Crowdfunding is a business financing tool under which a business obtains a small amount of funding from individual investors, but does so from a large number of investors. The result is a modest total amount of funding. This type of funding can be obtained from friends and family, through appeals using social media, or other alternatives.
Crowdfunding expands the pool of potential investors beyond the traditional group of angel investors and venture capital funds, to individuals with smaller resources. However, these smaller investors are not as sophisticated as larger investors, so there are regulations in place to mitigate the risk of these smaller investors being swindled.
The regulations come from the 2012 JOBS Act. The essential elements of the crowdfunding regulations are:
- The aggregate amount that a company can sell to investors during a 12-month period is $1 million (inflation-adjusted).
- There are strict limits on the amount that can be sold to any single investor.
- A person acting as an intermediary in a crowdfunding sale of securities must register with the SEC as a broker or a funding portal.
- The issuing entity must file a variety of information with the SEC and other parties.
- If there are material misstatements in the company’s representations, a person who purchases its securities can take legal action to recover the amount paid plus interest, minus the amount of any income received on the securities (such as dividends).
- The securities sold cannot be transferred by the seller for a period of one year from the date of purchase, unless the securities are transferred back to the issuer, or to an accredited investor, or as part of a registration with the SEC, or to a family member of the buyer.
These crowdfunding regulations may prove to be of limited use to organizations trying to raise money. These businesses are tightly restricted in terms of the amount of money they can raise, must still provide periodic reports to the SEC and investors, and are liable for any material misstatements made to investors. In addition, if the amount to be raised is greater than $500,000 (inflation-adjusted), an organization must produce audited financial statements; given the cost of an audit, many firms may conclude that the real limitation on fund raising is actually $500,000, rather than $1 million. Given these limitations, companies may instead use more traditional fundraising methods, such as Regulation D stock sales to accredited investors.