- Jobs Act Opens Door to Crowdfunding
- June 4, 2012 | Authors: Nicholas V. Albu; Nicholas C. Conte; Michael J. Hertz; Kimberly M. Lacy; Russell T. Schundler
- Law Firms: Woods Rogers PLC - Roanoke Office ; Woods Rogers PLC - Richmond Office ; Woods Rogers PLC - Charlottesville Office
Crowdfunding will soon be available to startup companies and existing private businesses thanks to the Jumpstart Our Business Startups Act of 2012. Better known as the JOBS Act, this legislation created a new, limited exemption under the federal securities laws that allows domestic, non-public companies to raise up to $1,000,000 in any 12-month period by receiving small investments from a large pool of investors. Though the final implementation of this new exemption will not be known until the Securities and Exchange Commission (“SEC”) adopts its final regulations, the key provisions of this new crowdfunding exemption are provided in the JOBS Act and could have a significant impact on the way small businesses raise funds going forward. However, a variety of legal requirements associated with the crowdfunding exemption and continuing legal requirements under state law are likely to make crowdfunding a very costly means of capital raising for most start up companies at present.
As background, “crowdfunding” relies on the presumption that a group of people will, on average, make better decisions than any single individual. Under this theory, if a web-based platform listed a large number of business ideas and allowed a wide cross-section of people to make small investments in those ideas that they thought would be the most successful, the wisdom of the crowd would, on average, direct more funding to the better ideas on the list. Thus, the theory goes, good ideas receive the funding they need and bad ideas do not.
Whether this theory is correct in practice is beyond the scope of this article. However, the mere fact that crowdfunding will now be possible represents a significant change in the federal securities law regime. To date, the crowdfunding model has been incompatible with federal and state securities laws. Under present law, companies are generally prohibited from publicly offering securities and issuing securities to a large number of investors (and, in particular, small unaccredited investors) unless the company first files a registration statement with the SEC and publicly offers its securities - a process that is cost-prohibitive to most start up companies.
Under the new crowdfunding exemption, these two limitations are relaxed so long as certain conditions are met. Thus, under the crowdfunding exemption, a company may now raise funds publicly by selling its securities to anyone, regardless of whether such investor is “accredited” or had a pre-existing relationship with the company. As might be expected, though, this new exemption comes with some limitations.
First, the amount of funds that a company may receive from any one investor is small (for investors with less than $100,000 in net worth or annual income, the limit is $2,000 or 5% of their annual income or net worth, whichever is greater, and for investors with $100,000 or more in net worth or annual income, the limit is 10% of their annual income or net worth, not to exceed $100,000). Also, these investment limits are aggregated amongst all offerings under Section 4(6) of the Securities Act of 1933. Thus, an investor with $1,000,000 in net worth who invests $100,000 in one company pursuant to a crowdfunding offering may not participate in any other crowdfunding offerings for a full 12-month period.
Second, as noted above, a company may not raise more than $1,000,000 through crowdfunding in any given year. It is not yet clear how this limitation will be integrated with other types of securities offerings and whether a company that conducts a crowdfunding offering could, within the same 12-month period, also conduct another, larger offering under another securities law exemption. Depending on how the SEC’s final rules address this issue, crowdfunding could have the effect of limiting a company’s access to capital after the crowdfunding offering has been completed.
Third, crowdfunded offerings must be conducted through an intermediary - either a broker or a funding portal that is registered with the SEC. The role of the intermediary is to reduce the likelihood of fraudulent offerings. As a result, the intermediary plays a gatekeeping role and is required to collect and transmit information about the offering company. Also, given the role the intermediaries will be required to play, one might expect their rates to be material as compared to the total size of an average crowdfunding offering.
Fourth, an issuer in a crowdfunding offering must file certain information with the SEC and provide it to the intermediary and potential investors. The type of information depends on the size of the contemplated offering. However, the costs associated with preparing the information are likely to be substantial.
Finally, even after the offering is complete, a company must comply with a laundry list of other restrictions and requirements. For instance, the company must provide the SEC with ongoing reports and filings, including an annual report that includes its financial statements and a description of its results of operation. Also, a company that uses a crowdfunding offering will need to consider the ongoing expenses associated with managing a large shareholder base. Unlike a normal startup that has a small group of founders and initial investors, a crowdfunded company could have hundreds or even thousands of shareholders, all of whom would have certain state law rights as owners of the company.
In sum, there is no question that the new crowdfunding exemption provides small businesses and startups with unprecedented access to capital and allows small investors, previously excluded by the securities laws from making investments in small start up companies, to invest their money in companies they believe in. At the same time, the burdens associated with undertaking such an offering - including both the upfront costs of the offering and ongoing expenses to manage securities law and corporate law obligations - may reduce interest in this form of offering as it compares to the more traditional types of offerings under the exemptions that pre-date the JOBS Act.