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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 networks. If passed by the Senate and signed off by the President, the bill will become a law, giving entrepreneurs new options for raising money for their companies.

Here’s a look at the current and proposed crowdfunding rules, and how this bill could shake things up for startups.

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.

Can startups use crowdfunding now?

Under current laws, startups may not sell stock or other securities through crowdfunding sites or social networks, such as Twitter or Facebook. They may, however, accept donations.

This is because of applicable federal securities laws, which have been in place (in one form or another) since the 1930s. The laws include 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 “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 too costly and onerous. (See “Ask the attorney — securities laws.”)
  • 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 “Finder keepers could be losers, weepers”).

What will the new crowdfunding bill do?

Basically, if this new crowdfunding bill becomes a law, all of the foregoing prohibitions and requirements will be lifted, and a startup will be able to sell securities through crowdfunding sites like Kickstarter, or social networks like Twitter or Facebook, so long as the company (and its intermediary, if applicable) comply with the bill. According to the bill, the company will have to meet 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.
  • 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 key downsides that you need to be aware of before jumping into crowdfunding.

First, startups must understand that minority stockholders have certain significant 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 and drag-along rights. There will also be administrative issues relating to voting and stock transfer issues.

Third, startups will likely have difficulty raising funds from VCs 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 I would assume D&O liability insurance rates will sky-rocket for these companies.

What’s next?

Now we wait for the U.S. Senate, which hopefully will quickly pass a similar bill. The White House supports the House bill, so upon reconciliation, it will be signed into law. Then entrepreneurs will have a new option to consider when raising money for their startup.

Scott Edward Walker is the founder and CEO of Walker Corporate Law Group, PLLC, a law firm specializing in the representation of entrepreneurs.

[Crowd image via Shutterstock]

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