Crowdfunding is an innovative means of raising capital in which small investments are widely solicited from the public at large through internet-based platforms. As part of the JOBS Act passed in 2012, Congress sought to increase access to capital for startups and small businesses, including provisions that would allow qualifying companies to conduct equity crowdfunding through SEC-registered intermediary funding portals. While donation-based crowdfunding has met with some success as a funding tool and several states have passed laws permitting equity-based crowdfunding within their boundaries, the national equity-based crowdfunding contemplated by the JOBS Act has been awaiting implementation by the SEC.
The SEC has now adopted the final rules mandated by the JOBS Act to permit companies to offer and sell securities through “crowdfunding.” While substantially similar to the October 2013 rule proposal, the final rules reflect a number of notable changes designed to minimize the burdens and costs for companies and intermediaries while preserving sufficient investor protection measures.
The new crowdfunding rules will be effective May 16, 2016 and the forms enabling funding portals to register with the SEC will be effective January 29, 2016. The following is a brief summary of the offering-related provisions of Regulation Crowdfunding.
New Regulation Crowdfunding
Regulation Crowdfunding allows qualifying private companies to raise up to $1 million in a 12-month period through equity crowdfunding offerings conducted online. The rules include certain restrictions and disclosure requirements for companies and intermediaries, and investors are subject to caps on the amount they can invest during any 12-month period. Securities purchased in a crowdfunding transaction, however, cannot be resold for one year, and all transactions relying on the new rules would be required to take place through an SEC-registered intermediary, either a broker-dealer or a funding portal.
If a company using the new equity crowdfunding rules does not raise the full amount of its stated funding goal, however, the company must return to investors all of the money raised. As a result, setting a realistic funding goal will become an important part of the equity crowdfunding process for entrepreneurs.
Regulation Crowdfunding is available for use only by domestic companies that are not subject to the reporting obligations of the Securities Exchange Act of 1934. Certain private companies, such as foreign issuers, certain investment companies and companies deemed “bad actors” are not eligible to use the new regulation. Going forward, companies that fail to comply with the annual reporting requirements under Regulation Crowdfunding will be disqualified for two years from filing a crowdfunding offering statement.
In addition, companies without a specific business plan will not be eligible for a crowdfunding offering under the new exemption. In this regard, a plan to engage in a merger or acquisition with an unidentified company or companies is not a permissible business plan for this purpose.
Form C: Offering Statement. The new regulation requires companies using the exemption to provide a number of disclosures. As part of a crowdfunded offering, companies must file via EDGAR a new Form C which will contain at least the following information regarding the offering:
- Basic company information such as name, legal status, address, website where the annual report will be posted, business description, biographical information for the company’s officers and directors, identification of significant shareholders, related party transactions, number of employees, material risk factors, ownership and capital structure;
- The terms of the securities being offered (including transfer restrictions);
- A summary of the intended use of proceeds;
- The target offering amount and deadline to reach the target or to return the funds, and whether the company will accept investments in excess of the target offering amount;
- The offering price and method for determining the offering price;
- Information regarding the intermediary being used in the offering; and
- Financial statements (discussed in more detail below) and a discussion of the company’s financial condition.
The information may be provided in standard narrative format or in an optional question/answer format.
Financial Statements. In a change from the proposed crowdfunding rules, the final rules provide some accommodations with respect to financial statement requirements depending upon the target offering amount and for first-time issuers. The initial equity crowdfunding proposal by the SEC in 2013 called for audited financial statements for any company seeking to raise more than $500,000 through crowdfunding, which likely would have had a chilling effect on use of the exemption. The final rules did away with this expensive requirement for companies using the exemption for the first time. In this regard, companies are required to disclose:
- For offerings of $100,000 or less: tax information (in lieu of filed tax returns) and financial statements certified by the company’s executive officer.
- For offerings more than $100,000 but not more than $500,000: financial statements reviewed by an independent accountant.
- For offerings more than $500,000:
- If the offering is a first-time offering up to $1 million: financial statements reviewed by an independent public accountant.
- If the offering is not a first-time offering: financial statements audited by an independent public accountant.
Form C/A Amendments. Information in the Form C must be updated on Form C/A in the event of any material changes, additions or updates to information previously provided. In some cases, an update will trigger an obligation of investors to reconfirm their investment commitment within five business days or have their commitments cancelled.
Form C-U Offering Progress Updates. A company conducting an equity crowdfunding is required to file updates with the SEC on the progress of the offering on Form C-U. Updates are required within five business days after any of the following milestones:
- Commitments for 50% of the offering amount are received;
- Commitments for 100% of the offering amount are received; and
- If subscriptions will be accepted in excess of the initial offering amount, completion of the offering.
Advertising. Companies are restricted in their ability to advertise the terms of the crowdfunded offering. An advertisement may not include any more than the following information:
- A statement that the company is conducting an offering;
- The name of the intermediary being used in the offering and a link to the intermediary’s portal;
- The terms of the offering (amount of securities offered, nature of securities, price of securities and closing date of offering);
- The name, address, phone number and website of the company;
- The email address of a representative of the company; and
- A brief description of the company’s business.
There are no limits imposed on how a company distributes its advertising notices, which will be similar to tombstone ads permitted under Rule 134 of the Securities Act of 1933. For example, a company could place notices in newspapers or post notices on social media sites or the company’s own website. Also, persons acting on behalf of a company during a crowdfunded offering may communicate with prospective investors about the terms of the offering through communication channels provided by the intermediary’s platform, but must identify their affiliation with the company. A company engaged in a crowdfunded offering should not be limited in its ability to make business-related press releases or otherwise promote its business in the normal course as long as it does not include information regarding the offering.
Form C-AR Annual Reports. A company that completes an offering in reliance on the exemption must file an annual report with the SEC within 120 days after its fiscal year-end and post the annual report on its website. The annual report must contain the information generally required in the offering statement other than the offering-specific information.
The ongoing reporting obligation is annual only; companies are not required to provide quarterly or current reports or proxy materials. Also, unless reviewed or audited financial statements are otherwise available, the financial statements in the annual report need only be certified by the company’s principal executive officer to be true and complete in all material respects, and not reviewed or audited by the auditors.
Form C-TR Termination of Reporting Obligation. The company’s obligation to file annual reports will continue after the offering until any of the following occurs:
- The company becomes an SEC reporting company under the Securities Exchange Act of 1934;
- The company has filed at least one annual report and has fewer than 300 holders of record;
- The company has filed at least three annual reports and has total assets not exceeding $10 million;
- All of the crowdfunded securities are redeemed or repurchased; or
- The company liquidates or dissolves.
Investor Limits and Cancellation Rights
The SEC modified the investor limits from those included in its proposed rules so that the aggregate amount that an investor may invest in crowdfunded offerings during any 12 month period is capped at a specified level based on the annual income or net worth of the investor. The aggregate caps across all crowdfunding offerings over a 12-month period for any investor who is a natural person are as follows:
- If either their annual income or net worth is less than $100,000, the greater of $2,000 or 5% of the lesser of their annual income or net worth; or
- If both their annual income and net worth are at least $100,000, 10% of the lesser of their annual income or net worth, up to a total of $100,000.
The value of an individual’s primary residence is not included in his or her net worth calculation. A company is permitted to rely on an intermediary’s calculation of the investment limit, provided that the company does not know that the investor has exceeded, or would exceed, the investment limits as a result of participating in the company’s crowdfunding effort.
An investor will have an unconditional right to cancel an investment commitment for any reason until 48 hours before the stated offering deadline. During the final 48 hours, cancellation would be permitted only if there was a material change to the offering terms or to other information provided by the company regarding the offering.
All transactions that rely on Regulation Crowdfunding are required to take place through an SEC-registered intermediary -- either a broker-dealer or a funding portal. A funding portal would be required to register with the SEC on new Form Funding Portal and become a member of FINRA. Moreover, a company relying on the crowdfunding exemption would be required to conduct its offering exclusively through one intermediary platform at a time. The company would post its disclosure materials on the platform and they must remain available there for at least 21 days before sales may occur, though commitments may be accepted by the intermediary.
An intermediary is intended to be a gatekeeper for crowdfunded offerings to reduce the risk of fraud. In this regard, the intermediary has a number of duties, such as taking steps to have a reasonable basis for believing that the company complies with the exemption and has established means to keep accurate records of its security holders, monitoring investors to ensure aggregate investment limits are not exceeded, ensuring that investors review and understand account-related educational materials and investment-related disclosure materials, and ensuring that offering proceeds are released to the company only when the target offering amount is met or exceeded and returned to investors if the offering is cancelled. Intermediaries are also required to conduct background and securities enforcement checks on companies and their officers, directors and 20% owners, and deny access to their platform if they have a reasonable basis for believing that the company or the offering present the potential for fraud, otherwise raises investor protection concerns, or the company or any of its officers, directors or 20% owners is subject to “bad actor” disqualification.
The SEC confirmed in its adopting release that intermediaries will have the same exposure to Section 4A(c) liability for material misstatements or omissions as any company making a crowdfunded offering. The intermediary will also have the same due diligence defense as the company, if the intermediary is able to show that it did not know, and in the exercise of reasonable care, could not have known, of the untruth or omission. Finally, in a notable change from the proposed rules, an intermediary will be permitted to have a financial interest in a company that is offering securities on its platform, provided that the intermediary receives the financial interest as compensation for its services and the financial interest consists of the same securities being offered or sold (i.e., no extra warrants or carried interests).
Regulation Crowdfunding includes a safe harbor for insignificant deviations from a term, condition or other requirement of the regulation. To qualify for the safe harbor, a company must show that:
- The failure to comply with a term, condition or requirement was insignificant with respect to the offering as a whole;
- The company made a good faith and reasonable attempt to comply with all applicable terms, conditions and requirements of the rules; and
- The company did not know of the failure to comply, where the failure to comply was the result of the failure of the intermediary to comply with certain requirements, or such failure by the intermediary occurred solely in offerings other than the company’s offering.
Notwithstanding the safe harbor, however, a failure to comply with Regulation Crowdfunding remains actionable by the SEC enforcement staff.
An offering made pursuant to Regulation Crowdfunding will not be integrated with another exempt offering that precedes the crowdfunded offering or that takes place concurrently or subsequently. Of course, a company must ensure that it has satisfied all of the conditions for the exemption that it is claiming for each such offering.
For example, a company conducting a contemporaneous exempt offering for which general solicitation is not permitted as under Rule 506(b) of Regulation D, would need to conclude that purchasers in the Rule 506(b) offering were not solicited by means of the crowdfunding offering. Otherwise, the crowdfunding solicitation would be deemed a prohibited “general solicitation” under Rule 506(b) and preclude reliance on that exemption. On the other hand, a company conducting a concurrent exempt offering for which general solicitation is permittedas under Rule 506(c) of Regulation D, could not include in its general solicitation a crowdfunding advertisement unless the solicitation otherwise complied with the advertising restrictions of Regulation Crowdfunding noted above.
State Blue Sky Law Preemption
The JOBS Act specifically preempts the ability of states to regulate certain aspects of crowdfunding conducted in compliance with the exemption. Under this preemption, companies will not have to register their crowdfunding offerings or sales made with the states. Moreover, the JOBS Act also provided that intermediaries, including funding portals, do not have to comply with state registration or other requirements applicable to broker-dealers with respect to their crowdfunding activities.
Despite the many positive changes made by the SEC in response to the public comments, Regulation Crowdfunding remains unavoidably complex due to the mandates of the JOBS Act. This complexity, together with the relatively low offering limit of $1 million raises concerns about the usefulness of the Regulation Crowdfunding to small businesses. In fact, the lone SEC Commissioner who voted against its adoption expressed concern that, as a result of the regulation’s complexity, “many traps for the unwary are hidden in the regulations, creating potential nightmares for small business owners that fail to place regulatory compliance at the top of their business plans.”
Some of the restrictions put in place to protect unsophisticated investors, such as having reviewed or audited financial statements and requiring the use of an intermediary, will make equity crowdfunding more costly than traditional methods of raising capital from accredited investors in a private placement. Also, companies that use the exemption must be willing to post their financial information and annual report on their websites for the world (including competitors) to view. This company information could remain confidential if, for example, Regulation D were utilized to offer securities.
Considering that the heart of crowdfunding is small investments by many unsophisticated investors, a company should consider the potential corporate governance and communication challenges of a dispersed investor base, many of whom may not otherwise be affiliated with the company. These challenges are magnified for small businesses and start-ups, which typically have very limited personnel and financial resources.
Finally, it seems unlikely that any of the larger or more established investment banking firms will expend resources to serve as intermediaries for small crowdfunded offerings that are likely to yield relatively small fees in relation to private or public offerings. As a result, crowdfunding intermediaries are likely to be unknown firms with limited experience and resources to fulfill their affirmative responsibilities under Regulation Crowdfunding, including preventing fraud.
While crowdfunding has received an extraordinary amount of publicity in recent years, it remains to be seen whether the exemption as put in place by the SEC with Regulation Crowdfunding will be a useful capital raising tool. Only time will tell whether small businesses choose to use the exemption despite its higher costs and challenges.