Sunday, July 29, 2012

The Crowdfunding Festival—JOBS Act, Kickstarter & Indiegogo--What Do They Mean to Entrepreneurs?

The founder of Pebble Watch, a smartwatch that pairs with phones to run apps, had hoped to raise $100,000 on crowdfunding site Kickstarter and raised over $10 million instead. With technology enabling investors and entrepreneurs to connect quickly and the recently-signed JOBS Act allowing small companies to raise capital through crowdfunding,  it’s no wonder entrepreneurs are asking: What is going on? Is crowdfunding good for them? Should they participate, and if so, how?

After all, what is crowdfunding exactly?  Of the so-called crowdfunding platforms out there--Kickstarter, Indiegogo, Microventures, Crowdfunder, etc.. how do they differ?  What does a company need to do to participate and what are the obligations, if any, that a company has after raising the funds?  Through this blog post I will try to answer each of these questions and provide some food for thought for entrepreneurs thinking about joining the crowdfunding fete.

What is Crowdfunding?

To begin with, crowdfunding is the act of pooling financial resources from a group of people, usually through the Internet, to support a certain cause, project or venture.  It can be raising funds to support building maternity clinics in Africa, an indie film project, or a company selling customizable watches that sync with iPhones. Depending on the type of crowdfunding, what you get in return for your financial contributions differ.

Different Types of Crowdfunding Platforms—Kiva, DonorsChoose, Kickstarter, Indiegogo, Microventures, Crowdfunder, etc.

Of the several types of crowdfunding, one type is lending-based crowdfunding on sites such as Kiva, where funders lend their monies to projects and are repaid over a period of time.  For example, a potential funder can loan $1000 to an Ecuadorian food vendor to help him purchase a food truck and get paid back over a period of 6 months.   Another type of crowdfunding is donation-based, such as, where funders donate monies to a particular cause, for example, tsunami relief.  Then, there is perk-based crowdfunding (aka reward-based crowdfunding), with the most-talked about being KickStarter and Indiegogo, where funders contribute funds in exchange for certain perks, such as contributing to an indie film project and in return, receiving a limited edition DVD copy of the film.

The latest type of crowdfunding, as well as the most-hyped form of crowdfunding signed into the law by Obama in April 2012, is equity-based crowdfunding, also known as crowdinvesting. Rather than repayment of a loan, a thank-you letter for donation, or a limited edition DVD, funders receive a stake (so-called equity) in the company. In other words, funders become shareholders of the company with their contributions. If the company does well, the funders may receive returns on their capital. If the company goes bust, the funders lose all of their contributions.  MicroVentures and Crowdfunder are examples of equity-based crowdfunding.

This blog will focus on perk and equity-based crowdfunding platforms as they receive the most attention from the media.  Also, they are the most likely venues for entrepreneurs to pursue should they wish to raise capital without the obligation of repayment. However, before I move on to the next section, I would like to bring it to the readers’ attention that equity-based crowd funding platforms permissible under the JOBS Act are not allowed to accept investments as of yet.  Although signed into law in April 2012, the SEC still needs to figure out how to implement the law, and has until January 2013 to do so. With regards to Microventures, it is allowed to operate under a different set of laws:unlike the JOBS Act-enabled crowdfunding platforms, which would be open to mom and pop investors, Microventures is open only to accredited investors as of now (i.e. investment funds and individuals with a net worth of at least $1 million). However, once the JOBS Act is implemented, Microventures may expand to accept mom and pop investors.

Perk versus Equity Based Crowdfunding—The Big Picture Questions

Before the entrepreneur dives into the sea of platforms comparing and analyzing each of them, the initial questions an entrepreneur should ask him or herself are:
·       how much capital does s/he need to raise?
·       nature of the project—is it one-time, or is it ongoing?
·       what is s/he comfortable with giving away—perks or equity?
·       at what stage is his/her project at—just starting, or already in operation?

How Much Capital--$1M Cap for Equity-Based Crowdfunding Within 12 Month Period

While there is no limit as to how much an entrepreneur can raise through perk-based crowdfunding, in the event that the entrepreneur wishes to raise monies through equity- based crowdfunding, the entrepreneur can raise no more than $1M for the company within a 12 month period. The cap applies to all monies raised during those 12 months, regardless of source.  In other words, in the event you raise $999,999 through Crowdfunder by Christmas Eve, and your uncle wishes to invest $100 that night, you can take no more than $1 from him, and will have to wait till next Christmas to take the remaining $99. On the other hand, if you raise monies through perk-based crowdfunding, like Kickstarter, the sky’s the limit.

Nature of the Project

Before loading up your application onto the crowdfunding platforms, it is good to take a minute to think about exactly what it is that you’re seeking monies for—is it monies to finish a comic book, monies to fund a social media website, or monies to fund the expansion of an existing company that owns renewable energy plants?  For projects that are one-time in nature with a discrete goal, such as finishing a comic book, perk-based crowdfunding platforms such as Kickstarter or Indiegogo will be the appropriate choice. Equity-based crowdfunding requires that the project or venture be an ongoing operation, of which funders will have a stake in the venture’s future. For ongoing ventures such as a social media website or a renewable energy company, equity-based crowdfunding will be more appropriate.  In fact, Kickstarter explicitly mentions how starting a business or social media sites do not qualify as a project, and hence, they are not eligible to apply to Kickstarter.

Note however, certain projects, depending on how you wish to reward your funders, may qualify for both perk and equity-based crowdfunding.  For example, if you have a game company with a topseller iPhone game called Angry Pigs and you’re seeking monies to develop an Android version, you can either raise monies as a project on KickStarter, or, if you’re comfortable with people sharing a stake in your company’s future as a whole (which can include making Angry Pigs and a bunch of other games), apply to an equity-based crowdfunding platform to raise funds for the company.

Perks or Equity-Your Comfort Zone

The third question an entrepreneur will want to ask is: what does the company need to give in exchange for the monies raised? First, the entrepreneur will need to pay the crowdfunding platform provider its usual administrative and transaction fees. What the entrepreneur needs to give to the participant though, is very different with a perk vis a vis equity based crowdfunding. With perk-based crowdfunding, you give your contributors a perk, such as a limited edition DVD of the indie film. The contributor has no say in your project nor any connections with your company. You take the money and you have no other obligations to the contributors other than completing the project and giving them their perks—their limited edition DVDs.

With equity-based crowdfunding, you are required to give your funders (so-called investors) equity in your company. Equity comes in various flavors and can be in the form of common stock, preferred stock, convertible notes, etc. In other words, through equity, these funders may have shareholder rights equal or superior to yours.  The type of equity and portion the funders receive correlate with how much the venture is worth as of the time of raising capital, as to be discussed in the next section.  These funders will not go away.  Unless they sell their shares at some point in the future, the company will have to report to them, and in certain instances seek their approval regarding certain major company events.  Sometimes, depending on the terms of their equity, they may be able to participate in future rounds of financing.  Are you ready for such participation by strangers?

Equity-based Crowdfunding--Stage of Development—Startup or Existing

For equity-based crowdfunding, the type and portion of equity you have to give away to the funders depend on how much your venture is worth at the time of raising capital,   as well as how much capital you need.  If your venture is worth $10K and you need to raise $2K, you’ll probably give away a smaller portion of your company than if your venture is just starting (worth $0). Therefore, the impact of giving control to strangers through equity may be lessened if your company has a high valuation, as you will have more leverage in terms of the type and portion of equity to be issued to the investors.

Perk versus Equity Based Crowdfunding—The Application Process

Now that we’ve taken care of the big picture questions, the next question is, what does it take to apply? For perk-based crowdfunding, the application process usually involves submitting materials describing your project, such as a project pitch and video.  Certain perk-based platforms, such as Indiegogo, post all projects, while others, like KickStarter, has a screening process where they review applications and may reject if your project does not conform to their guidelines. 

The application process for equity-based crowdfunding platforms is much more strenuous. The company is required to submit a business plan, capital structure, planned use of proceeds, and (depending on target offering amount) income tax returns and officer-certified financial statements. In addition, if the company seeks to raise between $100K and $500K, the company is required to retain accountants to review its financial statements, and for raises between $500K and $1M, the financial statements must be audited. The legal and accounting fees can be high.  In light of the differences, perk-based crowdfunding may be more suitable for startups, and equity-based crowdfunding may be more suitable for companies with track records.

Perk versus Equity Based Crowdfunding—The Aftermath

Suppose you have succeeded in raising the monies you seek. Congratulations! Is there anything else you need to do other than accepting the monies and paying the platform providers their fees?  In the event that you raised the monies through perk-based crowdfunding, using the indie film project as an example, the only things you need to do are to finish the indie film as promised, update your contributors with your results,  and deliver to your contributors their limited edition DVDs.

In the event that you raised the monies through equity-based crowdfunding, you are in a different ball game. Unlike perk-based crowdfunding, equity-based crowdfunding is governed under securities laws, as equity is considered a “security.”  As the issuer of equity, you are required under the law to file annual financial statements with the SEC. Also, there is a chance that you may be required to publicly disclose confidential, proprietary or competitive information. In addition, the officers and directors of the company face potential liabilities for securities fraud in the event any materials submitted to investors or the SEC contain material misstatements or omissions.

Last but not least, your funders have not disappeared. They own a part of your company, they are shareholders.  As shareholders, they will have approval rights on certain major company decisions. What is more, they are required to be invited to the company’s annual meetings. In event you have many shareholders, the task of seeking their approval or notifying them can be daunting. As they are your shareholders, you have a fiduciary duty toward them and they can sue you for breach of fiduciary duty if they are disgruntled.

Final Thoughts

There is no clearcut rule as to what type of crowdfunding works best for a certain venture or project. Like all other major decisions to be made, one needs to weigh several factors—the amount of capital to be sought, the nature of the project or venture and what the venture is capable of fulfilling in terms of the obligations imposed by the various crowdfunding platforms and the laws. What is more, as the SEC is still drafting the laws to implement the equity-based crowdfunding supported under the JOBS Act (and they are behind schedule as of today), it remains to be seen what type of financial statements that recipients of equity-based crowdfunding will need to file, as well as the type of information that needs to be disclosed. Also, we have yet to test the equity-based crowdfunding market—will the investors be comfortable with crowdfunding? How much equity will they want? Will it be difficult to manage the investors? Will it be difficult to raise monies from VCs and angels further down the road if they know you have 100 mom and pop investors out there whom they may need to deal with in event they invest in your company?

Like the Olympics, we never know how the games will play out. Just join, know the rules, play your best and enjoy the fȇte!
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  4. With the hype surrounding crowdfunding in the news, such as Kickstarter raising $10 million for a smart watch maker and the recently-signed JOBS Act allowing small companies to raise capital through crowdfunding,

    Rim Sanson,