Crowdfunding – Now and Not Yet
On April 5, President Obama signed the JOBS Act, a package of changes to securities laws designed to make it easier for startup and emerging businesses to raise investment capital. In the ensuing weeks, the bill has been both lauded and criticized for its attempts to loosen the various restrictions that have made it difficult for entrepreneurs to obtain funding, while at the same time trying to maintain acceptable protections for investors.
Most of the changes in the JOBS Act are intended to benefit of privately held but well-established companies that are nearing a public offering. But Congress also included an exciting change for entrepreneurs and other small business owners that will allow securities to be sold to the public through crowdfunding.
New Crowdfunding Exemption – Ready, Set, Wait!
Although the crowdfunding provisions of the JOBS Act won’t be implemented until early next year, the prospect of easier access to capital markets has entrepreneurs and investors understandably optimistic about the possibilities. Crowdfunding itself is not a new idea, but so far companies have not been able to use it to offer and sell securities to the public because of strict federal and state regulations. Popular crowdfunding sites like Kickstarter, Indiegogo, Rockethub and Fundable provide a platform that tens of thousands of individuals and businesses have used to pitch their projects, products and ideas, but these platforms focus mainly on creative and humanitarian projects, with funders receiving special recognition, memorabilia, products or services in exchange for their contributions. However, a growing number of entrepreneurs are using crowdfunding sites to raise capital, offering perks like participation in product pre-sales rather than an ownership stake in their companies.
Crowdfunded offerings of securities are currently prohibited by the Securities Act of 1933, which requires that any offer or sale of securities be registered with the SEC unless an exemption from registration exists under the law. To avoid registration, issuers of securities have typically relied on a few narrow exemptions, most notably those found in section 4(2) of the 1933 Act and Rules 504, 505 and 506 of Regulation D. Each of these exemptions features strict restrictions and requirements which make raising funds difficult and costly. This difficulty is increased by the different state regulations, which do not always align with federal exemptions.
The biggest impediment to crowdfunding in the existing exemptions is the prohibition on offering securities to the public. This means that, under 4(2) or Rules 504, 505 or 506, an issuer is usually limited to accepting capital from “accredited investors” (wealthy individuals with an understanding of the private securities markets or institutional investors, like angels or venture capital groups) or from friends, family and other investors with whom the business owner already has a close relationship. Given these limitations, it is no surprise that many small business owners, rather than undertaking expensive private securities offerings, end up taking on credit card debt and bank loans to keep their businesses afloat.
The Crowdfunding bill creates a new exemption that allows privately-held U.S. companies to raise up to $1,000,000 per year through the sale of securities to the public through crowdfunded offerings. These offerings will typically involve a large number of investors each purchasing a small amount of the company’s securities. The crowdfunding exemption preempts state securities laws, though states will be allowed to require a notice filing for crowdfunded offerings.
Restrictions on Crowdfunding – Rules and More Rules
While this new exemption sounds like great news – and it is – small business owners are well-advised to proceed with caution. Congress provided a long list of restrictions and reporting and disclosure requirements, and issued a directive to the SEC to draft additional guidelines before crowdfunding gets the final green light. The following is a brief summary of some of the initial restrictions and requirements for crowdfunded offerings:
Investor Limits: Investors will be limited in the amounts they are able to invest in crowdfunded offerings in a given year. Investors with annual income or net worth under $100,000 will be able to invest up to $2,000 or 5% of their annual income or net worth, whichever is greater. Investors with annual income or net worth over $100,000 will be able to invest up to 10% of their annual income or net worth, up to a maximum of $100,000.
Funding Portal Requirements: Crowdfunded offerings will need to be done through intermediaries registered with the SEC (“funding portals”), who will be subject to various restrictions and requirements.
Funding portals will be required to:
- Provide disclosures mandated by the SEC;
- Ensure that each investor reviews investor-education information, understands the risks involved with crowdfunding investments, and answers questions relating to the risks;
- Take measures to reduce the risks of fraud, including obtaining background checks on each officer, director and 20% shareholder of a company issuing securities;
- Make information about the issuer available to the SEC and investors;
- Ensure that investor funds are not available to the issuing company until the minimum offering amount is reached, and allow investors to cancel their commitments prior to such time;
- Make efforts to ensure that investors do not exceed their investment limit in any year.
Funding portals will be prohibited from:
- Offering investment advice or recommendations regarding the securities listed on their sites;
- Soliciting purchases, sales or offers to buy the securities listed on their sites;
- Providing compensation based on the solicitation or sale of the securities listed on their sites;
- Allowing their directors or officers to own an interest in any companies whose securities are listed on their sites; or
- Holding, managing, possessing or handling investor funds or securities.
Issuer Disclosure Requirements: A Company issuing securities through crowdfunded offerings will need to disclose to the SEC and to investors:
- Its official name, legal status, physical address and website address;
- Names of officers and directors and each shareholder owning more than 20% of the company’s shares;
- A description of the company’s business and anticipated business plan;
- A description of the company’s financial condition, including its most recent income tax return and financial statements (certified by the principal executive officer if raising less than $100,000, reviewed by an independent CPA if raising between $100,000 and $500,000, and audited if raising more than $500,000);
- Purpose and intended use of proceeds;
- Target offering amount;
- Price to public (or method of determining price);
- Description of ownership and capital structure;
- Certain risk factors.
The company must make annual filings with the SEC and regularly provide financial statements and operations updates to investors. The terms of the offering may not be advertized, but the company direct investors to the funding portal. A company may not provide compensation for promoting the offering unless such compensation is disclosed as mandated by SEC.
Restricted securities: Shares issued in crowdfunded offerings will be restricted, meaning that they may not be transferred within the first year following their issuance unless they are transferred back to the issuing company, to an accredited investor, as part of a registered offering, or to a family member or in connection with a death or divorce.
While the SEC’s final rules and regulations won’t be published for several months, one can assume at this point that complexity will only increase. In addition, a self regulatory organization will be formed to regulate funding portals (think FINRA), which will have its own rules and regulations.
Potential Pitfalls Abound
While the new crowdfunding exemption offers a promising new method for small businesses to raise capital, business owners must be cautious before jumping in. Crowdfunding may significantly reduce the costs of accessing capital, but the risks for business owners are as serious as ever, with potentially greater consequences. For example, the new act does not limit the application of existing anti-fraud rules under federal and state law. Businesses and their principals will continue to face criminal and civil liability for false statements or omissions of material facts. If a company makes a material mistake in a crowdfunded offering, the scope of its potential liability could be significant, as the number of potential plaintiffs is exponentially larger than in a private offering.
Before undertaking a crowdfunded offering, a small business owner will need to be sure that the business is structured properly to issue new securities. For a businesses operating as an S corporation or limited liability company, it will likely be necessary to convert to a C corporation to handle a significantly larger number of owners.
The upfront and recurring disclosures that will be required in a crowdfunded offering may also be a significant burden to a small business, especially if audited financial statements are required. Increasing the number of shareholders from a few to several hundred, or even thousands, could have a stifling effect on management’s ability to run day-to-day operations and lead to crippling increases in accounting fees, legal fees and communication expenses.
Crowdfunded offerings, like offerings under the current exemptions, will be a highly regulated environment featuring strict requirements for disclosure, reporting and federal and state notice filings. There will also be strict restrictions on how securities may be advertized and sold to the public.
For all the above reasons, and many others, small business owners should consult with an experienced securities lawyer before undertaking a crowdfunded offering. An experienced lawyer will be able to assess and explain the potential benefits and drawbacks of an offering as well as ensure that the company’s corporate form and capital structure allow for an influx of new shareholders, assist in preparing the disclosure documents and SEC filings, and provide guidance when problems arise.
Crowdfunding is set to revolutionize the way startup and emerging businesses gain access to capital. Stay tuned in the coming months for more information on how to take advantage of this new fundraising framework.