The Securities and Exchange Commission adopted “Regulation Crowdfunding” on October 30, allowing companies to raise capital online through low-dollar securities offerings. Currently, crowdfunding platforms such as kickstarter.com are used to allow new businesses, projects or causes to raise money online through small, individual contributions. Contributors are often thanked with gifts or rewards associated with the project or business, but they do not receive any equity interest or other share in the financial returns of the financed business activity. Regulation Crowdfunding, however, will now permit issuers that are not subject to reporting under the Securities Exchange Act of 1934, including start-ups, to use regulated crowdfunding platforms as a way to offer and sell limited amounts of securities without registration under the Securities Act of 1933 (Securities Act).
Regulation Crowdfunding was promulgated to implement Title III of the Jumpstart Our Business Startups (JOBS) Act, which was signed into law by President Obama in 2012. The JOBS Act was designed to reduce the burden of securities regulations on small companies seeking access to capital markets. Title III of the JOBS Act added Section 4(a)(6) to the Securities Act. This section creates an exemption from the securities registration requirements of Section 5 of the Securities Act for certain crowdfunding transactions. As a result, issuers can seek limited investments through means other than a private placement offering to accredited investors or a public registration of securities.
Limitations on Capital Raised
To qualify for the Section 4(a)(6) exemption, crowdfunding transactions by an issuer must meet specified requirements, including limits on the dollar amount of the securities that may be sold by the issuer and the total dollar amount that may be invested by an individual in a 12-month period. Specifically, an individual investor, over the course of a 12-month period, may invest up to:
(x) if either the investor’s annual income or net worth is less than $100,000, the greater of $2,000 and five percent of the lesser of his or her annual income or net worth; and
(y) if the investor’s annual income and net worth are both $100,000 or more, 10 percent of the lesser of his or her annual income or net worth, subject to a maximum aggregate amount of $100,000.
These limits apply on an aggregate basis to all of an investor’s crowdfunding investments in all issuers during the relevant 12-month period. Annual net income and net worth will be calculated in the same manner as they are for determining accredited investor status under the Securities Act. In addition, an issuer (including entities controlled by, under common control with, or a predecessor of, the issuer) may not offer and sell more than $1 million under Regulation Crowdfunding in any 12-month period. Regulation Crowdfunding offerings will not be integrated with other exempt offerings, provided that each offering complies with the applicable exemption.
The types of issuers that are eligible for the registration exemption under Section 4(a)(6) are limited. The following companies are not permitted to rely on Section 4(a)(6):
- Non-US companies;
- Companies that are already subject to the reporting requirements of the Exchange Act;
- Companies defined as investment companies under the Investment Company Act of 1940 or companies that are excluded from the investment company definition under section 3(b) or 3(c) of such Act;
- Companies that are disqualified under Regulation Crowdfunding’s disqualification rules (generally consistent with existing “bad actor” disqualifications in Securities Act Rules 262 and 506);
- Companies that have no specific business plan or have indicated that their business plan is to engage in a merger or acquisition with an unidentified company or companies; and
- Companies that have previously relied on Section 4(a)(6), but have not complied with applicable annual reporting requirements under Regulation Crowdfunding during the two years prior to the filing of a required new offering statement (any ongoing annual report that was due during the two years immediately preceding the currently contemplated offering must be filed before a company may rely on the Section 4(a)(6) exemption).
An issuer relying on Section 4(a)(6) must comply with certain disclosure requirements (on new Form C) regarding its business and finances. This information must be made available to both the crowdfunding intermediary (the broker or “funding portal” described below) and the potential investors. These required disclosures include, among others:
- Information regarding the issuer’s legal status, business and business plan, as well as information about its officers, directors, 20 percent shareholders, and related party transactions.
- Information on the terms of the securities offered and the issuer’s capital structure.
- Information regarding the offering, including the price to the public (or the method of determining the price), the target and maximum amount of securities offered, the use of proceeds (or range of uses), and the deadline for the offering. If an issuer indicates that it will accept proceeds in excess of the target offering amount, it must provide a reasonably detailed description of the purpose, method for allocating oversubscriptions, and intended use of any excess proceeds.
- Financial statements of the issuer for the most recently completed two fiscal years that have been reviewed by an independent public accountant or audited by an independent auditor, as well as a narrative of the issuer’s financial condition and financial history (if the aggregate amount offered and sold over a 12-month period does not exceed $100,000 and reviewed or audited financial statements are not available, the issuer may instead disclose financial statements certified by its principal executive officer and specified information from its tax return).
- Disclosure of the identity of, compensation to be paid to, and interests in the issuer held by, the intermediary.
- Legend requirements and risk factor disclosures.
Issuers will be required to amend or supplement the required disclosures, to the extent any material change occurs (including to its financial condition or the intended use of proceeds, or a determination of the final price where only a method has been disclosed), and to provide updates on the issuer’s progress toward reaching the target offering amount. In addition, issuers relying on Regulation Crowdfunding are required to file an annual report including specified information with the SEC (no later than 120 days after the end of the fiscal year covered by the report) and provide such annual report to their investors (through website posting). Filing of annual reports will continue to be required until the earliest of the following events: (i) the issuer is required to file reports under Exchange Act Section 13(a) or 15(d); (ii) the issuer has filed at least one annual report and has fewer than 300 holders of record; (iii) the issuer has filed at least three annual reports and has total assets that do not exceed $10 million; (iv) the issuer or another party purchases or repurchases all securities issued pursuant to Section 4(a)(6); or (v) the issuer liquidates or dissolves in accordance with state law.
Restrictions on Intermediaries
Regulation Crowdfunding transactions must take place exclusively through intermediaries or “crowdfunding platforms,” which are required to register with the SEC either as a broker or a funding portal and become a member of a registered national securities association (currently, the Financial Industry Regulatory Authority (FINRA) is the only such association). An issuer may not use more than one intermediary when conducting an offering (including concurrent offerings under Section 4(a)(6)).
Under Regulation Crowdfunding, intermediaries are required to follow certain rules, which include, among others:
- Providing materials to educate investors, including relevant issuer disclosure documentation and information regarding the process of and risks involved in purchasing and issuing securities on the crowdfunding platform.
- Having a reasonable basis to believe that each issuer they work with is, at all times, in compliance with applicable SEC regulations. The purpose of this rule is to reduce fraud; however, it does not excuse the issuer’s independent obligation to ensure compliance.
- Displaying required issuer disclosures on their platform a minimum of 21 days prior to the first day any security is sold in the offering.
- Prohibiting its directors or officers from having or obtaining a financial interest in any issuer that uses its platform.
- The rules prohibit funding portals from:
- Offering investment advice or making recommendations.
- Soliciting purchases, sales or offers to buy securities offered or displayed on its platform.
- Compensating promotors and others for solicitations or based on the sale of securities.
- Holding, possessing or handling investor funds or securities.
Securities purchased in a crowdfunding transaction generally cannot be resold for a period of one year (other than to the issuer, to an accredited investor, as part of a registered offering, or to certain specified family members). Holders of these securities do not count toward the threshold that requires an issuer to register its securities with the SEC under Section 12(g) of the Exchange Act if the issuer is current in its annual reporting obligations, retains the services of a registered transfer agent, and has less than $25 million in assets.
Any advertising notice that includes the terms of the offering can include no more than: (i) a statement that the issuer is conducting an offering along with the name of the intermediary through which the offering is being conducted and a link to the platform; (ii) the terms of the offering, and (iii) factual information about the legal identity and business location of the issuer.
Regulation Crowdfunding will become effective 180 days after it is published in the Federal Register. The forms that allow funding portals to register with the SEC will be effective on January 29, 2016.