What You Need to Know About Crowdfunding
May 27, 2016
Written by Christopher J. Charles
Special Guest Writer Andy G. Anderson
I have a soft spot for freebies – giveaways, handouts, complimentary gifts, whatever you prefer to call them.
Since 2013, I’ve participated in a medley of musical “crowdsourcing” projects, which have netted me quite the bounty, including, but not limited to: pre-release digital downloads, vinyl (which, according to the Journal, will outsell CDs this year), coffee mugs, autographed posters, VIP parties and private shows, and something one artist named “The Musical Kitchen Sink,” a collection that included his entire discography.
And most would say that I’ve been a part of “crowdfunding.” But this isn’t the case. And there is a big difference in the law between what I described as “crowdsourcing” and “crowdfunding.”
While crowdsourcing is about donations in exchange for small tokens or perks, crowdfunding, on the other hand, is all about harnessing the capital of crowds as investment, issuing an equity stake in your company.
Starting a Kickstarter or Indiegogo crowdsourcing fundraiser is a relatively simple endeavor that you can launch over the weekend. Crowdfunding, on the other hand, is a technical project that needs legal acumen. If you aim to raise money through crowdfunding, get good advice from your attorney and avoid the risks of that project, including civil and criminal penalties.
Brief Background on Arizona’s Crowdfunding Law
Generally, accepting investment dollars from strangers is a highly regulated area of law. It is also a complex area, considering that both federal law and state law may apply. And so, companies need to determine whether they have complied with both.
The JOBS Act is the federal law intended to relieve regulatory burden of Dodd Frank and Sarbanes Oxley, two gargantuan regulatory schemes that overburdened small business, pushing them out of the capital markets.
But the federal government has been unable to successfully implement the JOBS Act. And in the meantime, twenty-two states, including Arizona, have tackled the problem themselves. Specifically, Arizona enacted A.R.S. § 44-1844(D), declaring “crowdfunding” to be a transaction exempt from registration with the Arizona Corporation Commission, if transacted under certain parameters. Examples of other exempt transactions under Arizona law include private placements, stock dividends, and statutory or judicially approved reorganizations.
How Much Money Can I Raise under the Arizona Crowdfunding Law?
In simple terms, the issuer can raise up to $1 million every twelve months, without audited financial statements. That amount increases to $2.5 million every twelve months with GAAP audited financial statements. The legal analysis is more complicated, however, as sales to officers, directors or 10% shareholders do not count towards the total. And, generally, multiple offerings made within the same six-month window are integrated, that is, counted as one offering.
This $1 to $2.5 million cap makes crowdfunding unworkable for companies with high capital requirements. But for a single-owner or micro-business, it may be adequate, considering a study done by the Kauffman Foundation in 2009, estimating that the average start-up cost was approximately $30,000. And according to U.S. Census data, more than 40 percent of all small businesses started up for under $5,000. Those “average start-ups” are home-based businesses with low upfront investment.
Considering the relatively small amount that can be raised through Arizona’s crowdfunding law, there is slim margin for error in your cost-benefit analysis.
Practically, companies should raise enough capital to justify the cost of hiring professionals, namely, an accountant and attorney, along with the cost of ongoing legal compliance. Obtaining an audit for a small or midsize private company might cost between $7,000 and $50,000, depending on the audit firm, geographic location and complexity of the business. And the legal fee could be of similar magnitude. And so, crowdfunding will likely be uneconomical for the “average start-up” mentioned above that aims to raise its initial $30,000.
Limitations of the Arizona Crowdfunding Law
The Arizona crowdfunding law is an intrastate exemption. That means that the company and the investors must be located, generally, in Arizona.
To be intrastate, companies issuing the securities must be formed in Arizona. All investors must be Arizona residents. And at least: (a) 80% of the issuer’s revenues must come from business within Arizona, (b) 80% of the issuer’s assets must be located in Arizona, and (c) 80% of the proceeds raised in the offering must be used in Arizona. And the investors can only resell their shares to Arizona residents within the first nine months after the end of the offering.
Additionally, beyond A.R.S. § 44-1844(D), companies must comply with Section 3(a)(11) of the 1933 Act and SEC Rule 147 in connection with intrastate offerings.
Further, each non-accredited investor — someone who has a net worth of less than $1 million (including spouse) and who earned less than $200,000 annually ($300,000 with spouse) in the last two years — may only contribute no more than $10,000. That comes to 100 non-accredited investors, at $10,000 each, to reach the $1,000,000 cap for companies without audited financials and 250 non-accredited investors, at $10,000 each, to reach the $2,500,000 cap for companies with GAAP audited financials.
Anecdotally, there are logistical challenges that have stalled many companies who are interested in crowdfunding. For instance, a web portal and website operator are needed; and the proceeds raised must be deposited into a single escrow account maintained by a bank, credit union or other depository financial institution in Arizona.
Disclosure is the touchstone of securities law, assuring that competent investors have full and timely information for their investment decisions. In short, companies must disclose all material information to the Arizona Corporation Commission and all potential investors. Crowdfunding is no exemption from full disclosure.
All investors must receive a Disclosure Document comprised of specified topics for mandatory disclosure. And investors receive additional protection through anti-fraud requirements under SEC Rule 10b-5 and Arizona’s counterpart.
Also, companies must file certain items with the Arizona Corporation Commission at least ten days before its crowdfunding offering. Importantly, companies must inform the Commission your Target Offering Amount and the Offering Deadline. They must also provide notice of the offering, a disclosure document, and a copy of their escrow agreement.
Moving forward, companies must provide quarterly reports throughout the offering period and while securities are outstanding. Additionally, companies have an ongoing obligation to preserve books and records prescribed by Arizona Corporation Commission for three years.
Arizona crowdfunding is not one-size-fits-all. The legal exemption under A.R.S. § 44-1844(D) is just one of many ways to raise capital, and your business attorney can determine whether crowdfunding is the proper tool for you.
If you or someone you know has questions regarding crowdfunding or any other business or real estate matter, please call or email today.
Christopher J. Charles is the founder and Managing Partner of Provident Law, PLLC. He is a State Bar Certified Real Estate Specialist and a former “Broker Hotline Attorney” for the Arizona Association of REALTORS® (the “AAR”). He is also an Arbitrator and Mediator for the AAR regarding real estate disputes; and he serves on the State Bar of Arizona’s Civil Jury Instructions Committee where he helped draft the Agency Instructions and the Residential Landlord/Tenant Eviction Jury Instructions.
Christopher is a licensed real estate continuing education instructor and he teaches at the Arizona School of Real Estate & Business. He can be reached at email@example.com or at 480-388-3348.