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Crowdfunding seems to be everywhere these days.  High school students are using crowdfunding to pay their way to college. Charities are using crowdfunding to raise money for their causes. Entrepreneurs want to use crowdfunding to raise money for their startups. Although the term “crowdfunding” is frequently used, it is rarely defined.  To add some clarity to all of the buzz, here is a quick tour of the world of crowdfunding.

Generally speaking, crowdfunding refers to a method of financing a project, charitable cause or company by obtaining small amounts of capital from a large number of individuals, usually via the Internet.  Since there is more than one way to obtain capital from the “crowd,” there is more than one type of crowdfunding.  In fact, at least four, very different, types of crowdfunding currently exist:  (1) rewards-based crowdfunding; (2) donation-based crowdfunding; (3) debt crowdfunding; and (4) equity crowdfunding.

The first type, rewards-based crowdfunding is, perhaps, the most well-known form of crowdfunding.  Popularized by websites such as Kickstarter and Indiegogo, in this form of crowdfunding, people give money to a business in exchange for a reward, such as a t-shirt or a product that the company makes.  For example, a photographer might use a website like Kickstarter to raise the money to print a book showcasing his photography, and people giving money to this project might receive a copy of the book, in return.

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Donation-based crowdfunding sites, such as Crowdrise and Gofundme, allow donors to give money to support a cause. The cause might be a traditional charitable cause, such as finding a cure for a disease or alleviating hunger, or it might be a personal cause, such as an individual trying to raise money to attend college. Unlike rewards-based crowdfunders, donors on donation-based crowdfunding sites get nothing in return for their money, other than the satisfaction of giving.

The third type of crowdfunding, debt crowdfunding (also known as peer-to-peer lending) is not as well-known as rewards-based or donation-based crowdfunding.  Debt crowdfunding sites, such as Prosper and Lending Club, allow borrowers to get a loan that is funded through the investors on the website.  Typically, investors on these sites lend a small portion of many loans, rather than the entire principal amount of a single loan, as a way to mitigate their risk.  Consequently, loans on these sites are usually made by a “crowd” of investors, rather than a single person or institution. Investors who lend money via peer-to-peer lending sites are paid interest, just as traditional lenders are, and, borrowers are obligated to repay the principal amount of a crowdfunded loan at the end of the loan term, just as they would be required to repay a loan from a bank or other traditional lender.

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In equity crowdfunding, businesses use the Internet to sell stock or other equity interests in their companies.  Equity crowdfunders give money to a company and, in return, they receive an interest in that company, usually in the form of stock.  The sale of this interest in the company is subject to the requirements of both federal and state securities laws, and, until recently, both federal and state securities laws prohibited equity crowdfunding. Consequently, until recently, a company could use rewards-based crowdfunding as a financing source, but it could not use equity crowdfunding.  This meant that, as a practical matter, many companies could not use crowdfunding to raise money since many companies either do not produce the kind of product that can be used as a reward or need to raise money in the pre-production stage of their existence, when they have not produced any product at all.

Recently, however, there have been moves, on both the federal and state level, to change existing laws so that equity crowdfunding will be legal in some circumstances. In fact, two states — Georgia and Kansas — have already passed new exemptions to their state securities laws that permit companies located in their state to use crowdfunding, in some circumstances, to raise money from residents of their states. Similar legislation is now pending in North Carolina and Washington, and three Wisconsin legislators recently announced that they plan to introduce a similar bill during the next legislative term.

On the federal level, the Jumpstart Our Business Startups Act (JOBS Act), passed by Congress in April, 2012, created a new crowdfunding exemption to the registration requirements of the federal securities laws.  When fully implemented, the JOBS Act should make crowdfunding possible, on a national scale, subject to the requirements of the JOBS ACT and the regulations that implement it.  Unfortunately, regulations fully implementing the JOBS ACT have not yet been approved by the Securities and Exchange Commission, so, for the time being, true equity crowdfunding, i.e. companies using the Internet to raise money from both accredited and unaccredited investors, is still not permitted by the federal securities laws.

This article was written by Janice L. Gauthier, Esq. Ms. Gauthier has an A.B., cum laude, from Harvard University and a J.D, cum laude,. from Harvard Law School.  She is a startup lawyer and the owner of The Gauthier Law Group, LLC, a boutique startup law firm in Milwaukee, Wisconsin, that represents founders, entrepreneurs, startups and early-stage businesses in both Wisconsin and Illinois.  You can contact Ms. Gauthier at 414-270-3855, ext. 101 or by email. To learn more about Ms. Gauthier’s background and experience, visit her Google or LinkedIn profiles.

© 2013 The Gauthier Law Group, LLC