Crowdfunding and Social Entrepreneurs

August 16, 2012 at 12:05 pm 4 comments

Tichelle Sorensen is an attorney at Swider Medeiros Haver, where she advises business in the areas of intellectual property, marketing and employment law.

One of the challenges for any small business, including the social enterprise, is the ability to raise sufficient capital to fund business operations. Even where funding is available from willing friends, family, or fans of the business, the complication and expense of complying with state and federal securities regulations can be a barrier. Those regulations were implemented largely to protect potential investors and the public from fraud and other harmful business practices. However, the practical effect is that understanding and complying with the regulations in order to raise money – even where you have an identified investment source – can be complex and expensive.

Some entrepreneurs are able to build effective campaigns on sites such as Kickstarter and IndieGoGo. Platforms such as these have provided an avenue for project-based funding for innovative and creative individuals and entities. But those sites are only useful to certain categories of entrepreneurs who have the type of offerings that can fit that project funding model, such as films or tangible products that can be returned to the participant in exchange for the “investment.” Those who support such projects are not “investors” in the traditional sense; while they may be investing in a certain project or undertaking, they do so with the understanding that they will not share in the risk and reward of the company’s overall operations as an investor would. Although their participation may help propel the business operation, the only return that is expected is whatever tangible item or intangible experience that is offered in connection with that project.

An investor, by contrast, is interested in the opportunity to participate in the success of a business in an ownership role. In the securities sense, an investor has the expectation of a profit or potential profit. The evidentiary instrument of this expectation may be a debt instrument, such as a promissory note, or an equity instrument, such as a stock certificate. Along with this expectation, they also share in the risks. If the company fails, the investment is often lost. One of the barriers to the ability of a social entrepreneur to raise capital is the transactional costs of complying with state and federal securities regulations. But another is the ability to connect with like-minded investors who understand and support the social mission and are willing to invest in a company that prioritizes social mission (in some cases, over increasing profits in a way that contradicts that mission).

For those social entrepreneurs that are seeking investors to participate in their company, the Jumpstart Our Business Startups (“JOBS”) Act may open the door to opportunities for true crowdfunding, meaning the ability to raise capital by offering ownership interest in the venture through crowdfunding portals. This could help simplify the process, as well as allow for a greater ability to promote the project to potential investors.

The following is a brief overview of some notable provisions of the JOBS Act that may be of interest to social entrepreneurs. First, the JOBS Act amends Rule 506 of Regulation D. The practical effect of this change would allow more widespread advertising or general solicitation for investment, but only where all purchasers are “accredited investors.” An accredited investor is a category of sophisticated purchasers that includes company officers and directors, banks, certain charities and trusts, and high net worth individuals. (For more information on accredited investors, please visit the SEC website at http://www.sec.gov/answers/accred.htm.) So, for a social enterprise that is seeking investment specifically from accredited investors, this could allow for broader media and advertising campaigns which could also help the enterprise communicate its mission and build its brand at the same time it is seeking investment.

The more compelling piece of the Act, however, is the provision that would allow for “crowdfunding.” This would allow entrepreneurs to seek funding through online portals, where they could connect with potential investors who could enter into equity purchase transactions. The portal operator would be responsible for ensuring that investors have an appropriate understanding of the risks of investing, and that the investor has not exceeded the law’s limits on individual investment (which are based on the investor’s income).

For now, we can only guess how the provisions of the new law will be implemented in practice. The SEC requested additional time to implement the changes to Rule 506, and it has several more months before the draft rules related to crowdfunding are expected.

However, despite the potential benefits of the new law, the JOBS Act will not eliminate the transactional costs for the entrepreneur. Companies using crowdfunding portals would still need to provide financial analysis and disclosures, and comply with ongoing reporting requirements. Additionally, closely held companies who have never worked with outside investors may need additional assistance understanding and complying with proper governance and recordkeeping procedures. For social entrepreneurs, this would also mean the need to better understand how to protect the social mission of the organization, perhaps by taking advantage of newer forms of entity available in some states, such as benefit corporations.

As always, before taking steps to offer or sell securities to any third party, all entrepreneurs (including social entrepreneurs) should seek advice from competent legal and financial counsel. This article is not intended as legal advice, and may not be relied on as such.

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4 Comments Add your own

  • 1. Ahmed  |  August 16, 2012 at 7:00 pm

    Great Article Tichelle

    Reply
  • 2. Lumos For Business (@LumosBusiness)  |  October 17, 2012 at 3:11 pm

    Great overview of the different types of crowdfunding and their application for social entrepreneurs!

    In relation to the JOBS Act, how significant do you think the transactional costs for the reporting requirements will be?

    Will those regulatory requirements and transactional costs be too high and prevent, a student for example, from raising $20,000 for a new social business through a crowdfunding portal?

    Reply
    • 3. Impact Entrepreneurs at Portland State University  |  October 18, 2012 at 1:13 pm

      I’m afraid we don’t know what the requirements and costs involved will be until the SEC and FINRA write the final regulations. Here’s hoping they make it simple and inexpensive enough to open up equity crowdfunding for all kinds of entrepreneurs!

      Reply
  • [...] can’t sell shares of your business through crowdfunding sites (yet), so the first option is more or less unavailable. It’s possible you’re selling [...]

    Reply

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