Soon startups will be able to use crowdfunding platforms to sell an equity stake in their business to investors in exchange for working capital. However, as explained below, this new capital pathway may be of limited utility due to its dollar thresholds and the additional burdens it places on the issuer and the investor.

Background

On October 30, 2015, the Securities and Exchange Commission (“SEC”)—the federal agency tasked with overseeing the buying and selling of financial instruments like stocks and bonds—adopted final rules allowing privately held businesses, including most startups and small businesses, to sell shares of a company to investors through online crowdfunding platforms. These new rules are currently open for public comment and will likely take effect in the first quarter of 2016. A copy of the proposed rules—including a copy of required form filed with the SEC in connection with a crowdfunding offering (“Form C”)—can be found by clicking on this link: SEC RIN 3235-AL37

Crowdfunding is already a common form of financing for some startups. The most well-known example of a crowdfunding platform is Kickstarter. Other common methods of financing for startups include bootstrapping (dipping into personal savings, shaking down friends and family), incubators, angel investors, and venture capital funds. Currently, however, when an individual gives money via a crowdfunding site, the individual is rewarded with a product or service from the company or project (e.g. a book, DVD, deck of Cards Against Humanity). Until now, the companies that raised money through crowdfunding websites were prohibited from offering investors a stake in the company in exchange for capital, which greatly limited the amount of funding available and the type of company that could obtain this type of funding.

This is set to change under the new rules. Startups will now be allowed to sell a stake in their company to individual investors—through an online crowdfunding platform or brokerage firm—in exchange for capital for their business.

The new rules impose limitations on both companies looking to raise funds through crowdsourcing and on the individuals seeking to purchase a company’s securities. The rules also provide a regulatory framework for online platforms managing crowdfunding transactions.

What This Means for Companies

Under the new rules, a company may raise up to $1 million from crowdfunding investments in a 12-month period. They have to be prepared to show how the sausage is made, though: the rules establish significant reporting and disclosure requirements for companies that sell securities crowdfunding using this method. A company that takes advantage of crowdsourced funding would be required to register with the SEC and to file an annual report, a copy of which must also be provided to its investors.

Further, the company would need to disclose certain information to its investors and the intermediary conducting the transaction, including a description of the business’s product or service, how the business will use the proceeds from the offering, information about the company’s officers and directors, as well as owners of 20 percent or more of the company, and a discussion of the company’s financial situation (including copies of recent financial disclosures). A company must provide investors with information regarding the price of the security, the target offering amount, the deadline to reach the target offering amount, and whether the company will accept investments in excess of the target offering amount.

Regulations for Crowdfunding Investors

Individuals who make less than $100,000 a year or have a net worth of less than $100,000 will be limited to up to $2,000 of total annual investments in crowdfunded investments in all companies. If an investor has both an annual income and net worth of more than $100,000, he or she may invest up to 10 percent of the lesser of the two amounts, up to a maximum of $100,000. Below is a simple table showing the different levels of options for crowdfunding investors:

Income/Net Worth Investment Limit If either annual income or net worth is less than $100,000.00 (the greater of) $2,000.00 or 5 percent of the lesser of their annual income or net worth If both annual income and net worth is more than $100,000.00 10 percent of the lesser of their annual income or net worth Regardless of income / net worth Total crowdfunding investments by single investor may not exceed $100,000 per year

Securities purchased through crowdfunding may not be resold for one year. These rules are not intended to limit large-scale private investors (i.e. angel investors) from investing directly in a company.

Crowdfunding Platforms

All transactions relying on the new rules would be required to take place through an SEC-registered intermediary, either a broker-dealer or an online funding portal. The crowdfunding platforms will face significant regulatory hurdles to ensure that investors are protected from fraudulent activity.

Conclusion

Although this new crowdfunding option may be useful in the early funding stages for smaller startups with low capital needs, the $1 million capital limit and additional burdens placed on the issuer may mean that this new capital pathway is of limited utility.