THE DETAILS ABOUT EQUITY CROWDFUNDING
FIRST, THE BASICS
Crowdfunding is a way to get small amounts of money from a large number of people to fund a particular project. It’s been around for a few years in the form of small donations for arts and social projects, in return for token rewards such as t-shirts or dinner with the founders.
The CROWDFUND Act, signed by the President on April 5, 2012, as part of the JOBS Act, now allows crowdfunding to be used by for-profit enterprises – so a start-up that needs money to expand its business can now turn to everyday investors. The investors can receive equity (i.e. a “share” of ownership in the business) or bonds (i.e. providing a small loan to the business) depending on what the start-up chooses to offer. Large-scale crowdfunding was not previously permitted under federal securities regulations. In broad terms, selling an interest in your business is the sale of securities, and any offer or sale of securities has to be registered with the SEC (e.g. in an IPO) or tailored to fit one of the exemptions from registration, which are very narrow (and mainly for accredited investors, i.e. rich people).
The traditional pattern of financing for entrepreneurs starts with the entrepreneur maxing out her own credit card, then getting “friends and family” financing, before moving on to “angel” financing (having a rich person support your company in exchange for an interest in it), bank loans and money from venture capitalists (private funds that provide money and advice to startups in return for some ownership in the company). Crowdfunding expands the “friends and family” stage, and may offer some new funds from the other stages as well. Now, in addition to friends and family, everyday people unknown to the entrepreneur can invest small amounts in her enterprise and receive an equity (ownership) stake in the company in return.
Why would entrepreneurs want to give up even a small amount of the ownership of the company to people they don’t know, who probably can’t help them much with advice and experience the way angel and VC investors can? For some companies, it’s the only way to get the “seed capital” to develop their idea enough to get to the stage where angels and VCs will take notice of them. Other companies may be in areas of the country where it’s hard for start-ups to get noticed. And many entrepreneurs can be found in communities that have not been well-served by traditional banking and capital markets.
This is a revolutionary and exciting form of investing. However, it is also risky. Many startups don’t make it.
So why would anyone invest in crowdfunding? The worst reason would be because you think you are going to make a fortune. For a start, you can only invest a small amount of money through crowdfunding. Regular folks are limited to $2,000 a year. Even the richest among us can only invest $100,000. Even if you think you’ve identified the next Facebook, after further rounds of financing (and the “dilution” that entails) and the length of time it takes to get a company to the IPO stage, a crowdfunding investment isn’t going to change your life. The best reason to make a crowdfunding investment is because you love the idea the entrepreneur is presenting, or you’re a fan of the product, or you believe in the entrepreneur herself, and you want to give her a shot at making it. Indeed, the best reason for making a crowdfunding investment is to give someone else the chance to change their life.
For the basic flow of the most simple crowdfunding, please see the following chart. Scroll below the chart to dig deeper into the details of crowdfunding.
NOW FOR SOME DETAILS
Crowdfunding has been used to describe a number of methods that enterprises and collections of people may use to fund or support various initiatives. For startup companies looking to raise debt or equity from the sale of securities, crowdfunding refers to raising such funds, primarily over the Internet, in smaller amounts from a larger pool of investors though intermediaries.
On March 27, 2012, the House accepted the Senate version of the Jumpstart Our Business Startups Act (the “JOBS Act”) which provides for amendments to our securities laws to allow for crowdfunding activities. President Obama signed the JOBS Act into law on April 5, 2012. In order for crowdfunding to get underway, the SEC and other regulatory agencies will need to adopt certain rules and regulations implementing the new law. The law provides that these measures should be adopted within 270 days of signing by the President, and the SEC has already begun to collect comments from the public for this purpose.
This is exciting news for companies that are attempting to raise capital. Title III of the JOBS Act allows business enterprises to raise capital through crowdfunding initiatives. These companies can raise capital from individual investors by offering stock for sale through their third-party intermediaries. The JOBS Act adds a new Section 4(6) to the 33 Act, which provides a new exemption for the small business from registration for the offer and sale of securities in connection with crowdfunding transactions. The exemption would be available for offerings not greater than $1M in the aggregate during any twelve month period, subject to further limitation on a per investor basis. The amount sold to any particular investor during a twelve month period by all crowdfunding issuers may not exceed:
- (A) for investors with less than $100,000 in net worth or annual income, the greater of $2,000 or 5% of their annual income or net worth, and
- (B) for investors with greater than $100,000 in annual income or net worth, up to 10% of the investor’s annual income or net worth, not to exceed $100,000.
Securities issued pursuant to the new 4(6) exemption will be considered (1) “covered securities” which means that they will be exempt from state Blue-Sky registration and (2) “restricted securities,” subject to Rule 144 restrictions for public resales. The one-year restriction on resale described above would apply to private as well as public resales. Another benefit to small businesses – the crowdfunded investors will not count against the shareholder cap for triggering public reporting requirements with the SEC.
As described above, sales of securities under the new crowdfunding exemption must occur through third-party intermediaries. Who can serve as an intermediary? An intermediary must be a registered broker or funding portal (as defined in new Section 3(a)(80) of the 34 Act). It is not specified whether the intermediaries must be an electronic system or manual brokerage operation.
Regulations still need to be adopted regarding these intermediaries. Funding portals will be required to register with the SEC and an applicable self-regulatory organization, but are conditionally exempt from registration as a broker dealer. It is expected that FINRA will become the self-regulatory organization.
What will it cost? Restrictions regarding fees and how much an intermediary may charge an issuer or investor in connection with a transaction are not specified. However, the JOBS Act does provide that the intermediary and its directors, officers or partners cannot have a financial interest in an issuer using its services, which would presumably preclude taking stock for providing the service. Intermediaries also may not compensate promoters, finders, or lead generators for providing them with the personal identifying information of any potential investor. Other restrictions regarding disclosures, risk, cancellation and protection of privacy have been set in place for intermediaries and issuers to protect investors and reduce the risk of fraud with respect to such transactions. It is expected that these restrictions will be further clarified as the SEC adopts the needed regulations.
How does the JOBS Act compare against Rule 506 under Regulation D? Separate from the crowdfunding measures, the JOBS Act also requires that the SEC amend Rule 506 under Regulation D to permit general solicitation in 506 offerings in which sales are made only to accredited investors. It also provides for an exception from broker-dealer registration requirements for platforms or mechanisms that aim to facilitate offerings under Rule 506 of Regulation D. More specifically, a person (including a platform or other service provider and its associated persons) would not be obligated to register as a broker-dealer for engaging in any of the following:
- (A) permitting offers, sales, purchases, negotiations, general solicitations or similar activities in connection with a 506 offering,
- (B) co-investing in the 506 offering, or
- (C) providing ancillary services, such as due diligence and documentation, in connection with the 506 offering.
To be eligible for this exemption, however, the person and its associated persons:
- (A) may not receive any compensation in connection with a purchase or sale in the 506 offering,
- (B) may not have possession or control of customer funds or securities in connection with a purchase or sale in a 506 offering, and
- (C) may not be subject to statutory disqualification, as defined in the 34 Act.
Rule 506 may therefore serve as an alternative type of “crowdfunding” exemption for accredited investors without any of the limitations in related to the new Section 4(6) exemption for crowdfunding.
THE CROWDFUND ACT OF 2012 (TITLE III OF THE JOBS ACT) - EXPLAINED
New Crowdfunding Exemption 4(6)
The Act adds a new exemption from registration under the Securities Act of 1933, Section 4(6). The new exemption is subject to the following conditions:
- The aggregate amount sold to “all investors”, including any amount sold in reliance on the new exemption, may not exceed $1 million in any 12-month period. The language of the statute suggests that offerings made under other exemptions (Regulation D, for example) might count towards the $1 million limit, but discussions with Commission Staff suggest that the best view is currently that the limit applies solely to a crowdfunding round, and that amounts sold under other exemptions will not affect the limit.
- An investor is limited in the amount he or she may invest in the crowdfunding securities in any 12-month period:
- If either the annual income or the net worth of the investor is less than $100,000, the investor is limited to the greater of $2,000 or 5% of his or her annual income or net worth.
- If the annual income or net worth of the investor is $100,000 or more, the investor is limited to 10% of his or her annual income or net worth, to a maximum of $100,000.
- The transaction must be made through a broker, or through a “funding portal” (a new designation under the Securities Exchange Act of 1934) which meets the requirements set out below.
- The issuer must comply with the disclosure and other requirements set out below.
Requirements for Intermediaries
A person acting as an intermediary in a transaction involving the sales of securities for someone else pursuant to section 4(6) must:
- Register with the Commission as a broker or as a funding portal.
- Register with a self-regulatory organization or SRO (the only eligible SRO at present being FINRA).
- Provide Commission-mandated disclosures (including disclosures relating to risk) and investor education material.
- Ensure that investors review the education material, affirm that the investor understands the risk of loss, and answer questions demonstrating an understanding of the risks involved in investing in small businesses and the risks of illiquidity and other matters to be determined by the Commission.
- Take measures to reduce the risk of fraud as mandated by the Commission, including obtaining a background and securities enforcement regulatory history check on officers, directors and 20% equity holders of the issuer. The statute does not provide how the results of such checks are to be used or disclosed.
- Make the required issuer information (discussed below) available to investors and the Commission at least 21 days before any sales take place.
- Ensure that the issuer gets the offering proceeds only when it has reached the target offering amount, and let investors cancel their commitment to purchase securities in accordance with rules to be set by the Commission.
- Make such efforts as the Commission may determine to ensure that investors do not exceed the limits on investment set out above.
- Protect the privacy of information collected from investors.
- Not pay for finding potential investors.
Funding portals are exempt from having to register with the Commission as brokers, but the Commission will be adopting rules establishing conditions for that exemption.
Funding portals may not:
- Give investment advice or recommendations. (They may sort or “curate” issuers, and may offer their services only to certain types of issuers, but any selectivity with respect to issuers may be problematic.)
- Solicit offers or sales to buy the securities offered on its portal.
- Compensate anyone for such solicitation or based on the sale of securities on its portal.
- Hold or manage funds.
- Undertake other activities to be specified by the Commission.
The Commission will specify by rule the circumstances that will disqualify a broker or portal from offering securities under Section 4(6).
Requirements for Issuers
The issuer must be incorporated or organized under the laws of a US state. It may not be an “investment company” under the Investment Company Act of 1940, and cannot be an SEC-reporting company.
Issuers of crowdfunded securities must:
- Provide (the statute says “file” but as discussed below, liability follows private as opposed to public standards) the Commission and investors and the intermediary with:
- Name, legal status, web address and physical address.
- Names of officers, directors and 20% shareholders.
- Description of business and anticipated business plan.
- Description of financial condition AND:
- If raising $100,000 or less, tax returns and financial statements certified by principal executive officer.
- If raising $100-500,000, reviewed financial statements.
- If raising $500,000 or more, audited financial statements.
- Description of use intended use of proceeds of offering.
- Target offering amount, deadline to reach that amount, and regular updates regarding progress toward target.
- Price of securities or method to determine that price (with the ability for investor to rescind commitment to purchase after the price has been determined).
- Description of ownership and capital structure of the issuer, including:
- Terms of securities offered and each other class of securities of the issuer (and the differences between them), including how those terms might be limited, diluted or qualified by the rights of other classes of security.
- A description of how exercise of rights of controlling shareholders could affect the rights of crowdfunding shareholders.
- Identification of holdings of 20% security holders.
- How securities offered are valued and how they may be valued in the future, including during corporate actions.
- Risks of minority ownership, risks associated with future corporate actions, including additional issuances of shares , sale of issuer’s assets and related party transactions.
- Other information prescribed by the Commission.
- Not advertise the terms of the offering, except for notices which direct investors to the broker or funding portal (the Commission may give some guidance as to the nature of these notices).
- Not compensate anyone for promoting its offerings without disclosing that compensation.
- File annual reports of results of operations and financial statements in accordance with Commission rules.
- Comply with other Commission investor protection requirements.
The Commission will specify by rule the circumstances that will disqualify an issuer from offering securities under Section 4(6).
Issuer (and control persons including directors and principal officers) have 12(a)(2)-type liability. If the issuer makes an untrue statement of a material fact or omits to state a material fact necessary to make its statements, in light of the circumstances in which they were made, not misleading, and cannot sustain the burden of proof that it did not know, and in the exercise of reasonable care, could not have known, of such untruth or omission, it must reimburse the purchase price of securities plus interest.
The Commission will make the issuer information available to state regulatory authorities. The states are pre-empted from requiring registration of Section 4(6) offerings, but there is no restriction of their ability to take enforcement action with respect to fraud or deceit by issuers, brokers or funding portals. States may impose fees if they are the principal place of business of the issuer or if more than half the purchasers of a crowdfunding offering are in that state. A funding portal’s home state may regulate the portal, but cannot impose rules that are different or additional to what is required under the Act.
Securities sold under Section 4(6) can only be resold:
• To an “accredited investor”.
• In a registered offering of securities (such as an IPO).
• To a family member on death or divorce.
The Commission may adopt other restrictions and will likely clarify that these are “restricted” securities under the definition of Rule 144(a).
Crowdfunding securities and registration under the Exchange Act
Securities acquired in a Section 4(6) offering are not included in counting the number of shareholders that triggers the need to register a class of securities under the Exchange Act.