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The Basics of Crowdfunding

on Friday, 18 September 2015 in The Closer - M&A, Securities and Corporate Counsel: Kevin P. Tracy, Editor

Author’s note: This article is the first of three addressing the issue of crowdfunding – the next will address pending federal legislation and the final will address the recently adopted crowdfunding exemption in Nebraska.

What is crowdfunding?

Crowdfunding is the pooling of money by the general public in support of a project, organization, or business venture through the Internet. There are two basic types of crowdfunding: nonequity crowdfunding and equity crowdfunding. While nonequity crowdfunding has been used for a host of different activities over the past few years, equity crowdfunding has been nonexistent in the United States largely due to restrictions posed by securities laws. However, equity crowdfunding is becoming more and more available on a state-by-state basis and may be possible at the federal level as soon as 2016 under proposed SEC regulations. This article will introduce the concept of crowdfunding by discussing the most common nonequity models.

Nonequity Crowdfunding.

Nonequity crowdfunding has been used for a wide range of activities, including raising seed capital, inventing and developing intellectual property, promoting scientific research, and funding artistic endeavors such as movies or music albums. Since contributors do not receive securities or any profit-based interest in exchange for their contributions, the industry is largely unregulated by securities laws and has experienced dramatic growth over the past few years. Kickstarter is among the most popular crowdfunding websites and has helped raise over $1.9 billion, funding over 92,000 different projects since its launch in 2009, with contributions by over 9 million people.

There are three basic models for nonequity crowdfunding: donations, rewards, and peer-to-peer lending.

Donation Model

The least regulated platform is a Donation-Based Model, which raises money for non-profit organizations and charities (e.g., Omaha Gives!). The contributions are primarily from related or otherwise interested contributors, but as the more popular causes gather momentum and attention, they attract contributions from across the globe. Because contributors do not receive any property in return for their contribution, this type of crowdfunding is treated as any other charitable donation.

Rewards-Based Model

The Rewards-Based Model is the most common platform for nonequity crowdfunding and is used by the popular websites Kickstarter.com and Indiegogo.com. This model allows contributors to fund a project in exchange for a pre-determined “reward” related to the project. For example, an author seeking funds for a novel may provide a free copy of the book for one contribution level and perhaps an autographed copy at the next contribution level. Since the contributor does not receive an ownership interest or have an expectation of profits, this model also is not subject to SEC regulation.

Peer-to-Peer Lending

Certain peer-to-peer lending activities operate much like crowdfunding. Websites such as Lendingclub.com and Kiva.org provide a platform for borrowers to receive and pool small loans from hundreds (or more) lenders. The loans are typically used for small business ventures. Potential lenders can view basic information regarding the borrower and proposed loan on the website and generally receive interest on their loans. Again, the contributor does not receive any ownership interest. (Note: this article does not address any banking or commercial lending regulations that may be applicable to the structure of peer-to-peer lending activities.)

Equity Crowdfunding

While the nonequity based crowdfunding models previously referenced, are unregulated, equity crowdfunding is subject to state and federal securities laws. The equity crowdfunding platform operates in much the same manner as the models discussed, except that the contributor would receive an ownership interest in the company.

When can we start using the equity crowdfunding exemption?

Not yet at the federal level. Until the SEC adopts the final rules, issuers and intermediaries may not rely on the crowdfunding exemption for interstate offerings. Currently, applicable state law crowdfunding exemptions are the only available route and generally permit only intrastate investments. However, once adopted at the federal level, equity crowdfunding may revitalize the crowdfunding market.

Stay tuned for the next article on the proposed SEC regulations on crowdfunding.

Amber N. Preston

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