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Jim Davis |
Published: Monday, April 23, 2012, 8:47 a.m.

Crowdfunding 101 for small businesses

Finding investors is probably the biggest challenge that business startups and small companies face. But small businesses are looking forward to a new way of attracting investors now that President Barack Obama has signed a law known as the JOBS Act.

The law, Jumpstart Our Business Startups, eases the requirements that small companies must meet to raise money. One of the most intriguing parts of the law for many businesses is crowdfunding. The new rules make it legal for companies to solicit money from millions of investors without having to go through the lengthy process of filing registration documents with the Securities and Exchange Commission. The law dramatically streamlines the paperwork that companies must complete. Obama signed the bill into law last week.

"It will make it easier for small businesses to attract investors, to gain access to capital, to become the next big thing," said Tom Quaadman, a vice president of the U.S. Chamber of Commerce.

Small businesses probably won't be able to start seeking investors until at least the end of this year, said David Scileppi, an attorney with the Gunster Law Firm in Fort Lauderdale, Fla., which specializes in business law. That's because the SEC must put together rules to govern how crowdfunding will work within nine months of its becoming law.

What is crowdfunding?

Crowdfunding is a method of raising money from a large number of people and it's generally done online. Charities have been using it for years -- the Internet and social networking sites such as Facebook have made it possible for them to reach millions of donors. Companies in India have also used crowdfunding to raise money.

Using crowdfunding to find investors has been illegal in the U.S. because of laws that were designed to protect the public from scams or bad investments.

There are crowdfunding websites in the U.S., but they tend to be fundraisers for individual products or inventions or projects like plays and art exhibits. And people who give money toward these projects aren't investors. As one site,, puts it, "the money contributed is not a loan or investment -- they are goodwill contributions." Typically, people who give money get something in return such as T-shirts or samples of the products that a budding company is trying to sell.

Profounder, a website that did aim to bring together entrepreneurs and investors, shut down earlier this year before the JOBS Act was passed. It cited "the current regulatory environment."

Crowdfunding under the JOBS Act

The JOBS Act allows companies to raise up to $1 million a year from individual investors. It aims to protect investors by limiting how much they can kick in. For example, people who have an annual income or net worth under $100,000 can invest no more than $2,000 in a company that's using crowdfunding.

Under the law, investors and companies will be brought together by a middleman, either a broker or an Internet website. The brokers and websites will have to register with the SEC. Companies seeking funding will need to provide financial records, business plans and other information that will help potential investors decide whether they want to take chance on a particular company.

Some small business lending experts expect that financial companies, such as banks, will act as brokers. While many are reluctant to lend to startups, they may be interested in making money from matching companies with investors.

The law is specific about the need to protect investors. Lawmakers were well aware that people who have never before invested in a startup will want to try their luck under crowdfunding. So brokers and websites will be required to ensure that investors understand that they're risking the loss of their entire investment should a startup or small business fail.

The drawbacks

Getting investors means companies will have to take on new responsibilities that may be time-consuming. Shareholders may have questions, concerns, complaints -- especially those who aren't sophisticated about buying stock in a young company that may not be able to show a profit or pay dividends.

"All of a sudden, you have 500 people who you don't know who you now have to answer to," Scileppi said. So an entrepreneur or small company may need to hire someone to be a liaison for investors

Tom Murphy, an attorney in Chicago with McDermott Will & Emery, another business law firm, said entrepreneurs might find they don't have as much freedom to run their companies as they did before taking on investors. "There will be a lot of things you can't do as cavalierly, like how much you pay yourself," Murphy said.

Having shareholders means businesses will need to comply with state laws that govern companies with shareholders, Murphy noted. "They're likely to have to prepare financial information for investors as they go along," he said. That means preparing regular reports on how the company is doing that includes information such as revenue, expenses and profit or losses.

Companies also are revealing their plans and finances to potentially millions of people. They could risk having their ideas stolen. However, as Chris Holman, chairman of the National Small Business Association, noted, "you're always going to expose yourself to that" when you seek investors.

Joyce Rosenberg can be reached on Twitter.
Story tags » Small business

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