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Posted at 07:00 AM ET, 07/09/2013

Small business advice: Costs to consider before jumping into crowdfunding

The Internet has streamlined nearly everything in its path over the past several decades. A noteworthy exception has been capital formation for startups due to securities laws, which have prohibited general solicitation and advertisements for unregistered securities.


Using new equity-based crowdfunding portals may require some additional accounting and bookkeeping resources. (Scott Eells - BLOOMBERG)
That is about to change thanks to the Jumpstart Our Business Startups (JOBS) Act, a monumental piece of legislation that clears the way for offerings of unregistered securities on Web sites operated by approved broker-dealers, or “crowdfunding” portals.

By leveraging the power of the Web, entrepreneurs will be able to reach a larger population of investors. The goal is to make raising capital much simpler; however, some new transaction and compliance costs are inevitable. An understanding of these expenses is necessary to properly plan for a forray into crowdfunding.

Before the offering

It’s important to remember that equity- or debt-based crowdfunding is a manner of conducting an offering of securities, so many of the same measures that should be taken prior to a conventional private placement should be taken prior to conducting a crowdfunded offering — many of which carry costs.

Related: How to make an attractive crowdfunding pitch

Deal documents and disclosures, for instance, should be prepared in advance. There are exciting, disruptive technologies coming to market that will make generation of key documentation easier and less expensive, but an entrepreneur should still budget to at least have legal documents and disclosures checked over by an attorney.

Similarly, entrepreneurs should expect to incur some accounting expenses, particularly if conducting a Title III crowdfunding transaction. A Title III transaction will be one in which both accredited and non-accredited investors can participate.

Title III of the JOBS Act created unique financial disclosure requirements for issuers, requiring compiled financial statements if, in a 12-month period, an issuer raises $100,000 or less, reviewed financial statements if the raise is between $100,000 and $500,000, and audited financial statements if more than $500,000.

During the offering

The most obvious cost associated with crowdfunding is the cost paid to the funding portal (i.e., the broker-dealer) to host the offering. These fees are projected to range between 4-8 percent. Importantly, some portals may assess these fees on funds raised even if an offering is unsuccessful overall (i.e. does not become fully funded).

Issuers should properly research and vet out the numerous equity crowdfunding portals coming to market to evaluate the fee structures and determine which have the best features and investor networks for accomplishing a successful raise with optimal terms.

In addition, crowdfunding portals are likely to incur some expenses in performing due diligence and compliance services that may be borne by the issuer. Issuers may be subject to rescission liability (i.e. having to refund an investor’s investment) in the event a transaction is not properly conducted. Accordingly, some issuers may want, and some portals may ultimately require, that the accredited status of investors for some transactions be verified, which will add some cost.

Other potential compliance costs may be associated with anti-fraud and anti-money laundering procedures that FINRA applies to broker-dealers that foreseeably will be imported into the crowdfunding system.

Without the final SEC and FINRA rules (currently behind schedule, but expected as early as the end of this year), it is not presently possible to fully estimate the scope or significance of these expenses, or whether intermediaries will just bake them into the price of the services.

Nevertheless, entrepreneurs should be prepared to vet out the compliance features of a portal and should analyze the terms and conditions closely to understand whether any such expenses are included or in addition to the portal’s original fee.

Because the crowdfunding process happens in real-time, unlike with current private placements, where money is typically transferred at closing, third-party payments vendors may be used by portals to manage the flow of funds. There are numerous electronic payments vendors in the marketplace. Issuers should clearly establish whether any services associated with payments, or refunds in the event a subscription is cancelled or unsuccessful, are solely their liability.

Perhaps most importantly, non-accredited investors may not invest more than is allowed by the JOBS Act in a 12-month period. This cap is based on income or net worth, with an onus on crowdfunding portals to ensure the measure is upheld in each transaction.

This level of consumer and marketplace protection is not without precedent, but it poses a serious challenge for portals.

After the offering

Entrepreneurs should budget to incur some legal and accounting expenses to manage their new life running a company with outside investors. If an issuer has raised capital through a Title III offering, issuers must annually disclose reports of operations and financial statements to investors, which will likely necessitate recurring bookkeeping or accounting expenses for a company.

In sum, crowdfunding will initially have costs that are in some ways unique, but in many ways similar to conventional financing methods. This does not diminish the power of crowdfunding to make capital raises more efficient and expeditious by broadening the available investor pool.

Over time, competition will lead intermediaries and compliance vendors to innovate and find ways to make raising capital more frictionless and inexpensive for customers.

Bob Carbone is the CEO of compliance control provider CrowdBouncer and a board member of the CrowdFund Intermediary Regulatory Advocates.

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By Bob Carbone  |  07:00 AM ET, 07/09/2013

Tags:  small business, startups, crowdfunding, jobs act, business

 
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