Crowdfunding is an online method of raising capital where entrepreneurs or small business owners seek funding for future ventures from the public (i.e., “the crowd”).
A successful campaign attracts many investors who each play a small part in reaching a funding goal by contributing to an idea of interest.
Before crowdfunding, founders would look toward the three F’s – friends, family, and fools – as means to obtain capital.
An additional option was to convince banks or venture capitalists to fund their venture by proving their qualifications.
Although crowdfunding may seem to be a new innovative way of financing, it is not. The underlying principles of crowdfunding can be traced back hundreds of years, and it is now establishing itself as an ethical and transparent way for entrepreneurs and small business owners to seek funding without having to rely on financial institutions. The crowdfunding industry has continued to grow rapidly and has raised over $12 billion worldwide as of February 2017[i].
Small business owners and entrepreneurs have faced numerous challenges over the years as they have struggled to obtain funds. Many were left with no option but to rely on family and friends for capital. However, some were lucky enough to receive financial backing from angel investors or other parties willing to risk money on them with the hopes of high returns. Starting in the 1930s, during the great depression, the attempt to obtain funds became increasingly difficult. At the time lawmakers were convinced too many Americans lost money because of purchasing equity in various business ventures that made large promises with no sufficient evidence to back it up. Government officials enacted the Securities Act of 1933, often referred to as the “truth in securities” law, that had two objectives: (1) require that investors receive financial and other significant information concerning securities offered to the public for sale, and (2) prohibit deceit, misrepresentations, and other fraud in the sale of securities[ii]. While enforced at the federal level by the U.S. Securities and Exchange Commission (SEC), some states enforced additional standards on the securities market as well.
One of the first examples considered to be a form of crowdfunding occurred in 1885 by Joseph Pulitzer. At the time, the state of New York did not raise enough funds to build the pedestal that would put The Statue of Liberty in place. The American Committee was unsure of how to finish building the pedestal, so Pulitzer turned to other Americans for help. Pulitzer took matters into his own hands, and through his newspaper, The New York World, advertised a fundraising campaign targeted at average Americans. In return for an individual’s contribution, Pulitzer promised to publish the name of the individual on the front page of his newspaper. His six-month crowdfunding campaign raised roughly $100,000, roughly $2.3 million today, from about 120,000 donations, most of which were less than a dollar[iii].
Pulitzer could solicit such a large amount of funds because of his access to a large “crowd.” Unfortunately, the average small business owner or entrepreneur did not have access to such a large “crowd” and faced difficult barriers to raise funds. Fortunately, these barriers went away once the internet arrived. Throughout the 1990s, the internet allowed nonprofit groups and charities an avenue for soliciting donations from the general public. Then musicians, artists, and other practitioners involved in creative fields began to raise money from their patrons and supporters. In 2001, a British rock band called Marillion e-mailed about 12,000 fans asking them to prepay for the group’s upcoming album Anoraknophobia[iv]. To Marillion’s surprise, it was successful and the band was able to write and record the album. In 2003, a website called ArtistShare, launched as the world’s first crowdfunding platform for creative artists. Individuals could go onto ArtistShare to fund some of their favorite artists in exchange for small rewards. Indiegogo was the next crowdfunding website to pop up in 2008. It started with a focus exclusively on independent filmmakers, but later expanded out to other ventures. The word “crowd” was becoming increasingly popular and was used to refer to the internet-using public. Kickstarter launched its crowdfunding website in 2009, and quickly became one of the largest reward-based platforms in the world.
While the crowdfunding trend was flourishing in the early 2000s, the economic downturn, also known as the great recession, was causing a devastating impact on small businesses. Raising capital was nearly impossible, so small business owner’s and entrepreneur’s decided to take action. They started to lobby for a reform of the rules governing securities offerings to the public established long ago. Congress responded and in 2012, the Jumpstart Our Business Startups (JOBS) Act was signed into law, allowing privately held companies to sell equity shares in a crowdfunding manner. Additionally, numerous states followed by changing their laws to allow in-state investment crowdfunding.
Today, there are hundreds of different crowdfunding sites that support all kinds of different ideas, projects, businesses, and causes. Crowdfunding falls into two categories as seen in figure 1, Donation- or Rewards-Based and Investment-Based. While both provide ways to raise funds, this article will be tailored towards Investment-Based crowdfunding.
Regulation D is a commonly used private placement exemption. In other words, it allows private companies to raise capital without going through the SEC’s typical registration process. Historically, there was only one type of Rule 506 offering, which prohibited general solicitation (public advertising) and limited the offering to accredited investors only. However, after the JOBS Act, two types of exemptions were made for Rule 506 of Regulation D. The original Rule 506 exemption became known as Rule 506(b), whereas a new type of exemption known as Rule 506(c) was enabled in 2013. As seen below, figure 2 illustrates the differences between the two.
There are three key differences between Rule 506(b) and Rule 506(c); (1) verification, (2) information, and (3) advertising.
The first major difference involves verification. For Rule 506(b), an issuer may rely on an investor’s word that he or she is accredited. With Rule 506(b), issuers often times take the investors own word or take few steps towards verifying the investor. For Rule 506(c), issuers must take reasonable steps to verify the investor is accredited which include review of financial statements, tax returns, or professional letters. If the rules of 506(c) are not followed accordingly, the violation may lead to a one year hold on an issuers fundraising efforts and a return of capital to investors.
The second difference is in regards to information. If all of the investors are accredited, then there is no difference between Rule 506(b) and Rule 506(c). However, even if there is one non-accredited investor in a Rule 506(b) offering, the issuer will have to provide much more information.
The third and final difference has to do with general solicitation or advertising. In a Rule 506(b) offering, advertisements are only permitted for the brand. Whereas in a Rule 506(c) offering, all sorts of advertisements are permitted for the actual deal.
Crowdfunding has become a growing alternative to venture debt, bank loans, credit card debt for startups and growth stage companies, as well as an alternative investment opportunity for investors. The significant growth of crowdfunding over the past few years proves that crowdfunding is here to stay. Investment-based crowdfunding will continue to compete with venture capital funds and banks’ small business lending by offering an alternative source of capital. Additionally, it will compete with asset managers as an alternative investment option. Companies that return to crowdfunding platforms possess the opportunity to build a relationship with the “crowd” rather than a bank. According to a study by Crowdfund Capital Advisors, many firms that have raised funds through equity or debt-based crowdfunding report having less interest in involving institutional investors since crowdfunding[vi].
Moving forward, small and medium-sized businesses (startups as well as established companies) will continue to have an increasing opportunity to borrow money without needing to go through banks. This provides a tremendous added value in almost every industry that includes a large amount of small businesses. Figure 3, listed below, illustrates that the average funding amount per campaign will continue to increase through 2021.
Consumer awareness plays another large role in the growth of crowdfunding for startups and growth stage companies. At the moment, roughly 22% of individuals with ages between 18-29 years and 30-39 years already use crowdfunding services; however, 38% of consumers with ages between 18-29 years and 37% of consumers with ages between 30-39 years say they are familiar with crowdfunding, and will probably use it[vii]. As consumers continue to access the internet at an increasing percentage through mobile devices, tablets, and computers, more individuals will discover the investment opportunity crowdfunding presents. Total transaction value is expected to reach 19,326 million U.S. dollars by 2021[viii]
[i] Disrupting Finance: Crowdfunding, (2017), https://www.forrester.com/report/Disrupting Finance Crowdfunding/-/E-RES115975#dialog-1494307793255-dialog (last visited Apr 21, 2017).
[ii] The Laws That Govern the Securities Industry, (2013), https://www.sec.gov/answers/about-lawsshtml.html (last visited Apr 21, 2017).
[iii] Aditi Srivastav, (2014), http://sofii.org/case-study/fundraising-for-the-statue-of-libertys-pedestal (last visited Apr 21, 2017).
[iv] Crowdfunding History – See How the Funding Revolution Started, (2014), https://www.fundable.com/learn/resources/guides/crowdfunding-guide/crowdfunding-history (last visited Apr 19, 2017).
[v] Mark Roderick, (2017), https://crowdfundattny.com/2017/03/06/whats-the-difference-between-rule-506c-and-rule-506b-in-crowdfunding/ (last visited Apr 16, 2017).
[vi] Crowdfunding In A Nutshell: What It Is, What’s Happening And What’s About To Happen, (2012), http://crowdforce.co/crowdfunding-in-a-nutshell-what-it-is-whats-happening-and-whats-about-to-happen/ (last visited Apr 9, 2017).
[vii] Tobias Bohnhoff, (2017), https://www-statista-com.esearch.ut.edu/download/outlook/whiterpaper/FinTech_Business_Finance_Outlook_0217.pdf (last visited Apr 21, 2017).
[viii] Tobias Bohnhoff, (2017), https://www-statista-com.esearch.ut.edu/download/outlook/whiterpaper/FinTech_Business_Finance_Outlook_0217.pdf (last visited Apr 21, 2017).