New Crowdfunding Rules: Good for Small Companies But at What Cost?
The Securities and Exchange Commission (the “SEC”) recently adopted final rules under the JOBS Act of 2012 that will permit crowdfunded offerings. The final rules known as “Regulation Crowdfunding” become effective on May 16, 2016, and will allow companies to use the Internet to raise capital by selling securities.
This three-part article will discuss these new crowdfunding rules and how they will impact companies (the issuers) and investors.
Description of Crowdfunding
Crowdfunding refers to a financing method that allows small businesses and startups to raise capital by soliciting small, individual investments from a large number of people, bypassing traditional financing methods, like private equity, banks or angel investors.
People have used crowdfunding sites like Kickstarter, GoFundMe or IndieGoGo to finance all manner of ventures, from feature films to mobile apps to potato salad recipes (true), raising funding through donations, lending, rewards or pre-purchased goods.
Regulation Crowdfunding Highlights
With the passage of the Jumpstart Our Business Startups Act of 2012 (the “JOBS Act”) securities-based crowdfunding was born.
Regulation Crowdfunding – Companies
Starting on May 16, 2016, companies can use Regulation Crowdfunding to offer and sell securities to the general public. For issuers, Regulation Crowdfunding was designed to help businesses raise capital by making low-dollar offerings of securities less costly.
Companies can raise up to $1 million in any 12-month period using registered broker dealers or SEC-registered portals from an unlimited number of unaccredited investors. Only funds raised via the crowdfunding exemption will count towards the $1 million limit. An issuer can conduct an offering using another SEC exemption provided the issuer complies with the respective rules applicable to each offering.
An issuer engaging in a crowdfunded offering must complete and file Form C, a newly created form which requires the disclosure of business and financial information, including financial statements prepared in accordance with GAAP. Companies using a crowdfunded offering, however, are not required to file a “blue sky” registration at the state level.
Regulation Crowdfunding – Investors
Regulation Crowdfunding will allow investors to receive a financial return through the purchase of equity, debt or revenue-based securities. These new crowdfunding rules seek to reach a delicate balance: they allow “ordinary” people (unaccredited investors) to invest in private deals usually reserved for the very wealthy, while at the same time putting requirements in place that seek to protect them from the inherent risks of these types of deals.
Unlike other securities offering exemptions, there are no restrictions on the number of unaccredited investors who may participate in a crowdfunded offering. The new crowdfunding rules, however, contain several provisions intended to protect unaccredited investors who participate in these offerings, including investment limits, required use of regulated intermediaries, and required disclosures by the issuing companies.
Conducting a Crowdfunded Offering
Individual Investment Limits
Since anyone can invest in crowdfunded offerings, the SEC placed limits on how much an individual can invest in any 12-month period. The limits on how much an investor can invest depends on her net worth and annual income.
Low Net-Worth Investor: If either the investor’s income or net worth is LESS THAN $100,000, then he may invest the greater of $2,000 OR 5% of the lesser of his net worth or annual income.
EXAMPLE: If Scott has an annual income of $100,000 and a net worth of $50,000, then Scott is only allowed to invest $2,500 which is 5% of his net worth.
High Net-Worth Investor: If both the investor’s income and net worth are equal to or GREATER THAN $100,000, then she may invest up to 10% of the lesser of her net worth or annual income, but not to exceed $100,000.
EXAMPLE: If Susan has an annual income of $150,000 and a net worth of $200,000, then she can invest up to 10% of her annual income or $15,000.
Here are more examples:
|Annual Income||Net Worth||Calculation||12-Month Investing Limit|
|$35,000||$150,000||Greater of $2,000 or 5% of $35,000 ($1,750)||$2,000|
|$100,000||$50,000||Greater of $2,000 or 5% of $50,000 ($2,500)||$2,500|
|$150,000||$200,000||10% of $150,000 ($15,000)||$15,000|
|$1.1 million||$2.5 million||10% of $1.1 million ($110,000), subject to cap.||$100,000|
Companies seeking to raise funds via crowdfunding may not offer investments directly to consumers. They must use an intermediary, a broker-dealer (through an online platform) or funding portal. To participate in these investment opportunities, investors must open an account with an intermediary before buying securities.
The crowdfunding intermediaries must be registered with the SEC via a new form (Form Funding Portal) and be a member of FINRA (Financial Industry Regulatory Authority). With rules that mandate the use of funding portals to facilitate Internet-based transactions, Regulation Crowdfunding seeks to reduce the costs of the offerings and boost efficiency.
The funding portals will be the intermediary through which all crowdfunding offerings will be conducted, and will need to comply with the following requirements:
- Provide investors with educational materials on how to use the platform.
- Provide investors with information about the securities being offered, including resale restrictions, investment limitations, etc., and relevant information about the issuer.
- Provide communication channels on the portal through which investors may engage in discussions about the offering.
- Explain the source, form and amount of compensation the intermediary receives for hosting the transactions.
- Take adequate measures to reduce fraud, including having a reasonable basis for believing an issuer is complying with Regulation Crowdfunding, that the issuer is maintaining accurate records of its securityholders, and that investors are in compliance with the investment limitations.
- Provide adequate notices and confirmations at each step of the investment process.
- Comply with requirements regarding completion, cancellation or re-confirmation of offerings requirements.
In addition to the requirements, intermediaries are prohibited from holding a financial interest in companies offering securities on its platform, receiving a financial interest in companies as compensation for services provided in connection with the offering (subject to certain exceptions), or offering investment advice or making purchase recommendations to potential investors. However, despite the numerous requirements, if intermediaries follow the guidelines and remain in compliance, they can be assured that they are in compliance with Regulation Crowdfunding.
Funding Platform Fees
Given the number of requirements that crowdfunding platforms must adhere to and the costs associated with them, intermediaries will offer their services to issuers for a fee. It remains to be seen how significant these expenses will be for issuers.
There are a number of companies that serve as intermediaries between issuers and accredited investors. Thus, the fee structure for Regulation Crowdfunding will likely be similar for these new crowdfunding portals that give companies access to a large number of unaccredited investors.
Part 2 of this Article will discuss other relevant topics, including issuer requirements and limitations on the resale of crowdfunded securities.
For more information on equity crowdfunding and the new rules, please do not hesitate to contact us.
This article was also featured in Legal Ink Magazine.