What is Crowdfunding?
In April of 2012, President Obama signed The Jumpstart Our Business Startups Act (JOBS) of 2012. Title III of the JOBS Act provided a registration exemption for limited-size offerings to be sold in small amounts to a large number of investors possible through the Internet.
Crowdfunding, in its simplest definition, is bringing together a large number of investors to financially support businesses or projects. In lieu of traditional forms of financing such as venture capitalist, bond markets, stocks markets or bank loans, crowdfunding allows business to raise capital inexpensively and easily from hundreds or even thousands of average Americans who can invest or donate as little as $1. The funding can be considered a loan, a donation or an equity investment in the company. While this practice previously existed, the return to investors was generally in the form of a goods or services.
How much can I invest?
Crowdfunding donations or investments can be as little as $1, but there are limits imposed. An investor with annual income or net worth below $100,000 can only contribute a maximum of $2,000 or 5% of the investor’s annual income or net worth. For an investor with annual income or net worth above $100,000, the aggregate annual investment in crowdfunded securities is capped at 10% of the investor’s annual income or net worth.
What are the benefits to small businesses?
With traditional financing from banks and/or securities markets, small businesses have to file lengthy forms and provide extensive financial documentation. The forms may require businesses to retain legal and specialized investment adviser help, none of which comes cheap. Of greater concern is that non-compliance with regulation leaves start-ups vulnerable to a huge penalty by stopping them from fundraising for one year– a death sentence for any fledgling enterprise.
What is limitations on Crowdfunding raising?
A number of limitations on crowdfunding are included in the law, including:
- Small businesses must have revenues of less than $5M and are not foreign corps, public or investment companies;
- Small businesses are not permitted to sell up to $1 million of securities in any rolling 12-month period, provided the issuer has met certain such requirements as initial and periodic disclosures to the SEC; and
- Each investor may not purchase in excess of $2,000 or a percentage of such investor’s annual income or net worth, up to a maximum of $100,000.
When will it be available?
After a long wait, the SEC issued preliminary regulations on October 23, 2013. Comments were due by February 3, 2014.
To be fair, the SEC can be pardoned for the length of time it took to issue preliminary regulations. Preventing securities fraud is most likely the major concern why the SEC is holdup rulemaking on crowdfunding. The SEC must balance investor protection against the costs of disclosure. To address these concerns, a private insurance model could spread the costs of fraud in crowdfunding across the issuers by using the market to determine the “present value of shareholder litigation risk” for that issuer.
What are the states doing in the meantime?
They have been busy! As of today, 12 states have already enabled intrastate investment crowdfunding, and 11 more states have started the process. Most have followed the lead of H680, which was the first intrastate crowdfunding legislation to be proposed and passed by any state house last year. This is now a nationwide trend, and North Carolina is in danger of missing the boat on this great opportunity.
Intrastate Crowdfunding Exemptions Enabled as of July 2014:
Intrastate Crowdfunding Exemptions in Process as of July 2014:
- North Carolina
- New Jersey
- South Carolina
These initiatives allow businesses in their state to raise up to $1 million, sometimes more, from non-accredited investors, so long as the investors are state residents. We recommend CF Abstracts for state updates and other helpful news updates.
What are the risks?
First off, where there is money to be made, like any investment, there is a possibility of a partial or total loss. Beyond this, some observers are concerned that the ease in raising capital in a Crowdfunding offering may also increase the risk of fraud. Other concerns include:
- Does the business have experience in the field?
- Are the managers experienced in running a business?
- Do the managers have skin in the game?
- Does the business have a prototype?
- Is there an endorsement from a prominent organization or individual?
- Will the business raise enough money to fund the project and what happens to the money raised if it never gets off the ground?
These are the typical factors that increase the chance a company being successful.
Is there crowdfunding insurance?
With respects to crowdfunding portals, the preliminary SEC rules calls for portals to purchase a fidelity bond of at least $100,000. The logic, according to the SEC is that a “fidelity bond .. aims to protect its holder against certain types of losses, including but not limited to those caused by malfeasance of the holder’s officers and employees, and the effect of such losses on the holder’s capital”. Unfortunately, the SEC misses the point. A fidelity bond covers the corporate policyholder from first party losses arising from the theft of money, securities or other tangible property so if the portal’s employees steal the money belonging to the crowdfunding company, the bond can be useful. However, if there is a claim against the portal for negligence in providing its services as a portal, the bond is useless. Thus portals should purchase professional liability insurance in addition to the bond. And, as with all companies, should investigate employment practices liability insurance if the portal has employees, D&O insurance, and if it has physical assets, standard GL and property.
The more interesting issue comes up with respect to the insurance for the crowdfunding companies and their investors. Such a discussion always results in a discussion of Directors and Ofifcers Liabiity (D&O) insurance. Current D&O policies designed for privately held companies were not designed with crowdfunding offerings in mind and it is unclear how those current policies, or the underwriters behind them, will handle claims alleging negligence or fraud on the part of companies or their management in crowdfunding offerings. There is some work currently being done to customize D&O policies for the crowdfunding exposure and even some development work on new crowdfunding policies or bonds. In 2016, AIG briefly announced a fidelity type crowdfunding insurance product. It is unclear whether AIG has removed the product from the market since that time.
Innovation Insurance Group, LLC
Innovation Insurance Group can assist crowdfunding portals, investors and companies in evaluating their insurance options and developing customized solutions for the risks of crowdfunding.