Crowdfunding for For-Profit Businesses, Generally
Crowdfunding is a money-raising strategy that emerged in the mid-2000s and continues to grow in popularity. Laws and technologies have shifted since the early 2000s, allowing for more flexibility for small businesses needing to raise funds this way. The riskiest aspect of crowdfunding is unintentionally running afoul of securities laws.
First, let’s establish what crowdfunding is– a fundraising strategy that relies on relatively small amounts of money coming from a large number of investors. The advent of the internet made this strategy viable on a large scale, though farmers have been doing a community-based version of this type of fundraising for a long time. Currently, some companies provide easy internet-based online platforms that streamline the crowdfunding process, Kickstarter likely being the most well-known. Some, like Barnraiser, are specifically geared toward farmers and food entrepreneurs.
But what about the risk of securities law infringement? When a business raises money and promises to repay that money if the business is successful, then the business is technically doing more than “fundraising.” In a legal sense, they are selling a ‘security’ to a buyer. The product is a conditional promise to repay the money invested, dependent on the business’ potential future profits. Selling securities is a highly regulated field that most farmers will want to avoid.
Fundraising with a promise to repay if the business is successful is highly regulated because it creates a lot of opportunities for fraud and deception. Can a funder trust the business person to make good-faith efforts to make the business successful? Is the business model strong? How sophisticated must investors be to adequately assess the quality of the business model?
These questions are difficult to answer, so the government (both on the federal and state levels) steps in to regulate the sale of securities or investment activity. The two central ways securities are regulated are by requiring (1) that people who invest capital in businesses be what are called accredited investors, essentially high net-worth folks who are assumed to be investment-savvy, and (2) that businesses who solicit funds for their business be registered with government agencies (and comply with copious paperwork).
These laws make it nearly impossible for small businesses to participate in the investor market. Registration with the appropriate governmental agencies is not only cost-prohibitive for small businesses but also nearly administratively impossible. There is too much paperwork, and professionals are required to comply with a maze of rules precisely. And on top of that, local businesses like farms aren’t likely to attract high-net-worth individuals who are experienced in the investment field and meet the ‘accredited investor’ standard.
Rewards-Based and Pre-Purchase Crowdfunding
The risk of security law infringement left the only option early in the internet’s days to be either rewards-based or pre-purchase crowdfunding. These are fundraising techniques where money is raised for a product that will be delivered later in time. There is a delay between payment and delivery of the product. However, funders aren’t buying a stake in the business or a potential return on their investment if the business is managed well. Instead, in this model, the funders are buying an actual product, albeit on a delayed schedule.
In pre-purchase crowdfunding, the funder eventually receives the product they are helping to get off the ground. For example, a farmer could raise money to start a line of value-added products. In exchange for $10 on a crowdfunding platform, each funder receives one of the first produced jars of jam once the operation has been funded, built, and is in operation. Community Supported Agriculture is a classic pre-purchase crowdfunding strategy familiar to farmers. Alternatively, in rewards-based crowdfunding, the funders receive an experience related to the overall project. This could be, for example, a farm tour or a chef-made dinner on the farm.
These two crowdfunding types will rarely fall into the securities arena and are, therefore, less legally risky. However, that doesn’t mean these strategies are without risk. Be sure to consult the section below on income tax, as any income raised in this manner will impact your business income and, therefore, your tax liability for the year. If you are fundraising in this way, you should strongly consider creating a business structure that provides limited liability protection–protecting your personal assets from any business debts.
Any farm fundraising with these strategies must carefully manage their funders’ expectations. Even if the crowdfunding campaign goes perfectly from the perspective of the business owner, you still have relationships with every person who gave money upfront. Is the product they eventually receive what they expected? Were you clear in your communications about expected deadlines, any delays, and the nature of the final product they were to receive? Be aware, too, that there are governmental agencies that regulate advertising and advocate for consumers. Overpromising or misleading funders can lead to action by these agencies against your business.
Of course, failure of the project could also lead to legal trouble. Most online platforms that support this type of fundraising require that if the monetary goals aren’t met, any money that was raised must be returned. Furthermore, they require that if you cannot provide the product or reward you promised, you must return the money you raised. In some cases, failure occurs after the money has been spent, and the business must then still repay the funds. Without clear recordkeeping and a reserve of funds, businesses can face lawsuits and high debt levels.
Rewards-based or pre-purchase crowdfunding should also clearly distinguish itself from what we will talk about next: equity-based crowdfunding. When soliciting funders for rewards-based or pre-purchase campaigns, businesses should be careful not to describe the contributions as “investments” or funders as “investors.” Funders should be told clearly that they will not be receiving a stake or equity in the business in exchange for their contribution.
Selling Equity in Your Business
Typically, whenever you sell a portion of the business to a person who will not be involved in the operations and decision-making process of that business, you are selling a security and have to deal with the onerous federal regulations that come with that territory. Therefore, selling people a percentage, share, or stake in your company in exchange for a share of the profits down the road is selling a security. Selling stocks of a corporation is, by definition, selling a security. There are a few exemptions, and both state and federal law must be consulted.
LLC Active Memberships – Are These Securities?
Federally, and in most states, the sale of an active LLC membership in a member-managed LLC will not be a security. This is when a member “buys in” to the company. If that member becomes an active member of the company with voting rights, then that transaction isn’t considered a security. In the context of a farm, members can contribute funds and have voting power without triggering securities law, even if they don’t do the physical labor on the farm. However, a person who invests in the business expecting an eventual return but who has no power to steer the company is the type of person securities laws were designed to protect. In this way, active members can make investments in the company and enjoy those returns later, but ‘silent’ partners are those that trigger greater regulations. Be sure to check your state laws on this, as the exemptions can change from state to state.
Equity Crowdfunding
In 2016, federal rules were released that opened up options for small businesses to participate in the investor market. What is known as the CROWDFUND Act opened up an avenue for investors who aren’t accredited to be able to help fund ‘emerging businesses’ and for businesses that aren’t registered to solicit investors. Of course, though, there are a lot of limitations and caveats to what is now possible.
First and foremost, businesses cannot go directly to the public. Equity-based fundraising campaigns must be run through an intermediary registered with the appropriate state and federal agencies. These intermediaries could be the type created by the CROWDFUND Act, the funding portal. Or, the intermediary could be a traditional broker-dealer. Funding portals are more accessible but are also more limited in what they can do. Broker-dealers are more heavily regulated and can, therefore, participate in more of the investment process than funding portals can. For example, broker-dealers can offer investment advice and recommendations, whereas funding portals cannot.
Under the CROWDFUND Act, the business itself doesn’t have to register with federal agencies, but the intermediaries do. All funding portals are also required to be a member of the Financial Industry Regulatory Authority (FINRA), which is helpful because they maintain a list of all registered funding portals here.
There are other restrictions to equity-based crowdfunding other than having to work with an intermediary. These solicitations must be conducted online. Campaigns cannot go on longer than 12 months and cannot raise more than $5 million. Furthermore, investors are limited on how much they can individually contribute based on their income or net worth. Businesses must still provide a fair amount of information to the intermediary with whom they are working, though businesses that gross less than $500,000 do not have to provide audited financial statements.
The CROWDFUND Act created optimism that small and local businesses would be able to raise funds in exchange for business equity and have access to investors. However, the changes are less than a decade old, which isn’t much time in the legal world. Generally, equity-based crowdfunding is still considered overly restrictive and expensive for small companies. However, the rise of funding portals as an option did help create several investment companies with environmental and even agricultural concerns front and center. NetGreen is one example of a farming-specific funding portal. With time, these services may become more accessible, consistent, and viable for small, local food-based businesses.