A conversation with attorney Erich Merrill about the latest way to raise money from large groups of people.
The 2012 JOBS Act introduced the idea of crowdfunding, in which people fund a business by raising money from the masses. Today crowdfunding is all the rage, with new campaigns seemingly launching daily. (Check out the latest Portland Crowdsupply campaign hawking a life changing reusable toothbrush.)
But crowdfunding means different things to different people — and to regulatory agencies like the Securities & Exchange Commission.
In Sept. 2013, the SEC adopted a rule enabling a new way of raising money from large groups of people. Called the 506 (c), the mechanism allows a business to conduct a private securities offering and promote it in the media and over the Internet. The caveat? All buyers must be accredited investors.
I talked to Erich Merrill, a partner with Miller Nash, about the benefits of the 506, how it differs from what most of us think of as crowdfunding and the latest McMenamins project in Bothell, Wash., funded through a 506 offering.
How does the 506 differ from what we typically consider crowdfunding?
Classic crowdfunding would be the Kickstarter model. You may get a product, but you don’t end up with ownership in the company. There are also a number of portals/websites that do crowd funding. On those sites, you do end up with ownership. But those sites have to operate under old rules that did not allow any public solicitation.
So the 506 eliminates the prohibition on public solicitation?
Yes. There’s a long history of Congress or the SEC saying: If someone is really wealthy or earns enough money, then they are either smart enough to avoid fraud or they can hire advisers who can help them avoid fraud. Under the 506 program, Congress is saying: We’re going to allow public solicitation for unregistered offerings or private offerings. But the exchange is we’re only going to let people participate who are going to be able to fend for themselves.
That’s the groundwork for the 506 offering. That is what makes it so wonderful because historically this hasn’t been available.
How is the 506 an improvement on traditional ways of raising money?
Ten years ago a business could have gone to investment banks and said: I’m trying to raise $10 million. Can you guys go out to investors and raise the money? So you would get intermediaries involved with contacts. That has worked relatively well for a number of years. The drawback is it doesn’t take advantage of the huge exposure that is easy to get on the Internet. It relies very much on who you know or the broker knows.
So the 506 program gives business owners access to more investors and more money.
Exactly. It makes it easier to get in touch with a larger group of investors.
The 506 program went into effect last year. Are there any regulatory hurdles remaining?
The SEC is charged with protecting investors, so they are very concerned about fraud. They see this mechanism as something potentially used for widespread fraud and they don’t like it. So they have proposed a second set of rules that puts a lot more restrictions on the process. It would require you to file in advance all the materials with the SEC and would give the SEC the ability to comment or change them. It would a lot to the administrative burden.
The second set of rules hasn’t gone into effect yet.* My feeling is that the comments received on the rule were very negative.
Is the 506 sending shock waves through the investment banking community?
People who will be raising significantly large amounts of money will probably still go through investment bankers, because they are going to want to bring in institutional funds, venture capital. So I don’t see it displacing those offerings. There will be displacement in the low and middle range: $10 million and below. Because it’s new, we’re going to have to wait and see.
You worked on the McMenamins Anderson School project, which broke ground a couple of weeks ago in Bothell.
The two brothers, Mike and Brian, are extremely community oriented. One thing that appealed to them about this is even though we’re talking about limiting them to accredited investors, it was likely to be people in the Northwest. They liked the idea of giving local people the ability to fund a new McMenamins project.
They started the campaign at the beginning of April and closed at end of August. They raised $6.3 million from outside investors. McMenamins put in $1 million.
This investment was done through an LLC set up for the project. People don’t own part of the whole McMenamins chain. They own part of this particular project.
What is the big picture? Is this an incremental change in the way money is raised? Or something bigger?
It’s absolutely game changing. It reduces the transaction barriers and transaction costs. Anybody who gets on the internet can look at your offering and say: hey, that looks like something I might be interested in. It reduces the cost to companies of raising capital and gives companies a lot higher success rate. The avenues are so much broader. They”re not just going through who they know. They are going out to anybody.
And it’s not just the Internet: it’s a whole change in the way to do private offerings. Now, if you can get Oprah to do a private offering, that’s fine. It didn’t used to be fine. Lawyers like me would tell companies: do not get anywhere near Oprah or the local news. Because if you did have information out there, that was grounds for you to get sued and you have to give all all the money back, totally aside from whether the investment was successful or not.
So this changes the whole dynamic for how you get word out about your company and your project.
And now you don’t have to pay an investment banker — just a lawyer.
Now you just have to pay a lawyer. For some people that’s not necessarily a good thing. For some what you would pay an investment banker is well worth the contacts. That would typically be a start up that didn’t have any brand or public persona. So for those guys, this may not be a great way to go. But at least they can try it out for pretty low cost.
*Update December 3rd, 8:30am:
The Oregon Department of Consumer and Business Services is holding a public hearing this morning on a proposed new crowdfunding rule. The rule would create an exemption that allows Oregon-based small businesses to raise up to $250,000 from Oregon investors without having to register the contributions.
Linda Baker is editor of Oregon Business
