It has been several years in the making, but at long last, on October 30, 2015, the U.S. Securities and Exchange Commission (SEC) adopted final rules to permit equity crowdfunding under Title III of the Jumpstart Our Business Startups (JOBS) Act. Under the new rules, companies are now permitted to raise up to $1 million in crowdfunding offerings during any 12-month period from all investors, including unaccredited investors, subject to compliance with the prescribed offering requirements.
Crowdfunding is the process by which companies raise capital with relatively small individual investments from a large number of investors, typically through the internet and social media. Over a span of only a few years, crowdfunding has brought about dramatic changes to capital formation. The crowdfunding industry is now expected to surpass venture capital and account for $34 billion globally in funds raised during 2015, according to a recent report by Massolution, an advisory firm specializing in crowdfunding.
The JOBS Act was enacted partly to facilitate capital raises for smaller companies by easing the regulatory burdens imposed by federal securities law. Other reforms under the JOBS Act intended to assist companies with capital building have already taken effect. In particular, Title II of the JOBS Act, which lifts the ban on general solicitation in private placements to accredited investors pursuant to Rule 506(c) of Regulation D under the Securities Act, and Title IV of the JOBS Act, which allows companies to raise up to $50 million in mini IPOs pursuant to Regulation A under the Securities Act, took effect in September 2013 and June 2015, respectively. But by far the most anticipated of these reforms has been the legalization of equity crowdfunding under Title III.
The SEC released proposed crowdfunding rules in October 2013, but it took two years for the final rules to be released on October 30, 2015. The new rules become effective 180 days after they are published in the Federal Register.
Title III of the JOBS Act creates an exemption from registration under a new Section 4(6) of the Securities Act for crowdfunding offerings. The rules set forth limitations on the amount of funds that companies can raise in a crowdfunding offering and the type of companies that are eligible to commence an offering. The rules also prescribe the manner in which such an offering must be conducted and the reporting and disclosure obligations with which a company must comply during and following an offering, all as described below.
Limitations on Funds Raised
The rules impose limitations on the amount of funds that an individual may invest in a crowdfunding offering. Individual investors, over the course of a 12-month period, are permitted to invest in the aggregate across all crowdfunding offerings up to:
- If either of their annual income or net worth is less than $100,000, then the greater of:
- $2,000; or
- 5 percent of the lesser of their annual income or net worth; and
- If both their annual income and net worth are at least $100,000, then 10percent of the lesser of their annual income or net worth.
In both cases, the aggregate amount of securities sold to an investor through all crowdfunding offerings during any 12-month period may not exceed $100,000. The proposed rules had included higher limits, but the SEC decreased them in the final rules in an effort to protect investors. Although the SEC acknowledged that tightening these limitations could constrain capital formation, it ultimately determined that doing so was necessary to protect investors.
Certain companies are not eligible to crowdfund under the new rules. The exemption is not available to non-U.S. companies, public companies, investment companies and companies affiliated with any person that is subject to certain federal and state “bad-boy” disqualifiers. Additionally, if a company conducts subsequent crowdfunding offerings after its initial crowdfunding offering, then the company must have complied with all annual reporting requirements during the preceding two years.
Constraints on Transfer
Securities purchased in a crowdfunding offering generally cannot be resold for a period of one year. As a practical matter, moreover, investors will have difficulty liquidating their investment even after that period if there is no active market for the securities. Unless and until a market for these securities develops or the company is acquired, investors could be holding their investment indefinitely.
Disclosure and Reporting Obligations
A company that conducts a crowdfunding offering will be required to disclose certain information to prospective investors and to make certain filings with the SEC. The company must disclose information about its officers and directors, and the owners of 20 percent or more of its securities. The company must also describe its business and the use of proceeds from the offering, and discuss its financial condition. Companies will also be required to amend the offering document during the offering period to reflect material changes and provide updates on their progress toward reaching the target offering amount. A company that has conducted a crowdfunding offering must also continue to file an annual report with the SEC even after the offering concludes. The ongoing reporting requirements terminate if the company is acquired, if the company has filed at least one annual report and has fewer than 300 holders of record, or if the company has filed at least three annual reports and has total assets that do not exceed $10 million.
Additionally, a company conducting a crowdfunding offering must provide financial statements that are, depending on the amount offered and sold during a 12-month period, accompanied by information from the company’s tax returns, reviewed by an independent public accountant, or audited by an independent auditor. Notably, the final rules provide that a company commencing its first crowdfunding offering will be permitted to provide “reviewed” rather than “audited” financial statements, which is a victory for startups that had vocally objected to the proposed rules that would have required audited financials. The company will be obligated to file updated financial statements annually as part of its annual report; however, these financial statements need only be certified by the company’s principal executive officer. This is another departure from the SEC’s original proposal that the financial statements in the annual report meet the highest standard previously provided by the company.
All crowdfunding offerings under Title III must take place exclusively through a broker-dealer or a funding portal registered with the SEC. Crowdfunding portals facilitate the offer and sale of crowdfunded securities and are required to take measures to reduce the risk of fraud. Under the final rules, portals are prohibited from offering investment advice or soliciting sales of securities displayed on their platforms. Portals can neither compensate promoters for solicitations or based on the sale of securities, nor hold or handle any investor funds or securities. Ever since accredited-investor crowdfunding under Title II of the JOBS Act began in 2013, online portals facilitating crowdfunding offerings have ballooned in number. Many of these platforms will now likely enter into the Title III crowdfunding market as well.
Proposed Changes to Intrastate Offering Rules
In connection with adopting final crowdfunding rules , the SEC also proposed changes to facilitate intrastate crowdfunding offerings under Rule 147 of the Securities Act. The proposed changes would eliminate the prohibition on a company advertising its intrastate crowdfunding offerings to out-of state residents, which effectively prevented companies from using their website or social media to attract investors. However, the laws that many states have adopted to permit intrastate crowdfunding still contain similar prohibitions against marketing offerings to out-of-state residents. Assuming that the proposed changes to Rule 147 are enacted, many states may amend their laws to remove this requirement. Until such time, companies conducting an intrastate crowdfunding offering need to confirm what marketing activities are permitted in their particular state.