The Crowd-Funding Problem

Crowd-funding - raising capital through a large network of individuals each providing a small investment that collectively adds up to a large sum - seems a natural evolution of the start-up financing model. The problem is that it's illegal. FN1

Securities laws generally require the "registration" of the sale of any securities, such as the common or preferred stock offered in seed or Series A financings, requiring technical compliance with a number of registration rules, including, among other things, the disclosure of vast quantities of information to purchasers and the preparation of audited financials. All of this is super expensive. The economics of crowd-funding don't allow it.

Of course, there are a number of exceptions to the registration rules, the most notable being the "private placement" exemption, originally curated under Section 4(2) of the Securities Act and later broadened under Regulation D. Most seed and series financings are conducted pursuant to Section 506 of Reg D, which permits sales of securities to "accredited" (i.e., wealthy) investors without costly disclosure documentation.

The whole idea of crowdfunding of course is that you shouldn't have to own a polo pony and a Porsche to make investments in start-ups, which moves us to Section 504 of Reg D, which does not impose an "accredited" investor requirement.FN2 The big problem here is that Section 504 still prohibits a "general solicitation" or advertisement of the offering to the public at large. 504 requires a pre-existing, substantive relationship between an issuer (or its broker-dealer) and the investor(s), and this is why 504 is relied on almost exclusively for investments from close family and friends (and not say, from half-known acquaintances you're connected to on linkedin).FN3

Accordingly, absent some special story, neither 504 nor any other federal exemption provides safe harbor for the crowd-funding structure. The only legal way (for now) to raise capital through crowd-funding would be to go through the full registration process at both the federal and state levels, which isn't economically tenable.FN4

FN1. This blog post presumes a conventional financing by a corporation and not a creative alternative (such as a revenue sharing plan, giving investors a flat payment or investors being involved in the day to day running of the business). Although be aware that Section 30(b) of the Exchange Act may prohibit transactions which are designed to evade the Exchange Act.

FN2. Note than 504 expresses a federal securities laws exemption. State securities laws impose their own requirements and exemptions. Although state securities laws tend to track federal requirements, in some cases, state laws are more restrictive.

FN3. Relatedly, for any entrepreneur interested in building a crowd-funding platform/web site, there is the broker-dealer problem. Section 15 of the Securities Exchange Act requires that anyone acting as a "broker-dealer" - which is broadly defined under the Securities Exchange Act of 1934 to mean “any person engaged in the business of effecting transactions in securities for the account of others" - must go through its own expensive and lengthy registration process. Whether a crowd-funding platform constitutes a "broker-dealer" is a technical question and the relevance of past precedent (comprised of almost exclusively of SEC no-action letters, etc.) is hardly clear. However, it's probably safe to say that the more any such platform/web site is promoting sales of securities (telling an investor about some company, trying to encourage investment) and the more the incentive the platform/web site has to make such sales happen (receiving a commission), the more the broker-dealer requirement is implicated. 

FN4. If history is any indication so long as there is significant market interest in a particular kind of transaction and no one is being taken advantage of, the SEC will make adjustments to the law to allow a market in such transactions to develop. Being a first mover in such a market involves without question legal risk but it would seem anyone who waits until the SEC makes compliance issues crystal clear will lose out. Such is the dilemma.