|November 20, 2013|
Previously published on November 2013
Crowdfunding. Crowdfunding is a financing method used primarily by startups and small businesses to raise small amounts of capital from a large number of people over the internet. Crowdfunding websites currently avoid the securities laws since they do not sell stock or other securities. For example, Kickstarter, a popular crowdfunding website provides “investors” a reward, like a free t-shirt, rather than stock in the business. Kickstarter generally charges a 5% fee on the capital raised plus an additional 3% - 5% fee for payment processing.
Congressional Action. The JOBS Act of April 2012 required the SEC to adopt regulations so that startup companies and other small businesses would have a new way to raise capital from ordinary investors without the costs of a full SEC registration.
SEC Action. The SEC proposed crowdfunding regulations in a 585 page release in October 2013. The release includes detailed provisions for the retail sale of limited amounts of securities without SEC registration. The SEC regulations also expanded current rules with respect to sales to accredited investors by allowing advertising and general solicitation. The retail crowdfunding part of the rules applies to all 300 million potential investors in the United States, while the expanded provisions for sales to accredited investors applies to the approximately 8.7 million accredited investors in the United States. Accredited investors are persons who generally have $300,000 of annual joint income or a $1 million net worth.
Likely Effect. The detailed requirements for retail crowdfunding are set forth below. Given the onerous nature of these requirements, many observers doubt that a vibrant market will develop for retail crowdfunding. However, a small company seeking to raise funds by means of a general solicitation has a much simpler route under the expanded rules applicable to accredited investors.
Crowdfunding Through Retail Sales
The detailed requirements for retail crowdfunding sales are summarized below.
Offering Cap. The total amount sold to all investors, including amounts sold in reliance on the crowdfunding provisions, during a 12-month period may not exceed $1 million.
Investor Eligibility. The total amount sold to any single investor in any 12-month period is limited. If the annual income or net worth of the investor is below $100,000, the limit is 5% of the annual income or net worth. If the annual income or net worth of the investor is $100,000 or more, the limit is 10% of the annual income or net worth, but not in excess of $100,000. The funding portal, described below, has certain obligations to verify the qualification of the investors.
Business Disclosures. Disclosure must be made to potential investors of various business factors, similar to what is generally found in an offering prospectus. These include a description of the business, the use of proceeds, risk factors, related party transactions, balance sheet descriptions and business plan information.
Financial Disclosures. Financial statements for the most recently-completed fiscal year must be provided. For offerings between $100,000 and $500,000, the financial statements must be reviewed by an independent public accountant. For offerings of more than $500,000, the financial statements must be audited by an independent public accountant.
SEC Filings. The information provided to investors must be filed with the SEC on a Form C. An annual update of the information must be filed with the SEC on Form C.
Required Funding Portal. A company raising capital pursuant to the crowdfunding regulations must use a registered funding portal as an intermediary. The funding portal can be a registered broker or a new registered funding portal entity. The broker or funding portal must be registered with the SEC pursuant to relaxed registration requirements and has certain obligations to verify the issuer’s compliance with the crowdfunding regulations.
Resale Restrictions. Resale of crowdfunding securities would be restricted for one year following the initial sale. During the one-year period, resales could only be made to the issuer, to an accredited investor, or to a family member of the purchaser.
Marketing Restrictions. The funding portal website would contain the general solicitation and advertising information. Issuers are prohibited from any advertising other than notices which direct investors to the funding portal.
Liability Exposure. Crowdfunding sellers have securities law liability for material misstatements or material omissions in the documents provided to investors. Under the proposed SEC regulations, these liabilities are based on negligence, as opposed to the general antifraud securities liabilities which require scienter.
Costs. Compliance with the crowdfunding regulations will require the use of lawyers, accountants and experts at the funding portal level. The SEC, in its proposing release, estimated the costs for a $1 million crowdfunding offering at $152,000.
Sales to Accredited Investors With General Solicitation
The expansion of the accredited investor sales provisions to allow general advertising and marketing provides a quicker and less costly method for a startup to raise capital, assuming the capital can be raised solely from accredited investors. There are various websites available, such as AngelList, which provides access to accredited investors.
Advantages. Sales to accredited investors have advantages over retail crowdfunding sales. There is no offering cap, no investor eligibility requirements (other than accredited investor status), no mandated disclosure requirements (either business information or financial information), no SEC filings, and no requirement to use a funding portal. There is no limit on the amount any person can invest. Notwithstanding the absence of any mandated disclosure requirements, most accredited investors will likely require some type of disclosure document with business and financial information. The liability standard for sales to accredited investors is based on the antifraud requirements, which involve both scienter and reliance. Issuers offering solely to accredited investors can generally solicit and advertise without any content restrictions.
Disadvantages. The universe of accredited investors is much smaller than the number of potential retail investors. Access to accredited investors may be more difficult than access to retail investors. The issuer must obtain verification of accredited investor status, which could include obtaining a copy of the investor’s W-2 or obtaining a certificate from the investor’s accountant as to the investor’s income or net worth. Some investors may not be willing to provide such information.
The SEC crowdfunding regulations are a proposal. No crowdfunding sales can be made until the regulations are final. The proposed regulations have drawn a great deal of flack for not accomplishing the congressional mandate to make retail crowdfunding sales easier and less costly. Unless the final regulations lessen these burdens, startups may prefer to use the enhanced provisions allowing general solicitation of accredited investors.