Colorado this week becomes the newest state to allow start-up businesses and entrepreneurs an opportunity to “crowdfund” for in-state investors.

With new rules put in place, the state’s Division of Securities also hopes to avoid some of the problems that intrastate equity crowdfunding has run into elsewhere.

Crowdfunding, which has been around for about 15 years, is a way for an entrepreneur or business to raise funds by soliciting contributions, usually over the Internet.

There are two types: rewards-based crowdfunding, where a donor might get something of value in return but not stock or equity in the business. Among the best-known crowdfunding sources are Kickstarter, GoFundMe and Indiegogo. Musicians and filmmakers have used rewards-based crowdfunding to raise money for various projects — among the best known is the effort by actress Kristen Bell to crowdfund a movie based on her Veronica Mars TV series.

Equity-based crowdfunding, however, provides a donor with stock or equity in a project, and is the subject of House Bill 15-1246 and of federal legislation passed in 2012.

During the 2015 legislative session, the Colorado General Assembly nearly unanimously passed crowdfunding legislation. House Bill 15-1246 was co-sponsored by House Speaker Pro Tem Dan Pabon, D-Denver and Rep. Pete Lee, D-Colorado Springs, with sponsorship in the Senate by Senate Majority Leader Mark Scheffel, R-Parker and Sen. Owen Hill, R-Colorado Springs. Gov. John Hickenlooper signed it in April.

The bill follows action taken by Congress several years ago and a rewards-based crowdfunding project that succeeded beyond its wildest dreams.

The rush to establish equity-based crowdfunding heated up in 2012, after Oculus Rift, a company that makes virtual-reality devices, raised more than $2 million on Kickstarter. The company was then sold to Facebook for $2 billion. According to a 2014 article in Salon, had the investors gotten company stock instead of T-shirts, their return on investment would have been close to 1,000 percent.

Congress in 2012 passed the Jumpstart Our Business Startups Act, with a provision allowing states to pass their own equity crowdfunding laws, requiring that businesses and investors reside within the state. Colorado’s congressional delegation was on board with the JOBS Act, co-sponsored by Democratic Reps. Ed Perlmutter and Jared Polis and Republican Scott Tipton. Sen. Michael Bennet, a Democrat, was a Senate co-sponsor.

The law required the Securities and Exchange Commission to put in place rules for interstate equity crowdfunding within nine months, but the rules haven’t been finalized more than two years after the legislation’s deadline. SEC Commissioner Mary Jo White said last month she expects them to be in place by the end of the year.

But states haven’t been willing to wait. At least 20 have already passed laws or rules allowing for intrastate equity crowdfunding.

The state Commissioner of Securities released Colorado’s rules last week, and the law went into effect on Wednesday.

According to the rules, the process starts with registering an offering with the Division of Securities, part of the Department of Regulatory Agencies. Transactions must be conducted by “online intermediaries,” who don’t have to be licensed by the division. Division spokesman Jillian Sarmo told The Colorado Statesman this week state regulators believe the rules include sufficient safeguards to protect consumers.

Under the Colorado law, a start-up business or entrepreneur can raise up to $1 million with the potential to increase that to $2 million if a business submits audited financial statements to the division. Investments are limited to $5,000 per person, although other states have allowed up to $10,000. Securities Commissioner Gerald Rome said in March he thought $5,000 was an appropriate amount. “When you make investments, you need a balanced portfolio,” he told the House Business Affairs Committee. This type of investment may appeal to investors with annual incomes of $50,000 or $60,000, he said. “Our thought was no more than 10 percent (of an investor’s annual income).”

There’s another type of investor who can put in more than $5,000, under both federal securities laws and the Colorado law: an accredited investor, whose net worth tops $1 million or who has an annual income of more than $200,000. Investors in that category don’t face limits on how much they can sink into a business.

The most important element of Colorado’s equity crowdfunding rules is location, location, location. All parts of a transaction must take place within the state. An investor must be a Colorado resident and the business or entrepreneur must also be located in Colorado. It isn’t enough that a company could have a registered agent in the state, according to Rome’s testimony in March. In addition, 80 percent of the proceeds raised through an offering must be spent in Colorado.

According to the legislation’s fiscal note, the division expects no more than three to five filings per year. Sarmo said that, while there is great interest — both from companies seeking investors and from intermediaries — the low expectation is based on numbers from other states. Given that Colorado entrepreneurs and small businesses don’t have experience with these kinds of offerings, it could take time for everyone to get up to speed, she said.

“When a posting goes up for an offering on the Internet, the intermediary will be required to explicitly state the offering is only available to state residents,” Sarmo told The Statesman. In addition, before any documents related to that offering can be viewed by a potential investor, the investor will have to confirm that he or she is a Colorado resident.

The division expects to complete work on each offering within a 30-to 60-day window, Rome said in testimony on the bill.

Eli Regalado, CEO of Denver-based Mad Hatter Agency, made a case for allowing equity crowdfunding in Colorado. He told the committee his company has helped raise more than $1 million in rewards-based crowdfunding in the last two years but noted that type of crowdfunding works well only if “you have something tangible.” If it’s software or an app, the population at large doesn’t understand it, he contended.

For a new company, that means the owner is stuck looking for large investors or an “angel investor,” someone who provides substantial capital to a start-up business.

Equity crowdfunding will provide the first round of capital for a start-up, Regalado said. Once that’s in place, the company can start a second round with more traditional investors.

Chris Votoupal of the Clean Tech Industries Association echoed the point. “Access to capital is the most critical issue for these clean tech sector companies, and the most difficult to obtain,” he told the business committee.

The range of businesses that could use intrastate crowdfunding is unlimited, according to Michael Pieciak, the corporate finance chair for the North American Securities Administrators Association. In June, Pieciak identified dozens of small businesses that could take advantage of equity crowdfunding, ranging from exercise studios and farms to medical device companies and defense contractors.

But securities experts warn that equity-based crowdfunding will do little more than separate investors from their money. In the 2014 Salon article, Southwestern Law School Professor Michael Dorff said the concept was appealing — “Kickstarter, but with stock” — but he also called it a disaster waiting to happen.

Crowdfunding investors aren’t the same as angel investors, he said. Angel investors do their homework — they invest in companies and industries they know well, and even then those investments often fall through, he said. Angel investors only make a profit on about 10 percent of their investments, offsetting other losses.

“It’s definitely an experiment,” Sarmo said this week. “But as far as Colorado rule-making goes, our rules are more detailed, and we’ve had the benefit of seeing how it took place in other state. … We have great confidence that the right things are in place.”

— info@coloradostatesman.com