House Passes Crowdfunding Bill: FAQ’s for Entrepreneurs

by Scott Edward Walker on November 9th, 2011

Last week, the U.S. House of Representatives passed a crowdfunding bill that will allow startups to offer and sell securities via crowdfunding sites and social networking sites.

What is Crowdfunding?

As the term suggests, crowdfunding is funding from a crowd of people — that is, many people provide small amounts of money to finance something.  Crowdfunding has its roots in charitable causes (including the advent of microfinancing to provide financial services to poor people), but has progressed to the online funding of creative and other projects via sites like Kickstarter and Rockethub.


May Startups Raise Funds via Crowdfunding?

No, startups are currently prohibited from selling stock or other securities via crowdfunding sites or social networking sites (such as Twitter or Facebook); they may, however, accept donations.  This is because of federal securities laws which have been in place (in one form or another) since the 1930’s, including the following:

  • A prohibition against “general solicitation” – which means that a company may not offer or sell securities unless there is a substantive, pre-existing relationship between the company (or a person acting on its behalf) and the prospective investor (see my post “Can I Raise Money For My Startup Via Twitter?” );
  • Disclosure and state law compliance requirements if the investors are not “accredited investors” — which usually makes the offering of securities too costly and onerous for a startup (see my post “Ask the Attorney – Securities Laws”); and
  • A requirement that any intermediaries (including websites) must be registered with the SEC as a “broker-dealer” in order to legally accept any transaction-based compensation in connection with the sale of securities (see my post, “Ask the Attorney – Beware of Finders”)


What Does the New Crowdfunding Bill Do?

If the crowdfunding bill becomes law, all of the foregoing prohibitions and requirements will be lifted, and a startup will be permitted to sell securities via crowdfunding sites like Kickstarter and/or social networking sites like Twitter or Facebook so long as the company (and its intermediary, if applicable) complies with the bill, including these key provisions:

  • The company may only raise a maximum of $1 million (or $2 million if the company provides potential investors with audited financial statements);
  • Each investor is limited to investing an amount equal to the lesser of (i) $10,000 or (ii) 10% of his or her annual income; and
  • The issuer or the intermediary, if applicable, must take a number of steps to limit the risk to investors, including (i) warning them of the speculative nature of the investment and the limitations on resale, (ii) requiring them to answer questions demonstrating their understanding of the risks, and (iii) providing notice to the SEC of the offering, including certain prescribed information.


Are There Any Downsides to Crowdfunding for Startups?

Yes, there are several significant downsides that startups should be aware of:

  • First, startups must understand that minority stockholders have certain key rights under State law, including voting rights, the right to inspect the company’s books and records, the right to bring a derivative claim on behalf of the company and certain protections against oppression by the controlling stockholders.  Indeed, the more stockholders a startup has, the greater the likelihood that a disgruntled stockholder will cause problems, including filing lawsuits.
  • Second, having hundreds of stockholders is an administrative nightmare and will be time-consuming and costly.  Presumably, each stockholder will be required to execute a subscription agreement and/or stockholders’ agreement to address key issues such as transfer restrictions, rights of first refusal, drag-along rights, etc.  There will also be administrative issues relating to voting and stock transfer issues.
  • Third, startups will likely have difficulty raising funds from VC’s and other sophisticated investors if they have hundreds of unsophisticated stockholders.  Needless to say, few sophisticated investors will want to sit on the Board of Directors of such a company due to the risks of lawsuits relating to director liability, and D&O insurance rates will presumably sky-rocket for these companies.


What’s Next?

The bill now moves to the U.S. Senate, which hopefully will quickly pass a similar bill.  The White House supports the bill, so upon reconciliation, it will be signed into law, whereupon the SEC will be required to promulgate applicable rules within 90 days.

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