Saturday, January 09, 2010

Biracy & Crowdfunding—Peril or Paradise?

While researching possible avenues of funding for a feature film, I've heard about crowdfunding over the years. Crowdfunding is fundraising from a large group of small donations instead of a small group of large donations. Several companies do crowdfunding now, and a few specialize for filmmaking. Here is an excellent collection of short videos of the top 15 crowdfunding companies in their own words.

I was recently contacted by David Geertz from The Biracy Project (@biracy) in my role as moderator for the Infinite Distribution Panel to help generate questions for a Biracy video Q&A. The panel had several great questions and Geertz personally responded to them. It was so helpful, Geertz said, that they might even do it on a weekly basis.

Crowdfunding has obvious advantages over traditional film financing, chiefly among them that filmmakers are able to find and connect directly with their fans even before they roll film. Whenever others are invited to come on board to have a say in which direction the ship is heading, it bestows ownership to them... which in turn sparks the sort of emotional investment to a project that advertisers salivate over. People who join crowdfunding projects want to see that project succeed—they have a natural incentive to participate in and promote their project. Anyone who understands the power of networks realizes that as the size of a network grows, its reach and influence increases geometrically. Crowdfunding locks in your funding and your audience at the same time. You can't really ask for a better scenario.

The question is—is it legal?

I'm not addressing the question of whether crowdfunding should be legal—I already feel strongly that it ought to be. Fans want to invest in films like buying stock in the stock market, and reap the same benefits as multimillion dollar film financiers, so why shouldn't fans be allowed that option? Unfortunately, America has a formidable legal obstacle—state laws called blue sky laws which "regulate the offering and sale of securities to protect the public from fraud." These laws were designed to protect unsophisticated investors from scam artists trying to swindle grandma out of her life's savings. For crowdfunding, the law seems not to fit anymore, but that's irrelevant—if the SEC decides you're violating their regulations, then it really doesn't matter how outdated the laws are. Are you able and willing to afford a proper legal defense to keep yourself out of orange overalls?

So the central issue to consider is whether crowdfunding is, in its current incarnation, legal under today's laws. If I join a crowdfunding operation, could I be involved in a class action lawsuit one day and/or criminal charges? Are all current crowdfunding operations simply a ticking time bomb? Whenever a new business model first emerges, existing legal codes often don't understand how to interpret legal code to accommodate the shifting market. Is this the case for crowdfunding?

I posed those questions to Biracy's Geertz on Twitter and I feel he answered them to my satisfaction. Before you see Geertz's reply, you ought to have a proper context of my own concerns because these kinds of articles made me extremely paranoid about crowdfunding. From Mark Litwak's site:

Question: We have a project and are interested in soliciting investors without violating SEC rules. What can we say that's legal but still gets the point across, and what is illegal?

Answer: The most important thing to say is that you are not making an offer. You are simply having a preliminary discussion with people. In order to take money from investors, you need to either register your company with the SEC, which costs a considerable sum, or fall into one of the limited offering exemptions. A major restriction on these limited offerings exemptions is that you cannot do any public solicitations like mass mailings and cold-callings. And you'll be limited to thirty-five unaccredited investors. An accredited investor is essentially a wealthy, sophisticated investor. Everyone else is an unaccredited investor. If you can live with those restrictions, the cost of complying with securities laws is considerably less but still significant. If you violate the securities laws, you can be subject to civil and criminal penalties. Link.

Another article:
In general, under the Securities Act of 1933, entrepreneurs who seek to sell stock in a business should register the securities with the Securities Exchange Commission plus comply with other often complex federal and state regulations. While this may seem daunting to a startup company like yours, the SEC provides some exceptions. One of the ways to bypass some regulatory requirements is by soliciting wealthy accredited investors, also known as "qualified investors."

Regulation D of the 1933 Securities Exchange Act defines accredited investors as individuals who have a net worth of $1 million or income of at least $200,000 in the two years prior to investment. For couples, the prior income requirement is $300,000. The SEC notes that income requirements are met only if there is a reasonable expectation that income levels will be maintained in the future.

Accredited investors can also include banks, insurance companies, small business investment companies and corporations, charitable organizations or partnerships with assets exceeding $5 million.

The thinking behind the financial means test is the presumption that wealthy investors are sophisticated about the risks associated with privately-held company investments and can "afford" to lose the entire investment.

Granted, families of more modest means invest in startup restaurants, retail establishments and service companies all the time without meeting accredited investor tests. They can without attracting regulatory attention because companies are generally permitted to raise money from up to 35 non-accredited investors, plus an unlimited number of accredited investors. Still the SEC does require that companies reject non-accredited investors who are not financially sophisticated and understand the risks associated with the investment. Link.

...and another article:
If a small contribution obtained via crowdfunding is actually an equity investment or even a loan, then crowdfunding companies may soon run afoul of securities laws. I forget the details but if you raise money from over a certain number of investors, you start being subject to all sorts of securities laws that are a pain.

If you ask me, those laws should be completely recrafted to allow crowdfunding and kick it into high gear. To me, crowdfunding is fuel for human capital and great projects that is currently untapped but has enormous potential to change the world as we know it. I'm sure there are some advocated at the SEC, the SBA, the Federal Reserve but, no doubt, bureaucracy is frustrating the heck out of them right now. Hopefully, we'll figure out how to tap into the power of crowdfunding soon.

The thing is, it does have to be regulated. I mean crowdfunding scams will be huge, once crowdfunding grows in popularity. When there's money involved, scammers will come.

There also needs to be some liquidity to crowdfunding shares. If people are going to make microinvestments, they will want to be able to profit from their investment. It will be a great day when a firm that raised $100,000 from 20,000 $5 investors sells out for a few million and everybody gets a tidy, albeit little, return on their investment. Link.

And a super recent article from Boing Boing:
Donors can get a little something in return through these sites if the projects they fund come to fruition, like a signed copy of a book that's produced (Kickstarter), or reimbursement in credit if a news organization buys the story (Spot.Us). But what if a crowdfunding site could offer donors a piece of the action, not just some thank-you goodies? That's what I would want, and I don't think I'm alone. I want investors for my schemes, not patrons, and if people support me to do something that flies, it would only please me to give them a cut.

But then I started talking about the scheme with lawyers, including Boingboing counsel Rob Rader, who has been extremely helpful. The legal terminology for my notion, it turns out, is "patronage-plus ex ante crowdfunding," at least in a recent article by Tim Kappel in the Loyola of Los Angeles Entertainment Law Review The short answer is, such a site would probably be illegal under U.S. federal securities law. "Securities" are defined as any investment whose return is dependent upon the effort of others. It's a one paragraph definition, very broad, hard to get around, and there's no de minimis dollar cutoff below which the regulations stop. A lemonade stand venture could be subject to SEC regulation.

Securities regulations don't apply if the investors are genuinely active in the day-to-day management of the venture-- but it isn't enough to just give them access to a project wiki and consider their suggestions; you must demonstrate that they are all critical to the venture's success. So much for that loophole.

Another possibility is the SEC's "Private Placement Exemption" under Regulation D, which allows unregulated investments if the number of investors is limited. Specifically, you can sell shares to at most 35 regular individuals (and an unlimited number of accredited investors, i.e. various institutions, plus people who have a net worth exceeding $1 million, an annual income over $200K, or a personal trust exceeding $5 million).

But Regulation D also prohibits any "general solicitation or general advertising" to let people know about the venture. The only published announcements of such investments are the cryptic "tombstone ads" that you sometimes see in the print versions of the Wall Street Journal or New York Times business section. These ads, which AFAIK have never been published online-only (although this might be possible) must be very limited in their disclosure. It might be OK to say "Paul Spinrad offers shares in a graphic novel based on the life of Elliot Smith" but that's about it. The announcement can't include anything that makes Kickstarter and Spot.Us so fun to browse through-- no details of the project, no wish lists, no video clips of people saying, "I'm so excited about this project-- it's got great indie film potential-- all I need is 4 months time and a round-trip ticket to Portland!"Link.

If you aren't a little nervous by now, then you have a heart of stone. Violating SEC regulations is serious business and could land you a princely fine and/or time in jail.

Geertz provided two Q&A videos and kicks it off by saying clearly that Biracy is not an investment, and thus should not be confused with a security—money given to Biracy is a donation, a membership fee, and a pre-ordering of a product. There is no financial remuneration as you would receive with an equity investment, be it stocks, company shares, or real estate. Thus, you don't fund films like multimillion film financiers for a jackpot if the film is a hit... instead, you get something called Kaps, a virtual currency. This is the key distinction—you don't get real money in return for your donation, just benefits with the company, like store credit. You can, however, earn money from commissions by referring others to Biracy, like a multilevel marketing company. It's clever.

If Biracy proves itself to be a sustainable crowdfunding model, then its founders will soon launch to let other producers benefit from Biracy's model. As I understand it, the only danger in violating SEC regulations is to the company, not its donors, so I think I'll invest in donate to Biracy today. However, were I to use Sokap as a Producer, I'd feel obliged to run all this through my own lawyer before committing any resources to it. Why? Because you never really know how governments react to radical new business models. Once crowdfunding begins to become popular, all it takes is one egregious crowdfunding scandal to push the SEC towards clamping down on "risky new businesses using securities law loopholes to rip off unsuspecting victims". Then it all turns into a make or break acid test on how clear the law is about crowdfunding. Bunch of hooey if you ask me, but it wouldn't surprise me in the slightest. If I were a crowdfunding company, I'd probably approach other crowdfunding companies and pool our resources to get a lobbyist in Washington to update SEC blue sky laws so crowdfunding isn't just legal, but actually fulfills the promise of film investing—to make real money on films like multimillion dollar film financiers... but on a micro level.

Here are Biracy's two Q&A videos by David Geertz:
Q&A: Is it an investment? Part 1
Q&A: Is it an investment? Part 2


Jeffrey B. Palmer said...

So much info! All good stuff, Ross. Will be reading through this and musing over the ins and outs of such things. As a filmmaker in the early stages of raising funds for a feature film, we're taking the "promotional trailer" route first; hoping to build an audience or at least create some interest/intrigue for the project and script -- a slippery slope indeed. :)
Jeffrey B. Palmer
writer/director "The Sleeping Deep"

Anonymous said...

Biracy's approach is interesting, but I don't see it violating SEC, though IANAL.... but Have you seen what SellABand's doing? They used to not sell in the US, but I saw a thing with one of their vice-presidents explaining hwo they got around SEC law because there was "no risk" to investors, because if money wasn't raised album wasn't made.... Hello? There's still PLENTY of risk of them not getting any of their money back, which is the exact point of the law...