Last month, Washington Attorney General Robert Ferguson filed suit on behalf of the State of Washington against a man and a business who raised $25,146 backers on the crowdfunding website Kickstarter. The lawsuit alleges that Ed Nash and his company, Altius Management, failed to deliver promised “rewards” to his 810 backers. This is the first known consumer protection suit brought by a state government involving crowdfunding, and highlights some of the risks for all participants in this new form of investment.
With “crowdfunding,” individuals, businesses, and non-profits, typically called “creators”, solicit funding for various projects from a large pool of donors or investors, called “backers.” The funding can be for a wide variety of purposes, ranging from donations for charitable causes or political campaigns to investments for startup businesses or projects like movies or games. The funding itself can take a wide variety of forms as well, including equity investment, microlending, or outright donations. The infrastructure for matching creators and backers is typically provided by a third-party website, called a “platform.”
While there is nothing new about charities and politicians raising money through large numbers of small donations-the Salvation Army’s red kettle could be considered a form of “crowdfunding” in that regard-the use of crowdfunding in the realm of business is a relatively new phenomenon that was only made practical in recent years by the internet. Because of the novelty of crowdfunding as a tool for raising business capital, the law regarding the obligations owed among crowdfunding platforms, creators, and backers is not well-developed. Despite this, crowdfunding has grown at a phenomenal pace-according to one market research firm, crowdfunding platforms raised $2.7 billion in 2012 worldwide.
Kickstarter, one of the most popular crowdfunding platforms, facilitates “reward-based” crowdfunding in which backers receive no equity or interest in exchange for their investment. Instead, the creator sets a certain goal for money raised, and if that goal is met by “pledges” from backers, the backers receive a “reward” which can range from a nominal gift such as a postcard to a copy of the game, film, or product being developed. If the goal is not met, the backers’ credit cards or accounts are not charged, no money is paid to the creator, and no one receives a reward.
In its suit against Ed Nash and Altius Management, the State of Washington alleges that Nash and Altius, who were purportedly raising money for the development of a card game, set a goal of $15,000, and ended up raising more than $25,000. Backers were promised copies of the game as a reward if the goal was met, with the rewards to be delivered in December 2012. However, the state alleges that Nash and Altius failed to deliver the promised rewards, and that they have not updated their website since July of 2013.
Fortunately, if a rewards-based backer is defrauded, he or she is usually only out a small amount of money and the frustrated expectation of receiving a nominal reward. Things could be quite different when equity-based crowdfunding grows in the near future.
To date, equity-based crowdfunding has largely been nonexistent in the United States due to federal securities law, which prohibited the marketing of unregistered securities to non-accredited investors. These laws are being significantly relaxed through Title III of the “JOBS Act,” passed by Congress and signed by the President in 2012. While equity crowdfunding will not “go live” until the SEC creates rules implementing the JOBS Act later-expected this fall-there is already a great deal of anticipation. Even though the law will place strict limits on the amount a business can raise through equity crowdfunding from non-accredited investors and the amount an individual investor may invest in a given year, expert projections of the size of the equity crowdfunding market in the coming years range from $4 billion to over $300 billion.
Unlike reward-based funding, equity crowdfunders will be risking significant amounts of money and will be expecting real returns on their investments. Regulations will permit individual investors earning less than $100,000 per year invest up to the greater of 5% of their annual income of $2,000 in a given year in Title III crowdfunding-this could be a significant part of a typical household’s savings. Those seeking crowdfunding investment will be exempted from many of the reporting and disclosure requirements required of companies issuing publicly-traded stock the old-fashioned way. If investors do not do their homework, they may come to realize too late that venture capital (which is exactly what crowd funding is) carries a high risk, and that the most likely outcome for an investor in any given startup company is that the company will fail and that the investment will be lost.
The brave new world of crowdfunding could be the great democratization of venture capital that its proponents claim, jumpstarting the economy and turning retail investment into Shark Tank for the everyman. However, the lack of regulation and lack of financial sophistication of many small investors could turn crowdfunding into the 90s’ penny-stock craze magnified by the power of the internet-the Wolf of Wallstreet on steroids. Only time will tell, but it seems likely that while we have just seen the first crowdfunding lawsuit, we certainly have not seen the last.