What are the risks and rewards of crowdfunding law?

Law | 28 Sep, 2015 |

Arizona’s new crowdfunding law, which is intended to give small companies in the local Arizona economy greater access to capital, took effect on July 3. Arizona joins a growing number of states that have recently enacted laws permitting some form of equity crowdfunding. For startups and other emerging growth businesses that may not have ready access to traditional sources of funding, equity crowdfunding may be an attractive option for raising capital.

Crowdfunding is the process by which companies raise capital with relatively small individual investments from a large number of investors, typically through the Internet and social media. Historically, crowdfunding has existed primarily in reward-based or donation-based models which allow individuals to contribute funds to particular projects, either as donations or in exchange for certain products or prizes. By comparison, equity crowdfunding is the process by which a company raises capital through crowdfunding in exchange for equity interest in the company.

Under Arizona’s crowdfunding law, a company can raise up to $2.5 million if it provides investors with its audited financial statements, or up to $1 million otherwise, from investors in an offering. An investor can invest up to $10,000 in any company, or if he or she is an “accredited investor” under federal law, an unlimited amount.

Arizona’s new law is not available for everyone. The company can only offer and sell securities to Arizona residents and must be “doing business” in Arizona, which requires, among other things, that it maintain its principal office in Arizona and derive at least 80 percent of its gross revenues from operations in Arizona. Although many local companies will satisfy these requirements, businesses with a more regional or national presence will likely not qualify.

Raising capital under the Arizona crowdfunding law has its drawbacks. Prior to commencing an offering, the company must specify the offering period and the target offering amount. All funds invested during the offering period must go to an escrow account until the end of the offering period. If the company fails to raise at least 80 percent of the target offering amount, the offering is deemed a failed offering and all funds must be returned to investors. Additionally, federal law also imposes limitations that could restrict a company from raising additional funds for up to six months after the offering, which might not be a viable option for many startups. Going forward, companies must also provide quarterly disclosure regarding the business to investors. Consequently, companies considering an offering under Arizona’s crowdfunding law must carefully consider their short-term and long-term capital needs before commencing any offering.

Investors should be aware of the risks of any crowdfunding offering. Most startups go out of business within a few years of launching, and because there is no active market for securities bought in a crowdfunding offering, even investors who invest in successful companies may find it difficult to achieve liquidity for their investment. Unless and until a market for these securities develops or the company is acquired, investors could be holding their investment indefinitely.

Kevin J. Walsh is an attorney at Quarles & Brady in Phoenix. For more information, visit quarles.com.

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