In 1997, fans of the British rock group Marillion began an internet campaign to raise funds to finance a U.S. tour. The campaign, which was not organized by the band, raised $60,000. The band picked up on this idea and in 2001, funded the production and distribution of its album Anoraknophobia by preorders from its fans without the involvement of any record label. Marillion was a pioneer in what we now call Crowdfunding. The 2001 album effort inspired authors, musicians, and movie producers to appeal directly to the public for funds to help complete their creative efforts. Shortly thereafter, entrepreneurs of all stripes began soliciting funds to help fund product development. Starting about 2005, the industry exploded and specialty crowdfunding websites began to emerge. Sellaband—a website that specialized in the music industry—started in 2006, followed by “generalist” websites such as Indiegogo (2008) and Kickstarter (2009). These websites vetted entrepreneurs in an attempt to gain credibility with potential “investors.” Typical is the Hillsborough Bike Shop which has raised $3,660 on Indiegogo and offers products to its subscribers ranging from a bike shop decal for a $10 gift to a complete bike overhaul for a contribution of $250. About 6 months ago, my daughter made a $50 contribution to a start-up company that was developing a self-cleaning litter box. Her only expectation was to receive a litter box once production started (no luck so far).
As suggested by the Marillion event mentioned above, crowdfunding is not an exclusively American phenomenon. “The Crowdfunding Centre,” a UK based nonprofit, estimates that worldwide crowdfunding activities raised $89 million in 2010, $1.47 billion in 2011, and $2.66 billion in 2012, of which $1.6 billion of the 2012 total was raised in North America (Canada is very active as well as the U.S.). Although we do not have more recent industry statistics, it is believed that these figures have been greatly exceeded in recent years.
Crowfunding has become big business. For example, the highest reported crowdfunded project to date is the $111.6 million raised by Star Citizen, an online science fiction game, which boasts on its website that it is 100% crowdfunded. The Glowforge 3D laser printer raised $27,907,995 in 30 days, which according to its website is the biggest 30-day crowdfunding campaign in history. You can “pre-order” a Glowforge printer for $4,795. Its website states
“We’ll process your payment immediately. You are pre-ordering a product that has not yet been manufactured. We’ve tried to accurately describe it, but we may make changes before it’s delivered. If that happens, we’ll let you know. You can get a complete refund, including shipping, at any time until the product is shipped [sic].”
The business model here is similar to that used by the Marillion rock group—folks who want to get an early copy of Star Citizen or a Glowforge printer are funding development by “preordering” a product that doesn’t exist yet.
The IRS has not issued any formal advice on the tax consequences of crowdfunding, but according to an article in the Journal of Accountancy (October 1, 2015), it is clear that the funds raised by the Hillsborough Bike Shop, Star Citizen and Glowforge in the examples above would be taxable income to the recipient.
Almost from the beginning, entrepreneurs have tried to raise equity—i.e., an ownership interest such as stock—for start-up ventures via crowdfunding. This has been problematic because in the U.S. and all developed countries, the issuance of securities is highly regulated. The U.S. Securities and Exchange Commission, acting under various laws, has promulgated regulations governing who can issue, who can sell or “broker,” and who can purchase securities. All securities issued in the U.S. must be registered with the SEC unless they meet certain exceptions. So called non-registered “private offerings” can only be sold to a limited number of “accredited investors” who meet certain income and net worth requirements. These laws and regulations are fatal to anyone trying to raise equity via crowdfunding.
On April 5, 2012, the President signed the Jumpstart Our Business Startups Act (JOBS) which was designed to facilitate equity crowdfunding. On October 30, 2015, the Securities and Exchange Commission issued regulations as required under the JOBS Act and these regulations became effective May 16, 2016.
The JOBS Act and SEC regulations means that equity crowdfunding is possible for the first time beginning May 16, 2016. Some people expect that this will be a revolution in financing small business which can raise up to $1 million. Companies are not permitted to crowdfund directly—all solicitations must go through either a traditional broker-dealer or a “Funding Portal” which is a website that has registered with the SEC. Registering a portal will be less complicated and less expensive than registering a broker-dealer, but as one lawyer put it, the process is “less than intuitive.” A portal can expect to cost at least $3,200 in registration fees and will need the services of a lawyer to navigate the registration process. Some established websites such as Kickstarter have announced that they will not go into the equity business, while others such as Indiegogo and RocketHub will.
Companies raising money through crowdfunding will also incur significant costs. Companies seeking to raise between $100,000–$500,000 must have financial statements “Reviewed” annually by a CPA. Those seeking $500,000–$1 million must have an annual “Audit” of their financial statements. The SEC estimates that a financial statement review will cost almost $15,000 and an audit in the range of $28,000. These fees will vary considerably and will be lower in non-urban markets, but they still represent a significant annual expense for a small business. Daryl Bryant, who co-chairs the portal committee of the trade group CFIRA (Crowdfund Intermediary Regulatory Advocates), estimates that most portals will charge fees of 7%–12% of the amount raised. On top of that, payment-processing services will charge an additional fee as high as 3%–5%, although some portals are planning to use bank electronic transfer payments which are much cheaper. RocketHub has said that it will require all issuers to be C corporations and to use the same simplified format in an effort to keep commissions down to 4%–5%. Issuers will also need to file a one-time form with the SEC that will probably entail preparation costs of $1,500–$5,000. Douglas Ellenoff, a securities lawyer who has been advising the industry during the regulatory process, believes that technological advances will allow portals to reduce fees over time.
So what types of businesses are likely to go the equity crowdfunding route? Ellen Grady, a corporate securities attorney, thinks it will be “companies with a community following.” Bryan Burt, also a corporate attorney, thinks “The first companies to raise capital will likely be those who offer a compelling story. Every company will highlight their potential return on investment. But those who take the time to tell their story are much more likely to catch an investor’s eye.” Catherine Clifford of the Entrepreneur website thinks it will mostly be companies that can tell a compelling story and have a loyal base of customer fans. Equity crowdfunding might turn out to be not much different from those original crowdfunders—the British rock group Marillion—who were able to raise money from their loyal fans.
Published in Business2Business magazine, June 2016