instructed in no uncertain terms not to say anything about raising money in order to avoid a cease-and-desist order from the SEC and other securities regulators. If a guest blurted out âwe are looking to raise $1 million for 20 percent of our company,â we had to stop taping and rerecord that segment to avoid being sued by the government. Not a happy outcome for a show devoted to the entrepreneurial life.
Enter crowdfunding.
The term crowdfunding, in its most general sense, means raising money for something from a group of people that is large and relatively undefined: the crowd. Crowdfunding has been around in one form or another since the mid-2000s, but only in late 2015 have crowdfunding techniques been legally approved for companies looking to raise capital.
Crowdfunding offers entrepreneurs who are not yet ready to exploit more traditional avenues of capital raisingâsuch as venture capitalists and angel investorsâto tap into their ever-expanding social networks on Facebook, LinkedIn, Twitter, and elsewhere to raise money for their businesses. It also gives them the limited ability to advertise and promote their offerings, even on television, without violating SEC rules and regulations.
Even more significant, crowdfunding offers investors chances to tap into start-up and early-stage companies that arenât yet on the radar screens of larger and better- informed investors, and (perhaps) get a piece of the next Facebook before the marketplace finds out about it and media attention drives up the price of the companyâs shares.
Of course, whenever the U.S. government loosens the rules in one area of the law, it tightens them somewhere else, and crowdfunding is no exception. As a condition for allowing entrepreneurs freer access to the capital markets, the SEC has imposed lots of conditions designed to ensure that unsophisticated investors do not lose their shirts buying into companies that arenât ready for prime time. Some of these conditions may pose insurmountable barriers to many companies and investors who want to take full advantage of crowdfunded investments.
This book is a guide for entrepreneurs, investors, and others to the new crowdfunding rules, with tips and advice on how to best take advantage of them.
The Different Types of Crowdfunding
There are three basic types of crowdfunding for companies looking to raise capital. With project crowdfunding, those who contribute invest in a specific project (such as a new book or film) but do not receive securities in a company. Accredited-investor crowdfunding allows high-net-worth individuals and organizations to invest in a company and receive securities (usually but not always preferred stock or convertible debt) in return. Title III of the JOBS Act, and the SEC regulations adopted in October 2015, have opened social media crowdfunding or equity crowdfunding to the general public, enabling them to participate in offerings of securities by start-up and early-stage companies as long as their total investments in such securities do not exceed specified amounts.
This book focuses on social media crowdfunding, but first a few words to explain the three types.
Project Crowdfunding, Including Gift Crowdfunding
Until now, most crowdfunding activity has been limited to project crowdfunding and gift crowdfunding.
In project crowdfunding, an individual or company solicits money from the crowd for a project of some kind and gives investors something tangible or intangible in return but not securities in a company.
Letâs say I decided to write a bookâa novel, for example, with vampires and zombies competing to have sex with remaining live humans on a reality television show after...