"In contrast to previous economic eras,
intellectual property will be the primary source
of new wealth in the 21st century."
- Gregory A Piccionelli, 1989
 
AREAS OF PRACTICE
• Internet Matters
• Music & Other Entertainment Matters
• Intellectual Property Rights Enforcement
• Crowdfunding Matters
• Freedom of Expression Matters

A New Way To Raise Capital For Adult Entertainment Businesses: “Crowdfunding”

MARCH 2012

There has been a lot of talk recently about a phenomenon called “crowdfunding”, a relatively new type of fundraising that relies on social media and the Internet to obtain small amounts of capital from large numbers of individuals to accumulate large aggregated amounts of capital. In recent years, Internet-based crowdfunding sites such as Kickstarter (www.kickstarter.com) and Indiegogo (www.indiegogo.com) have been used to raise millions of dollars for many types of businesses and projects.

 

This form of financing has been particularly effective for mainstream independent filmmakers seeking funds to finance their films. According to the Kickstarter website, 17 Kickstarter-funded films went to Sundance this year, and 31 Kickstarter-funded films are entered in the South By Southwest Festival.

 

But while creative projects have been the most publicized crowdfunding successes, this crowdfunding microfinancing can, in theory, be used as a means to raise capital for almost any kind of enterprise, including adult entertainment businesses.

 

Kickstarter and other crowdfunding projects currently do not sell investment shares or offer financial incentives. Current U.S. law prohibits crowdfunding platforms from offering equity in a company or profit participation in a project because of federal and state securities regulations. This means that a company cannot use the Web to offer to potential investors a share of the profits in a company or profit participation in a project in return for their investment of capital without complying with numerous and complex securities laws that effectively prevent such mass advertising.

 

Instead, project creators using kickstarter-type crowdfunding generally offer rewards to backers, such as pre-sale products and unique project experiences. This arguably provides a legal work-around of the strict prohibitions imposed by the securities laws. But the fact remains that project promoters cannot legally offer equity in a company or a profit sharing interest in project through crowdfunding. And this has effectively prevented what would otherwise be a killer Internet application for small businesses seeking investment funds by foreclosing a major new means of capital formation.

 

But all that may be about to change. On November 3rd, 2011 the House of Representatives passed H.R. 2930, approving new legislation called the Entrepreneur Access to Capital Act. The bill would create a new category of transactions exempt from federal securities regulation - a crowdfunding exemption. With the stated intention of increasing funding available to small businesses, the crowdfunding exemption would allow for the issuance of equity, such as stock in a company, without registration with the Securities and Exchange Commission provided that:

 

  • The aggregate value of the securities sold by an issuer in reliance on the exemption in any 12-month period did not exceed $1,000,000 (or $2,000,000 if the issuer provided potential investors with audited financial statements); and

  • The aggregate value of securities sold by an issuer to any individual investor did not exceed the lesser of $10,000 or 10% of the investor’s annual income.

 

Unlike current law, the proposed exemption would not limit the number of investors, prohibit advertising and general solicitation or require that extensive disclosures be made to investors. The current bill does, however, impose a number of conditions that would have to be met for the exemption to be available, including requirements that companies:

 

  • Warn investors of the speculative nature of startups and the illiquidity risks that accompany them. (The issuer must include this warning on its company website);

  • Warn investors that they are subject to restrictions on the resale of the securities purchased;

  • Take reasonable measures to reduce the risk of fraud with respect to these transactions;

  • Not provide investment advice;

  • Have each potential investor answer questions demonstrating an understanding of the level of risk and lack of liquidity inherent in investments in startups;

  • State a target offering amount and ensure that a third party withholds the offering proceeds until at least 60% of the target offering amount has been raised; and

  • Outsource cash-management to a qualified third party, such as a registered broker or dealer.

 

Supporters believe that this legislation, if passed by the senate and signed into law by President Obama, could open up new sources of capital to startups and exisiting enterprises because the exemption would permit companies to make wide-reaching solicitations for funding and would not limit the number of investors or impose burdensome disclosure requirements with respect to investors not qualifying as accredited investors, both requirements under current law. If the Entrepreneur Access To Capital Act becomes law, a company could seek investments from almost anyone via the Web. Proponents have argued that the exemption would grant small companies access to significant sources and amounts of new funding that are simply unavailable to them under current law. 



 

The Entrepreneur Access To Capital Act also permits intermediaries to be involved in the offering without requiring that they be registered as “broker-dealers”. The broker-dealer registration requirement is currently a significant complicating factor in capital raising transactions subject to current securities regulations. Finders and other intermediaries who might substantially assist issuers in raising capital often decline to provide their assistance because of concerns that they should be registered as broker-dealers. H.R. 2930 imposes limited requirements on intermediaries, but nothing comparable to registration as a broker-dealer. 



 

There is no guarantee that the Entrepreneur Access To Capital Act will ever become law. It still must be passed by the senate and signed into law by the president. But H.R. 2930 passed in the house on a 407 to 17 vote with overwhelming bipartisan support. Its passage displays an unusual amount of cooperation by democrats and republicans in these times of legislative paralysis due to political polarization. This can only be viewed as a positive sign that the law or something like it will probably emerge from congress before year’s end.

 

Now the focus will shift to the senate where Senator Scott Brown of Massachusetts has introduced the Democratizing Access to Capital Act, S.1791, which he claims is “[a] bill to amend the securities laws to provide for registration exemptions for certain crowdfunded securities, and for other purposes.”  This bill has essentially the same objectives as H.R. 2930. And while S. 1791’s provisions roughly track its counterpart passed in the house, it does impose a lower cap on individual investments at only $1,000 per person.

 

The house and senate bills will have to be reconciled to create a final bill that can be sent to the president for his signature before a crowdfunding exemption to the securities regulations can become law. But, while H.R. 2930 sailed through the house on a wave of government and public support, the process in the senate, as is often the case, is moving much slower. But at the time of this writing, some form of the bill is expected to eventually pass in the senate. And if a reconciled bill is passed by congress generally in the form of H.R. 2930 or the current version of S. 1791, the president is expected to sign the legislation into law.

 

If a crowdfunding exemption to U.S. securities laws is enacted, adult entertainment companies will be allowed to use the Internet to advertise and sell stock and other securities to raise capital for their companies and projects. Needless to say this could be a game-changer for industry.

 

My law firm is tracking the progress of this important legislation carefully. I invite those also interested in the bill’s progress, or in crowdfunding in general, to contact me at (818) 201-3955.

 

This article is not intended to be, nor should be considered to be, legal advice. If you have a legal question or other matter related to the any of the topics discussed in this article, I strongly urge you to contact our office at the number below or seek the counsel of another qualified and experienced adult entertainment attorney familiar with the legal matters discussed in this article.

 

1Gregory A. Piccionelli is an intellectual property attorney specializing in adult entertainment matters. He can be reached at Piccionelli & Sarno at (818) 201-3955 or greg@piccionellisarno.com.

 

 

 

 

 

 

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