Small business owners will soon have a new way to raise capital from small investors, one that resembles Kickstarter but allows contributors to get an equity stake.

In October 2015, the Securities Exchange Commission issued final rules for Regulation Crowdfunding under the JOBS Act. Those rules are slated to go into effect on May 16, 2016. They are designed to open up investing in startups and other small businesses to non-traditional investors.

Typically, only accredited investors have this opportunity. Following a model similar to crowdfunding websites like Kickstarter, investors worldwide will be able to back a company. However, the Regulation Crowdfunding rules will allow them to have an actual investment in the company, not just to make a donation.

From donor to investor

In the last five years, crowdfunding has become a growing force in the business community. Most people are familiar with websites like Kickstarter or IndieGoGo, which have allowed businesses and charitable enterprises alike to gather funds from an unlimited base of investors. However, unlike under the traditional model, these investors - better referred to as donors or backers - get no equity or other financial stake in the company. Instead, they often receive gifts or other donor perks, such as early access to a video game or one of the first units of a new product.

Some of these crowdfunded companies enjoy great success. One example is Facebook's 2014 purchase of Oculus VR, a leading virtual reality company. The purchase price of $2 billion dwarfed the initial crowdfunding, which came in at $2.5 million. Some early backers felt that they should have received a share of Oculus VR's purchase price because their early backing paved the way for the company's eventual success.

The SEC does not regulate fundraising on platforms like Kickstarter. However, there are still legal considerations. ISBA member Cory White, of The International Business Law Group, points out that in addition to considering tax implications, companies raising funds on Kickstarter have to beware of contract and common law fraud pitfalls. "Ensure that your clients are making it very clear to backers what they are getting and what they are not getting," he says.

Under the SEC's Crowdfunding Rules, companies like Oculus VR could seek initial investments from the general public while also giving them an equity share or other financial interest in the company. Under the new rules, companies that want to issue securities must file a specific set of disclosures with the SEC. They are limited to offering up to $1 million in investments over a 12-month period.

The offering must be done via a broker dealer or a funding portal. Funding portals and broker dealers must be registered with the SEC and the Financial Industry Regulatory Authority. Known as intermediaries, these entities must do due-diligence research on an issuer before allowing it to make an offering via its investment platform. There is a narrow list of exceptions to the rules regarding who can be an issuer.

White points out that issuers cannot solely rely on an intermediary's due-diligence requirements - both the issuer and intermediary share responsibility for the disclosures made in a crowdfunded offering. "Ultimately, the buck stops with the issuer."

Limits on investors

Although crowdfunded investments open the playing field to smaller investors, there are still limits to how much money a specific investor may spend. The Crowdfunding Rule divides investors into two classes.

Class One investors, who have an annual income or net worth below $100,000, may invest the greater of $2,000 or five percent of the lesser of their annual income or net worth. Class Two investors, who have an annual income and net worth that both equal or exceed $100,000, can invest 10 percent of the lesser of their annual income or net worth, up to $100,000.

These amounts represent what an investor can invest in a 12-month period across all crowdfunded offerings under Regulation Crowdfunding. Thus, issuers could theoretically raise $1 million with 10 investors at $100,000 each or 500 investors at $2,000 each. Even one million investors at $1 each is possible.

Regardless of the mix of investors, the SEC requires that all of this business be transacted online, with the intermediary maintaining detailed records of the disclosures and transactions. The intermediary's transparency requirements exist to protect investors.

White advises practitioners who are advising clients about crowdfunding under Regulation Crowdfunding to bring in a securities attorney. There are many options for raising capital, including under Regulation D and Regulation A+, as well as state-authorized crowdfunding coupled with SEC sanctioned intra-state offerings. An experienced attorney can help clients choose the right method.