Crowdfunding Demystified

Joe: And we’re back for Seedfunders podcast episode 6. I’m Seedfunders partner Joe Hamilton along with the founder Dave Chester. welcome, sir.

Dave: Thanks, Joe.

Joe: Today’s topic is crowdfunding and Angel Investing as it relates to crowdfunding. There’s a lot of confusion around the word crowd funding. So let’s start with the finding of what exactly is crowd funding.

Dave: Well technically crowdfunding is raising capital through a collective effort of a number of people thus the name crowd funding, but it’s a lot more complicated than that. And if you do some research, and I’m always looking on the internet for what’s new and what people are saying, if you do some research on crowdfunding 50% or more of the time you’re going to find information that is absolutely positively not correct.

Information from what you would think would be reliable sources and you know, I know from my experience and in the last seven years of doing this that this is completely wrong. so you can’t really do research without making sure you’re really really using reliable sources. So let’s start by saying there are three types of crowdfunding and this might help everybody clarify everything. There are three types: donation-based crowdfunding, reward-based crowdfunding and equity crowdfunding.

So on donation-based crowdfunding, that’s the most famous site, of course is GoFundMe and I think is heard of GoFundMe. It’s 100% donations. Kids or people or adults, anybody can go on there and and request money for school or trip or a car or a funeral and it’s really really successful. They’ve raised nine billion dollars. Basically for people that are completely donations.

I saw a meme the other day there was a kid mowing a lawn, and it said the caption was this is me growing up. This was my go fund me account. So on GoFundMe, of course everything’s donation. There’s no promise of work or anything like that is just strictly a donation.

Joe: Just to be clear there, What you’re saying is originally you can’t trust everything you read on the Internet?

Dave: No, especially Facebook.

Joe: So let’s move on to some of the other types of crowdfunding.

Dave: While the second type is, and there are no particular order, except the second type is reward based crowdfunding. And everybody’s heard of Kickstarter or Indigogo in particular. What happens in reward based crowdfunding, that the people supplying the funds – the crowd gets a product could be a tee shirt. Could be a coffee mug. It could be a trial are at initial issue of a product or something like that.

It’s not an investment – let’s make it clear: reward-based crowdfunding is not an investment in the company. That would be the third type of crowdfunding called Equity investment and we’ll get to that but reward-based crowd thing is not an investment the company. One of the most famous stories out of, that when Kickstarter ran a program for the Oculus Rift. This was in 2012, and it was actually before Equity crowdfunding was even legal but they ran a Kickstarter program and people who donated 25,000 or gave them $25,000 got a t-shirt $25 for a t-shirt. $275 got them a t-shirt plus an unassembled prototype of the Oculus Rift. They got ninety five hundred people to send them money. They raised two point four million dollars. It was ten times the amount they were asking for but it really took off. Well eighteen months later in 2014 Facebook acquired Oculus for 3 billion dollars.

Three billion dollars. A $300 investment $300 investment if that had been an investment but $300 in eighteen months became worth $20,000 had been an investment. That’s a 66 X what we would call 66x in in terms of in eighteen months getting sixty six times your money, but it wasn’t an equity investment. It was a reward-based – they got a t-shirt that led to get a t-shirt. I’ve seen a memes on t-shirts as I backed a Kickstarter project and all I got was this lousy t-shirt

Joe: And hitting the delete button real quick, it was $25 for the T-shirt not $25,000. though that might have been okay, and so with Equity crowdfunding it just so happens. You’re a Pioneer in equity crowdfunding. So let’s talk about that.

Dave: On April fifth, two thousand and twelve. The Congress passed the JOBS act. The jobs stands for jump starting our business startups. I started a number of companies myself, and I know how difficult it is to raise capital to start a company. Basically you have to know somebody to raise the capital. So I looked at the JOBS act and I thought: This could be big because what it did was allow outside people to join in the investment in your company. So previously that was illegal. Oh previously after nineteen thirty based on the scams and things that went on during the roaring twenties, a lot of people lost a lot of money. The FCC said, you have to have a previous business relationship in order to invest in a start up or someone who’s starting a company needs have a previous business relationship in order to solicit funds.

So that kind of limits you pretty much to people you know, or people you know, that know somebody but you couldn’t go out and just do what’s called General solicitation to try to find people to invest in your company. So after that passage in the JOBS Act of April 2012, the SEC did not like that. The SEC says well, wait a minute you’re expecting us Congress is expecting us to allow people that don’t know anybody to invest in companies without us vetting the company or determining whether this company is really legitimate. It’s just a start-up, so they dragged their feet, but finally off on September 23rd, 2013 a year and half later the SEC issued The first rules on the JOBS act.

It’s called title to there are four parts of the job title one is just basic background, but title two is the first effective part of the jobs Act.

That became effective on September 23rd 2013 and we’ll talk a little bit about title two and how that affects investment in startups. So on September 23rd 2013. I also on the same day formed Florida funders. You could say I didn’t waste a day. Basically my goal was to use crowdfunding to make Equity investments in startups. So Florida has became quite successful. I’m not managing day-to-day anymore. But last week I’m still in equity holder, last week Florida fund has invested the crowd on Florida for invested 1.6 million in one investment from the crowd.

Joe: So let’s dig a little deeper into how Equity investing actually works with the jobs Act.

Dave: Sure, as I said, there are three operable sections of the JOBS act, and they’re called title two title, three and title four title one. This is just basic background. It’s not an effective our operating portion of the jobs act. So previously as I said, startup was who you knew you had to know somebody with money to get startup investment. And that was done through what’s called a private placement. That private placement was used within the regs of the the FCC regulations called REG D 506b. That was the way things have been done. Reg D 506b, for with people that you had a previous business relationship with. Title two changed that significantly. Title two added what’s called Reg D 506c. And under reg D 506c Startups, entrepreneurs can now do what’s called general solicitation. They can advertise on the Internet. They could put on billboards. They can just do anything to try to get people that they don’t know, that did not have a relationship with them to invest in their company.

This is the first time in almost a hundred years that now people that did not have a connection to a start-up could actually invest in a start-up. the biggest qualification however, is that the investor must be an accredited investor as I said before an accredited investor is someone who has a net worth of over 1 million dollars, not counting the personal residence, or has an income for the past two years of $200,000 or a joint income with the spouse of $300,000. So under title two it only applied to accredited investors, but it did open up the floodgates for companies looking for capital

Joe: And all that Capital came in, is that Angel Investing?

Dave: Yes, actually it is. Basically what happened is now individuals could invest in startups that maybe they didn’t know about before because these startups weren’t allowed to advertise. They weren’t allowed to go out and solicit funds.

So they’re quite a few websites that have facilitated this that includes Angel list Funders Club, Crowd Funder, We Funder, Fundable, and of course my favorite Florida Funders. So these websites all essentially do crowdfunding and angels and investors can invest through these websites in in all kind of different deals. Now every one of those websites is different. some do a lot of due diligence and put companies up for funding. some have extensive information, but not necessarily any due diligence and you still have to do your own due diligence. Some charge fees.

They could charge the investor fees to join. They can charge companies fees to list their company for funding and some just list companies. All they do is charge the company and the company list themselves and then the angel investors have to go find the information and go contact the company to make an investment.

But it did create extensive opportunities that were previously not available before title, two of the JOBS act.

Joe: But all these opportunities in these websites, this is all just for accredited investors, right?

Dave: Actually no. This brings us to the next part of the JOBS Act, which is title three. Title three was passed in spring of 2016, four years after the original JOBS. act was passed by Congress. The FCC implemented title three spring of two thousand and sixteen. And that is called REG Cf, F for crowd funding. This finally allows non accredited investors to invest. Now there were a lot of restrictions on title three and reg C F. That resulted from title three. These restrictions made companies could only raise one million dollars a year. Investors were limited as the amounts they would invest. Even accredited investors were limited on the amount they could invest.

In these deals, the offer had to go through a new entity called a funding portal. a brand new SEC type of entity that had to be approved and registered with the SEC and a member of finra. So it was highly regulated. They required audits the companies had to have Audits and basically all the investors individual investors were stockholders in the company and names on the cap table. These details and this attempt to protect the general public from fraud really resulted in this so much detail and so much paperwork that title three really didn’t take off that well.

Joe: So it sounds like these restrictions had a pretty big impact on the use of right 3 or excuse me, title three.

Dave: Yes, they did. In fact in the first two and half years after title free and regs CF was passed. Only just over a hundred million dollars was actually raised on this which they were mostly very small deals and the professionals avoided these deals. So again, mostly going to be your smaller investor off, but the professionals avoided anything that was coming through reg CF. So what happened was the SEC really expected thiss, I think to be a disaster that you know, the public was going to get ripped off these companies were going to go bankrupt. So after two and a half years actually it wasn’t. It was limping along but due to those heavy restrictions that really didn’t take off the way it should of the way that was anticipated. So in November 2020 the SEC revised the rules, they basically raised the amount a company could invest to five million dollars from 1 million, they eased audit requirements.

They put no limit on the amount at accredited investors could invest through reg CF. They’ve basically ease the restrictions on non accredited investors of how much money they can invest. And most importantly, what happened is they changed rules allow was called a special purpose investment vehicle to be formed. As I said before, the previous roles said, every investor had to be up investor and on the cap table, the copy. This resulted in thousands, potentially thousands of individuals on a company’s cap table. Professional investors coming along after that were really leery of seeing that many people involved on in a company’s cap table. One that would have prevented has prevented a lot of companies from raising additional capital.

So what the SEC did said well now now special-purpose investment vehicle or SPV to be formed which allows multiple people to invest in an SPV and that SPV then invest in the company. So there’s one investor, even though there’s multiple investors that’s similar to the way we exactly the way we do things that Seedfunders.

Joe: I think you mentioned one more operational piece of the jobs act title 4?

Dave: Yes, title 4 took an old rarely use regulation called reg A and updated it and called it reg a plus and I mean as in regulation,not reggae music but regulation A became reg A Plus. It became effective on June 19th 2015. So it actually beat title three by a few months in getting implemented.

What title 4 does is allows a mini IPO or reg A plus which came out of title 4 allows a mini IPO. Basically rather than going public, a company can raise a lot of money and test the waters and basically rais enough money to determine whether or not at some point in the future, they want to do an IPO. As you may know IPOs are really expensive to launch. So this allowed another way for companies to raise funds they could raise up to 50 million dollars in an many IPO under reg A plus and they could also raise money from unaccredited investors. There’s no audit, there’s two tiers. There’s no audit and tier one, but it does require an SEC approval with the SEC has promised to accelerate the approval on the reg A plus deals. The biggest difference hwever is state blue sky laws.

Previously under the original reg A, every state had the right to review is the middle for funding. So companies raising money. And if you’re anywhere near the Internet, you’re in basically all fifty states. So basically, under the old reg A, every state would have to review your submittal to determine whether they approve you to raaise funds. That obviously was a deal. Killer and reg A plus was almost never – rarely if ever, used. Well, the way that the rules came about with reg A plus is they formed one entity that can review on behalf of all states. This really accelerated the reg A plus to allow people to start to raise a lot of money really quick. It’s basically another way for investors to participate in equity, startup investing. Companies and websites that are participating and reg A plus deals include Seed Invest, Star Engine and Next Seed amongst others.

Joe: And with that upgrade and taking away the state review has title 4 been successful?

Dave: Yes it has. But really buyer beware. It’s almost like home buying stock in a public company, but it’s a start-up. It’s a high-risk start up. The key difference is it’s not liquid. When you buy stock on a Stock Exchange in a public company, you can then sell it the next day when you buy stock in a reg A plus deal, it’s not liquid. You might never get your money back. So there’s a huge difference there between the actual stock market public companies and these private companies through reg A plus. Some risks we previously discussed also that besides not being liquid, you could lose all your money. But it does create opportunities for everyone that did not happen a way to invest in these companies before it just didn’t exist. And now a lot of people can invest in a lot of these startups

Joe: That’s great.

Dave: You know, just this morning. I saw it actually a reg A offer on Facebook advertised on Facebook. A company called Night Scope. It’s basically security robots and they were previously crowdfunded through reg A plus over forty million dollars.

They are now raising another $25 million dollars, and they have almost 6,000 investors in this round. The thing is the valuation is $447 million dollars. Now the company has about ten million dollars in revenue, but basically in financial terms for a company that ten million inrevenue to be valued at 447 million is basically nuts. It’s pretty ridiculous, but they’re raising millions and millions of dollars on reg A plus but you know, it’s an opportunity for folks who previously restricted from participating in participating in deals like this and it’s totally up to the individuals whether or not they want to participate

Joe: Wonderful. That’s a lot of information. Any closing thoughts, specifically something that will take my mind off of security robots so I don’t have nightmares.

Dave: In the past eight years, we’ve seen a lot of what’s called the democratization of capital. Where people can use their money to do things they could not have done. Companies can raise money from people that they never could have raised money for. So that’s really incredible. It all started with the JOBS act. Investing in startups now is is easier than ever as I said, I’ve always said the best ways to join an angel group. There’s a lot of these websites that have a lot out there. And if somebody’s into that, that’s what they can do. We’re really. You have to pick what suits you best. I think joining a an angel group is better than other methods, but there are these other methods out there. There’s websites, there’s reg A plus, there’s title 2, there’s like 506c. There’s reg CF. So amongst all these things, there’s multiple number of ways that people can invest in startups that did not exist 8 short years ago.

Joe: Wonderful. I vote for Seedfunders, Seedfunders.com. Thank you, Dave.

Dave: Thanks Joe.