REGULATION CROWDFUNDING:
The SEC’s Attempt to Assist Small Business Owners Who Have an Internet Connection and a Need for $1 Million
A new tool to raise capital is now available for small business and startup owners who may have previously believed that raising funds through selling an interest in their business to be too cumbersome or expensive. The Jumpstart Our Business Startups Act (the “JOBS Act”), enacted on April 5, 2012, established a regulatory structure for startups and small businesses to raise capital through securities offerings using crowdfunding over the Internet. On October 30, 2015, the Securities Exchange Commission (the “Commission”) released the final rules pertaining to these crowdfunding securities transactions (“Regulation Crowdfunding”). This advisory reviews how Regulation Crowdfunding, among other things, permits individuals to invest in securities-based crowdfunding transactions subject to certain thresholds, limits the amount of money a business can raise under the crowdfunding exemption, requires businesses to disclose certain information about their offers, and creates a regulatory framework for the intermediaries that facilitate the crowdfunding transactions.
The JOBS Act and corresponding rules are an attempt to, among other things, alleviate two general problems associated with offering securities in a crowdfunding format. First, such a profit or revenue-sharing model – sometimes referred to as the “equity model” of crowdfunding – could trigger the application of the federal securities laws because it likely would involve the offer and sale of a security. Under the Securities Act of 1933 (“Securities Act”), the offer and sale of securities is required to be registered unless an exemption is available. Second, someone who operates a website to effect the purchase and sale of securities for the account of others generally would, under pre-existing regulations, be required to register with the Commission as a broker-dealer and comply with the laws and regulations applicable to broker-dealers. To a business owner, this translates into more time and higher costs in raising much needed capital.
In response to these concerns, Title III of the JOBS Act (“Title III”) added new Securities Act Section 4(a)(6), which provides an exemption from the registration requirements of Securities Act Section 5 for certain crowdfunding transactions. Additionally, Title III added Section 3(h) to the Securities Exchange Act of 1934 (“Exchange Act”), which requires the Commission to adopt rules to exempt, either conditionally or unconditionally, “funding portals” from having to register as a broker-dealer pursuant to Exchange Act Section 15(a)(1). Regulation Crowdfunding now provides detail to the requirements and operation of this new crowdfunding offering scheme.
How the Crowdfunding Mechanism Works
A business wishing to raise capital by selling securities (i.e., selling equity or ownership shares of the business) through crowdfunding will be required to file certain disclosures to the Commission, including an offering statement. The business will find an “intermediary” to conduct the offering of securities over the Internet by using software that the intermediary has developed, referred to as a “platform.” The intermediary must either be a registered broker-dealer or a registered “funding portal.” Before the offering, the business will set a target offering amount of capital to be raised and a date to meet that target. The business may choose (but is not required) to continue raising capital after the target amount has been met, so long as it is done before the target date. During the offering period, the intermediary will take monetary commitments from investors through the Internet-based platform until the earlier of the target date, or when the target amount is met (but the business may decide before the offering to continue taking commitments over the target amount up to the target date). If the target amount is not met before the target date, then the investor commitments will be cancelled by the intermediary and returned to the investors. If the offering is successful, the intermediary will transfer the raised capital to the business and the investors will own equity in the business. Subsequent to a successful crowdfunded offering, the business will have certain ongoing reporting requirements to the Commission and investors.
General Limitations on the Use of Crowdfunded Offerings
Not all businesses will be eligible to utilize crowdfunding as a mechanism for selling securities. Ineligible businesses include non-U.S. businesses, Exchange Act reporting companies, certain investment companies, businesses that are subject to disqualification under Regulation Crowdfunding, businesses that have failed to comply with the annual reporting requirements under Regulation Crowdfunding during the two years immediately preceding the filing of the offering statement, and businesses that have no specific business plan or have indicated that their business plan is to engage in a merger or acquisition with an unidentified company or companies.
The new rules limit crowdfunded offerings by allowing a business to raise only a maximum aggregate amount of $1 million through crowdfunded offerings in a 12-month period, and by forbidding a business from offering aggregate amounts exceeding $100,000 to any one investor during a 12-month period.1 In addition, the rules limit individual investors from investing more than the following aggregate amounts in all crowdfunded offerings over a 12-month period, which may be calculated jointly with the person’s spouse:
- If the individual investor’s annual income or net worth is less than $100,000, then the investor may invest only the greater of $2,000, or 5% of the lesser of their annual income or net worth.
- If both the individual investor’s annual income and net worth are equal to or more than $100,000, then the investor may invest only 10% of the lesser of their annual income or net worth.
Once securities are issued through the crowdfunding mechanism, they may not be transferred by any purchaser for one year, unless such securities are transferred: (i) back to the business; (ii) to an “accredited investor”; (iii) as part of an offering registered with the Commission; or (iv) to a “member of the family of the purchaser or the equivalent,” including to a trust controlled by the purchaser, to a trust created for the benefit of a member of the family of the purchaser or the equivalent, or in connection with the death or divorce of the purchaser or other similar circumstance.
Requirements for Businesses that Use Crowdfunding
Although the JOBS Act intended to relieve many of the burdens normally imposed on businesses choosing to sell securities to the public, there are obligations under Regulation Crowdfunding that still must be considered before a business chooses to utilize the crowdfunding mechanism. The final rules require businesses to file certain disclosures with the Commission and to provide the same information to investors and the relevant intermediary facilitating the crowdfunded offering.
One of the most significant disclosure requirements that a business must make prior to offering crowdfunded securities is the requirement to provide financial statements of the business, generally dating back to cover the two most recently completed fiscal years. Depending on the amount of capital the business raises (or intends to raise), the financial statements may need to be reviewed by an accountant or audited by an independent auditor, adding extra costs for the business in its attempt to raise capital.
The rules provide that the financial statements must be (i) accompanied by information from the company’s tax returns if the amount offered and sold during a 12-month period is $100,000 or less; (ii) reviewed by an independent public accountant if the amount offered and sold during a 12-month period is more than $100,000 but no more than $500,000; or (iii) audited by an independent auditor if the amount offered or sold during a 12-month period is more than $500,000. However, a business offering more than $500,000 but not more than $1 million of securities relying on these rules for the first time would be permitted to provide reviewed rather than audited financial statements, unless financial statements of the company are available that have been audited by an independent auditor.
Other disclosures that a business is required to make prior to an initial or follow-up offering include:
- The price to the public of the securities or the method for determining the price, the target offering amount, the deadline to reach the target offering amount, and whether the business will accept investments in excess of the target offering amount;
- Information about officers, directors, and owners of 20% or more of the business;
- Descriptions of the business’s ownership, capital structure, business, and business plan;
- A discussion of material factors that make investment in the business speculative or risky;
- A description of the intended use of proceeds from the offering;
- A description and material terms of any indebtedness;
- A description of certain related-party transactions;
- A discussion of the business’s financial condition covering each period for which financial statements of the issuer are provided; and
- Several other required disclosures.
Additionally, a business that has raised capital through crowdfunding has certain ongoing reporting requirements. For example, the business is required to disclose to investors and the Commission when the business reaches 50% and 100% of its target offering amount. This can be done through the filing of a form and sending notice, or by having the information publicly available on the intermediary’s platform.
Also, the business must continually file with the Commission and post on the business’s website its annual reports along with its financial statements until one of the following occurs:
- The business is required to file reports under Section 13(a) or 15(d) of the Exchange Act;
- The business has filed, since its most recent sale of crowdfunded securities, at least one annual report and the business has fewer than 300 holders of record;
- The business has filed, since its most recent sale of crowdfunded securities, the annual reports for at least the three most recent years and the business has total assets that do not exceed $10,000,000;
- The business or another party repurchases all of the securities issued through the crowdfunding mechanism, including any payment in full of debt securities or any complete redemption of redeemable securities; or
- The business liquidates or dissolves.
Advertising a Business’s Crowdfunded Offering
Regulation Crowdfunding provides that there may be no advertising of the terms of an offering unless it is in a notice. Such notice may advertise terms of an offering so long as it directs investors to the intermediary’s platform, and may include no more than a statement that the business is making an offering, the name of the intermediary through which the offering is being made, the terms of the offering, and basic factual information about the legal identity and location of the business. Nonetheless, businesses may still communicate with investors about the terms of the offer through communication channels provided by the intermediary on the intermediary’s platform. Also, businesses will be permitted to compensate promoters who may promote the business’s offerings through those intermediary communication channels.
Requirements for Intermediaries of Crowdfunded Offerings
Under Regulation Crowdfunding, intermediaries can either be registered broker-dealers or operators of funding portals that direct investors to transmit payment to a specific registered broker or bank to hold funds or securities on their behalf or in escrow.
While operators of funding portals are more limited in the actions they can take (as discussed in the next section), all intermediaries are required to take certain measures to reduce the risk of fraud. First, intermediaries must have a reasonable basis for believing that an offering business is in compliance with Regulation Crowdfunding and that the business has an established means to keep accurate records of securities holders. Second, intermediaries are required to conduct a background check and a securities enforcement regulatory history check on each business issuing securities, and on each officer, director, and beneficial owner of 20% or more of that business. Third, intermediaries must provide investors with certain educational materials and provide them information about the compensation the intermediary receives. Finally, intermediaries may accept an investment commitment from an investor only after that investor has opened an account.
Regulation Crowdfunding attempts to ensure the fairness of transactions and the protection of investors. This is accomplished by requiring the intermediaries to make certain information disclosed by the business available to the public at large (even to those without an account) on its platform throughout the offering period and for a minimum of 21 days before any security is sold in the offering. Also, subject to certain guidelines, the intermediaries must provide communication channels on the intermediary’s platform by which persons can communicate with one another and with representatives of the business about offerings.
Additionally, the intermediary must have a reasonable basis for believing an investor is in compliance with the investment limitations, has reviewed the educational materials, and understands that the entire amount of his or her investment may be lost. This is accomplished by obtaining certain representations from the investor and requiring the investor to complete a questionnaire that explains the risks of the proposed transaction.
Finally, certain rights are granted to investors that are designed to provide comprehensive investor protection. For example, generally, an investor may cancel an investment commitment for any reason until 48 hours prior to the deadline identified in the issuer’s offering material. Also, an intermediary may not compensate any person for providing the intermediary with the personally identifiable information of any investor or potential investor.
Regulation of Funding Portals
Regulation Crowdfunding contains certain rules that are specific to registered funding portals that make their permitted activities more limited than that of a registered broker-dealer. The rules prohibit funding portals from, among other things: (i) offering investment advice or making recommendations; (ii) soliciting purchases, sales, or offers to buy securities; (iii) compensating promoters and other persons for solicitations or based on the sale of securities; and (iv) holding, managing, possessing, or otherwise handling investor funds or securities.
Despite these restrictions on funding portals, Regulation Crowdfunding expressly permits certain activities in which funding portals may engage—each a “safe harbor.” The safe harbor activities include:
- Determining whether and under what terms to allow a business to offer and sell crowdfunded securities through its platform;
- Advising a business about the structure or content of the business’s offering, including assisting the business in preparing offering documentation;
- Applying objective criteria to highlight offerings on the funding portal’s platform;
- Subject to certain restrictions, providing communication channels on the intermediary’s platform by which investors can communicate with one another and with representatives of the business;
- Compensating a third party for referring a person to the funding portal, subject to certain requirements;
- Subject to certain restrictions, advertising the existence of the funding portal and identifying one or more businesses or offerings available on the portal on the basis of objective criteria;
- Directing investors where to transmit funds or remit payment in connection with the purchase of crowdfunding securities; and
- Several other related activities.
What’s Next?
After waiting three years for the final rules to be released, the new rules will become effective 180 days after they are published in the Federal Register. In the meantime, small businesses and startups should begin to consider whether raising a limited amount of capital through crowdfunded offerings makes sense for them.
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1For calculating aggregate amounts offered and sold and determining whether a business has previously sold securities, the Commission will include all entities controlled by or under common control with the business and any predecessors of the business.
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