9.12.2014 | Crowdfunding: Can it Brighten the Future for Michigan's Small Businesses and Investors?
If you weren't aware that Crowdfunding was an option for your portfolio or business, read on, then call us.
In the closing hours of 2013, Governor Snyder signed the crowdfunding law (House Bill 4996 of 2013), which became effective December 30, 2013. The new law revised the Uniform Securities Act to allow Michigan corporations and limited liability companies to sell an interest in their business enterprise to non-accredited investors without having to register the offering or the interest as a "security." This new law provides a simple, more streamlined procedure to allow Michiganders to invest in the small businesses in their community, as well as allowing entrepreneurs and small businesses to raise capital beyond the traditional methods, which can be costly and, all too often, ultimately unavailable.
What is crowdfunding? Projects or ventures use crowdfunding as a means to raise capital, usually over the internet, by soliciting and raising small amounts of money from a large group of people. Rather than a bank or venture capitalist, which usually apply more leverage to control the terms. Crowdfunding, on the other hand, can allow flexibility in the terms for the enterprise, which can make all the difference to a startups and going concerns alike. Notably, it can substantively shift the preponderance of risk to the investor as the remedies available for nonperformance on the part of the company can be more limited.
Historically, until the recent proliferation of crowdfunding statutes, similar investment offerings were restricted to "accredited investors." Beyond banks, insurance companies and other traditional financial institutions and insiders, the Securities Act of 1933 defines an accredited investor as:
- A natural person who has individual net worth or joint net worth with the person's spouse, that exceeds $1 million at the time of the purchase, excluding the value of the primary residence of such person; or
- A natural person with income exceeding $200,000 in each of the two most recent years or joint income with a spouse exceeding $300,000 for those years and a reasonable expectation of the same income level in the current year.
Accredited investors comprise about 1% of the population. According to Forbes Magazine, only 10.5% of accredited investors have made informal investments over the past three years and 95% of business plans submitted to venture capitalists are summarily rejected. With small businesses comprising more than 99% of all employer firms and 44% of the U.S. private payroll, it is essential that these companies get access to capital to sustain themselves long enough to turn a profit because the country's economic future is dependent upon the success of its small business enterprises.
With access to equal opportunity, these players may experience disproportionate risk exposure, on both sides of the transaction. Arguably, the reason venture may not have funded an entrepreneur may be the exact reason why the company fail. Crowdfunding is a relatively new and exciting means for small businesses to raise capital; however, investors and small businesses need to be certain that they completely understand that there are still a myriad of federal and state requirements imposed on the raising capital through crowdfunding. The Michigan Department of Licensing and Regulatory Affairs (LARA) strongly advises investors, entrepreneurs, and small businesses to seek the advice of an attorney before participating in any crowdfunding activities. Your legal counsel should not only be familiar with the applicable legal issues but also aware of the relevant investment analysis relating to the investment or the fund raising process. The Katz Law firm has attorneys with experience as portfolio managers and investment advisors.
Enterprises seeking to raise capital through crowdfunding need to be cognizant of the requirements for qualifying for the exemption from registration so they do not violate federal and state securities laws. Below are some considerations:
- If the enterprise does not meet the federal intrastate exemption requirements found in section 3(a)(11) of the Securities Act of 1933, then the offering must be registered with the U.S. Securities and Exchange Commission, provided it does not qualifies for another exemption.
- Website operators may be required to register with the SEC as a broker-dealer or a funding portal.
- A Corporation must not offer or sell shares in excess of the amount authorized in the articles of incorporation.
We advise that investors do their own homework before investing in any small business. Crowdfunding does not miraculously make an investment less risky simply because you know the principals or they happen to be from your community. Investors should completely understand the risks being assumed; they could lose all of the funds invested because most startups fail. That's worth repeating: most startups fail.
Investors should ask questions, know about the individuals involved, and verify all of the information they receive. Investors should act as any private equity firm would act in similar circumstances, which means conducting due diligence and understanding the risks, including accounting for the unknown. In short, know exactly what you are getting yourself into. Most investors understand that it is acceptable to assume risk under the proper circumstances, but knowing what the risks are and how they can affect your investment and potential return are essential to success for both the investor and the enterprise; that is, disclosure on the enterprise's part and understanding on the investor's part.
On the Entrepreneur's side, the crowdfunding road is also fraught with risk and the potential for litigation lurks on numerous fronts. While investors need to be vigilant in watching out for the next Ponzi or Madoff scheme, entrepreneurs also need to use extreme caution when raising capital via crowdfunding. Potential issues for the enterprise include 1) the disclosure of proprietary ideas and trade secrets to larger groups of individuals, presumably including competitors, which may be more amply funded to execute the ideas; 2) publishing such proprietary information without the traditional protections or recourse provided in non-disclosure and non-circumvention agreements; and 3) individual law suits or class actions claiming fraud or violations of the a consumer protection act, among other claims from less sophisticated investors. Generally, the financial data provided during a crowdfunding campaign will more often than not be un-audited and include the minimum disclosures.
This certainly does not mean that an entrepreneur or an investor should not seriously consider crowdfunding as an option to commercialize their ideas or grow their investment portfolio; on the contrary, we simply believe that along with improved access to capital and investment securities comes significant risk on both sides of the transaction. On the other hand, remember that the fleecing of those accredited investors by Bernie Madoff happened right under the watchful eye of securities regulators and auditors. As in any business transaction, a healthy dose of skepticism is good for entrepreneurs and investors alike.
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Donald Katz, PLLC
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