Does Crowdfunding Work for Early Stage Growth Companies?

I guess crowdsourced funding or “crowdfunding” – as it seems to be known – has reached mainstream now that The Wall Street Journal (article), Knowledge@Wharton (article), TechCrunch (article) and The Economist (article) have all written articles on the topic.  The earliest article I found regarding crowdfunding was a Times article from 2008, so the concept is still relatively new.  By now, most people understand the concept of crowdsourcing and if you combine that concept with trying to raise money for something then you’ve got crowdfunding.  It’s a collaborative way to fund a project.  Given that the average amount crowdfunded appears to be somewhere between $2,000 and $10,000, I’d suggest that crowdfunding slides into the financing continuum somewhere around the “friends and family” level – generally the financing stage during which you are looking for smaller amounts of capital for market research or proof of concept.  Although $2,000 to $10,000 would still be small even by friend and family round standards.

There are a number of sites out there that appear to focus on this crowdfunding model, although most appear to be centric to the creative arts (music, painters, sculptors, fashion, etc.).  On the whole, people do not appear to be selling securities, with a few exceptions.  That is, they are not selling an ownership stake in their business.  They speak in terms of “pledging” or “contributing” or “donating” to a “campaign” or a “project” in return for a “reward” or a “perk”.  When they speak of rewards and perks, think along the lines of free samples, coupons, autographed CDs, a personal phone call or visit from a band member, copies of songs prior to release to the public, free t-shirts or a limited edition copy of original art work and the like.  Here’s a list of some of the current sites in this space:

  • 33 Needs – geared towards social ventures.  Claims that the “backer” receives a percent return based on revenue.  They claim that if a backer’s core motivation is not financial return but, rather, impact or consumption, then the securities laws do not apply.
  • Rockethub – geared to the creative arts.  No ownership exchanges hands.  Investors get a reward.
  • Pozible – Australian based.  Geared towards the creative arts.  No ownership exchanges hands.  Investors get a reward.
  • Catwalk Genius – U.K. based.  Geared towards fashion.  Claim to provide both perks as well as a share in the revenue.
  • Fans Next Door – focused on the creative arts.  You can contribute and receive a reward.
  • Cofundos – primarily focused on the creation of open source software.
  • Profounder – claims to be focused on raising money for your business.  This appears to be the only site involved in businesses outside of just creative arts projects.  That being said, they claim not to be selling ownership shares but rather selling a portion of revenues over a fixed period (we can argue about whether or not that is still a “security” under the Securities Act of 1933).
  • Peerbackers – you can contribute money in return for rewards or perks.  No offers of equity or shares of ownership.
  • Kickstarter – you can pledge money in return for a reward.  Rewards are typically produced by the project itself – think, if they were raising money to make soup, you’d get a bowl of soup.
  • IndieGoGo – focused on the creative arts.  No equity investments.
  • Spot.us – geared towards journalists.  Open source project pioneering “community powered reporting”.
  • Pledge Music – geared towards funding music artists.  Investors get no rights in the end product.  In return, you get music or signed merchandise.
  • Artist Share – geared towards music arts and funding recording projects in exchange for access to the creative process.  This site appears to be the oldest, dating back to 2003.

I’ve had a few entrepreneurs recently ask me whether or not crowdfunding is an alternative financing route for start-ups.  Crowdfunding certainly appears to offer an alternative to raising a few thousand dollars from friends and family.  And if not an alternative, maybe simply a way to augment a friends and family round.  Although the average dollar amounts raised aren’t very high, they still might be sufficient enough to put towards some market research, early concept exploration, product samples and the like.  Beyond the friends and family round, I am not sure that the current crowdfunding models could support the significant dollars that an emerging growth stage company might need.  In addition to not supporting the dollar level, you’d lose out on the advantage of raising money from committed partners with experience in building companies and that can provide additional resources (e.g., contacts, connections, advice) above and beyond simply writing a check.  If you plan on bootstrapping your company into positive cash flow and never taking on investors, crowdfunding might be an interesting place to start.

That being said, if you want to try crowdfunding a friends and family round, or just match some other friends and family money, then my first suggestion would be to stick with the sites that offer rewards or perks in return for a contribution (out of all the sites above, only 33 Needs, Catwalk Genius and Profounder appear to go beyond rewards and perks and get into ownership or revenue streams).  Of course, this assumes that your business model lends itself to doing rewards or perks.  But be creative!  You could turn anything into a reward or a perk.  Why do I suggest that you stick with sites just offering rewards or perks?  Here are a few reasons:

You Want to Avoid Selling a Security

Why?  Because there’s a lot that goes into selling securities (even privately) and none of these sites appear to be structured for doing that.  The rewards and perks, like free copies of CDs or t-shirts, will not put you in the realm of securities.  However, selling equity and potential future interests in revenue streams might.

  • Is it a Security – First, know whether or not you are even selling a security.  You should understand that the definition of a security is a broad one – see Section 2(a)(1) here.  Broader than most people think.  Every early stage growth company that is raising money by either selling equity or taking on a loan (including convertible debt) is generally selling a security.  Under the Securities Act of 1933, if you sell a security you need to either register that security or fit within an applicable exemption.  Selling ownership in a company or a revenue sharing or royalty financing structure (see this article explaining royalty financing) could be interpreted to be a security, thus requiring compliance with the securities rules – not something you want to screw up in the beginning stages of starting a company.  Consult your lawyer on this type of structure.  Profounder is selling a future interest in a revenue stream but takes the position that since there is no promise of a profit that it is not a “security” (similar to the argument posed by 33 Needs above).  Here’s a message board response by one of the founders of Profounder in which they lay out the legal basis for what they are doing.  Even though Profounder appears to take the position that it is not a security, they nevertheless claim to rely on Rule 504 under Reg D as a transactional exemption to the requirement that securities be registered for sale.  Not sure why they would indicate the securities exemption they rely on if they don’t believe they are selling a security.
  • Have you Found an Exemption – Second, if you are selling a security, you need to find an exemption for that transaction both under federal and state securities rules.  Some exemptions require certain disclosures and have other restrictions built around them.  The crowdfunding sites do not appear to be structured to handle this issue.  For instance, most companies raising angel or venture money rely on Rule 506 under Reg D for their exemption.  Under Rule 506, if you sell to accredited investors only then you can avoid much of the disclosure requirements.  If you sell to non-accredited investors (which is most likely what you would find by crowdfunding), you are limited to 35 and you need to provide certain disclosures which would require a fair amount of coordination and help from a lawyer.  You might decide to rely on Rule 504 as an exemption (which Profounder appears to do), but Rule 504 has its problems.  At first blush it appears useful because it has no limitation on the number of non-accredited investors (although your total dollar raised over the past 12 months is capped at $1,000,000) and it has no disclosure requirements for non-accredited investors.  One issue with Rule 504 is that it can be very difficult to find state securities exemptions (unlike Rule 506 where most states accept the Rule 506 filing along with some filing fees).
  • No General Solicitation or Advertising Permitted – Third, the prohibition on general solicitation or advertising could impact your ability to crowdfund securities.  Rule 502(c) under Reg D prohibits general solicitation or general advertising when relying on Reg D (with some very narrow exceptions).  Best practices require that you treat this restriction with broad interpretation.  Crowdfunding runs a serious risk of violating this restriction.
  • 500 Shareholder Rule – Fourth, Section 12(g) of the Securities Exchange Act of 1934 requires companies with 500 or more equity security holders (along with a few other factors) to register under the Exchange Act.  What’s this mean?  Well, you are now a public company for purposes of reporting under the Exchange Act.  Not exactly where you want to be as a start-up.  Is this likely to happen in most angel and venture rounds?  No, because you never have that many investors.  But with crowdfunding, you could easily end up with 500 or more people – and if you are selling securities, intentionally or by mistake – then you have 500 or more “equity securities holders”.  See here for the letter where a few years back Facebook tried for an exemption from that rule because it had so many employee security holders, only to run into it again with the recent Goldman deal.

You Want to Avoid Giving Non-Accredited Investors Preemptive Rights

Another quick practice tip on selling securities to non-accredited investors.  Avoid giving those investors preemptive rights or, if you must, make sure the provision states that at the time of exercising any preemptive rights those investors are no longer non-accredited but now meet the accredited investor rules.  Preemptive rights generally give equity security holders the right to participate in future financing rounds of the company, with some customary and limited exceptions.  If you successfully structure a financing round with non-accredited investors, regardless of whether or not you use Rule 504 or 506, and you provide the non-accredited investors with preemptive rights then you may have a difficult time structuring a future round of financing.  Why?  Because if the non-accredited investors have a “right” to put money into the round and you cannot structure another Rule 504 round (maybe because you’ve exceeded the dollar cap) and you now need to structure it as a Rule 506 – you’ve just created a situation where you’ll need to make all of the disclosures that Rule 506 requires for non-accredited investors.  Had you not made this mis-step, you could have relied on Rule 506 and sold only to accredited investors and provided only the minimum disclosures required.

Two Birds, One Stone

If you go the crowdfunding route, try and kill two birds with one stone by leveraging the crowdfunding model to create a community of supporters, early adopters or product evangelists.  Even though the average amount raised through crowdfunding may be small, you might still be able to drive some significant PR if your story gets picked up, or if the social networks become well stocked with your new supporters that have contributed money to your business and received some cool rewards.  If you can make crowdfunding double as viral marketing, then there are extra benefits to be reaped.

As always, I welcome your comments and questions.  Thanks.

Chris McDemus is founder of VC Deal Lawyer, a blog devoted to providing insights on start-up and emerging growth companies.  Chris is also founder and owner of MCD Law Partners, LLC, a boutique corporate law firm serving start-ups, early stage and emerging growth and middle market companies.

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13 Responses to “Does Crowdfunding Work for Early Stage Growth Companies?”

  1. Hi Chris,

    Thanks for this thoughtful input. My name is David Lang, I’m the Community Manager at ProFounder.

    Much of the advice and information you provided above is information I provide for all of the businesses using the ProFounder platform. To be clear, we do acknowledge crowdfunding on the ProFounder platform as issuing securities. We provide as much information as we can about the different state and federal regulations surrounding 504 raises. The response from Jessica on Quora referenced a public fundraising option that we no longer support (but was not a security offering.) We’ve since pivoted and are now only supporting the friends and family raises. The entrepreneurs on our site have been really successful, raising between $10k-$60k.

    Everything you mention above is GREAT advice for a business who is considering crowdfunding. I will definitely be referencing this blog post to entrepreneurs interested in crowdfunding.

    Thanks again for your insight!

    David

    02/28/2011 at 5:53 pm
  2. Chris McDemus #

    David – thanks so much for the comment. A few things. One, I am impressed how quickly you picked up on the posting (most likely Google alerts) and commented. You are obviously a good community manager. Two, thanks for the clarification on how Profounder is handling these issues – the more info available the better. Three, thanks for the fundraising range of $10k – $60k. It’s higher than I suspected or could confirm. Very helpful. Four, thanks for any reference you make to my blog. Take care!

    02/28/2011 at 7:14 pm
  3. Thank you for sharing this article, Chris. These are great insights.

    You’re right! One has to be creative as he/she sets up a crowdfunding or fundraising campaign. By doing so, one can easily attract the crowd or the public to donate or invest some funds in the campaign.

    Crowdfunding sites differ in their mission and policies. Here’s another useful information that will help compare and contrast some crowdfunding sites, http://www.crowdsourcing.org/l/505.

    If you want to check out other crowdfunding sites, just visit our site at http://www.crowdsourcing.org.

    03/24/2011 at 10:34 pm
  4. Hi Chris.
    Great article. Hope that it’s ok that I link to it since I think this is one of the few ones out there facing the possibility to offer shares as rewards when crowdfunding. After launching http://www.fundedbyme.com we’ve been asked and discussed the option on allowing shares as a reward. Our take on this is to partner up with key players that can handle the legal while we work hard on coaching early startup and entrepreneurs to focus on their product and see if crowdfunding can work as selling the product on the idea stage and by that building buzz and a fan base. In this way the methods of traditional fundraising through VC might change entirely.

    03/25/2011 at 5:01 am
  5. Thanks for the great read. Just want to jump in and point out http://www.migproject.org, crowdfunding an operational fighter jet launched yesterday and has already caught a decent amount of traction. Hope it isn’t a security.

    03/29/2011 at 2:06 pm
  6. Great post! Tom and I were talking about this the other day, and low and behold you have already recapped this subject!!

    04/21/2011 at 9:46 pm
  7. The internet is the perfect vehicle for crowdfunding, and Scooterr.com is the best websites for uk crowd funding. We have build this not-for-profit crowd-funding platform for the UK small and large donators.

    07/02/2011 at 5:57 am
  8. Crowdfunding allows you to fund your project through an online fundraising platform. Get crowd funding related updated news and blogs. Find the latest Crowd Funding information for business professionals.

    07/02/2011 at 6:20 am
  9. I think this is a great summary of the situation and choices regarding crowdfunding. Thanks for sharing! I think one of the values of this choice is along the lines of your last point. Sometimes an investor will want to see the company go out and raise other money, even if they could fund it themselves, just as a form of validation. Friends and family funding is not a form of validation, except that the person has friends and family. Crowdfunding his own middle-market input into an idea at its very early stages, and can provide at least some source of credibility for a fundable idea.

    07/19/2011 at 9:09 pm
  10. The internet is the perfect vehicle for crowdfunding, and Scooterr.com is the best websites for uk crowd funding. We have build this not-for-profit crowd-funding platform for the UK small and large donators.

    07/26/2011 at 4:13 am
  11. Barry Farmer #

    profounder is closing their site due to legal issues – another great idea stifled by a governement to large to effectivly work!

    04/28/2012 at 7:54 pm

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