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Equity crowdfunding comes with risks

Posted: August 3, 2012 2:00 a.m.
Updated: August 3, 2012 2:00 a.m.
 

While startups in the U.S. will soon be able to solicit small equity investments in a crowdfunding environment, area legal experts suggest that existing routes may be best for young companies anyway.

Crowdfunding is a relatively new fundraising strategy, where companies used Web-based platforms to raise money by pure donations, donations based on a promise of a reward, or through microfinancing. About $1 billion was raised for businesses and individuals through crowdfunding in 2011, and that amount is projected to double in 2012.

Through the federal Jumpstart Our Business Startups Act, also known as JOBS, startups and small businesses will be allowed to crowdfund another way — by promising equity to the donors, rising up to $1 million annually from these small-dollar investors.

Regulatory specifics are not hammered out yet, but by the end of 2012 companies will be able to solicit up to $1 million in any 12-month period from a large number of investors, who do not have to be accredited. The crowdfunding offerings must be conducted through either a registered broker-dealer or a funding portal that is registered with the U.S. Securities Exchange Commission.

Equity crowdfunding is already utilized in Europe and helps businesses secure larger funding sources from a smaller pool of willing investors, compared to the $10 or $25 donations procured through a general crowdfunding campaign. But Ryan Azlein, an attorney with the Los Angeles-based Stubbs Alderton & Markiles, said he wouldn’t recommend the equity crowdfunding route for most startups because crowdfunding can result in hundreds or thousands of donors, creating a large, unorganized investor pool.

“You’re dealing with a large group of investors,” Azlein told a group of 30 at a crowdfunding presentation hosted by the Small Business Development Center at the College of the Canyons on July 23. “The administrative costs of having all these investors is a potential deterrent later on.”

Unless the company is a hyper-local business or restaurant with a strong following of customers who would want to become an investor, small businesses are better off crowdfunding through general solicitation, where the business essentially asks for donations. Other options include the reward system, where business set up a tiered menu of rewards for the donors (a CD for a $10 donation, a T-shirt for a $25 donation, etc.) and the microfinancing system, where all the donations are considered loans.

Kickstarter and IndieGoGo are two of the most popular crowdfunding platforms and respective success stories include the Pebble watch, which raised $10.2 million within months ,and the Satarii Star smartphone stand, which will start selling in Apple stores thanks to the exposure. But Azlein said there are between 400 and 500 platforms available, with many catering to different types of industries or products. Businesses should find the best platform for their product or service and based on what kind of crowdfunding route they want to take.

Crowdfunding “is creating an entire new market and industry,” Azlein said.

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