What if you could have bought shares in Facebook when it was just a startup? Despite the iffy performance of the company’s first day of trading Friday, an early investment could have made you millions.
Of course, to have that opportunity you would need to have been connected to Mark Zuckerberg’s inner circle at the time. With new laws in the United States related to crowdfunding, the inner circle of the next Facebook may just be a click away.
“Crowdfunding” is the practice of funding a venture by raising numerous small amounts of money from a large group of investors, typically through the use of the internet. It started with a ripple in the form of websites supporting the arts and, in a world dominated by social media, is quickly becoming a wave in other industries, particularly for start-up technology companies. Crowdfunding opens up a whole new way for individual investors to participate in the early stages of potentially great companies, but investors need to know and understand the risks involved before strapping on their surf boards and catching this wave.
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Until recently, crowdfunding has not had much appeal for serious investors. In many ways, putting money into such a fund has had more in common with charity than with traditional investment. For example, on the website KickStarter.com, investors are referred to as “backers”. Backers receive remuneration in the form of goods and/or services as they reach certain investment benchmarks for a given project. In other words, due to restrictions in current securities laws, both in Canada and the United States, investors do not receive equity (i.e. shares) in return for their investment.
But, at least in the United States, all of this is about to change. On April 5, the Jumpstart Our Business Startups Act (JOBS Act) was signed into law. Under a portion of the JOBS Act, investors in U.S. crowdfunds will have the opportunity to receive equity in return for their investment. It is still unclear what legal form the crowdfund securities exemption will take, as the Securities and Exchange Commission has 270 days from the passing of the law to put it into effect.
Although the passage of this new law makes crowdfunding a lot more appealing to serious investors, it also creates some new risks:
1. There will be an increase in the number of crowdfunding scams. Scam artists will almost inevitably use the promise of equity, combined with lowered disclosure obligations, to lure new victims into fraudulent schemes. Much of the onus for early screening will fall to the crowdfunding websites, which will need to develop or adapt standards to further protect investors.
2. It will be difficult for crowdfund investors to determine the quality of a company. Even if the venture is not a scam, it still may be poorly run. Information about companies on crowdfunding websites is more limited than the information available about publicly traded companies. Proactive due diligence will be key for smart investors.
3. Shares in crowdfunded companies will not be easily transferable. As with other private companies, there will almost certainly be restrictions on the transfer of shares by investors. In the U.S. and Canada, this is a requirement of securities regulations for private companies.
4. Investors must still be careful to distinguish between equity crowdfunding and traditional crowdfunding websites. Remember, only crowdfunding websites in the U.S. will (until securities laws in Canada change) be able to offer equity stakes to investors. Even then, it is unlikely that all of the crowdfunding websites in the U.S. will change-over to, or include, an equity-based model. The result will be two forms of crowdfunding existing in parallel, which could be confusing for investors.
As investors rush to find the next Facebook, crowdfunding will have a profound effect on U.S. start-ups. However, as with any type of investment, it is essential that investors understand the playing field, and do their homework on the ventures being funded, to minimize their risk of losses.
Timothy W. Murphy, LL.M, is the principal of Murphy & Company, a business law practice based in Vancouver, Canada, that delivers comprehensive legal advice in the technology and finance sectors. Mr. Murphy articled with a leading national law firm, has international experience with Freshfields Bruckhaus Deringer LLP in Paris, France, and, until September 2010, acted as in-house legal counsel for a multinational software company. Mr. Murphy holds a master’s degree in law from McGill University.