The recently enacted Jumpstart Our Business Startups (JOBS) Act was intended to make raising equity capital easier, particularly for smaller startup companies.1 A key provision of the JOBS Act relates to “crowdfunding,” which amends the securities laws to add a new registration exemption intended to permit companies to raise small amounts of capital from a large number of investors through the internet and social media. Crowdfunding should enable small startup businesses that may not have easy access to traditional fundraising methods (e.g., senior lending, mezzanine lending, venture capital and other capital sources) to raise capital to further their businesses.
The JOBS Act provides the U.S. Securities and Exchange Commission (SEC) with broad rulemaking authority with respect to crowdfunding. The success of crowdfunding will likely depend on whether the result will be a lean, efficient process for early stage capital raising or a complicated set of rules that makes crowdfunding unappealing or costly to startups and small issuers. The SEC is required to issue rules to protect investors who participate in crowdfunding within 270 days of April 5, 2012. Before these rules are issued, the crowdfunding exemption will remain unavailable.
Traditional registration exemptions are often not available or are difficult to use to raise capital online because, under existing rules, companies are generally not permitted to publicly solicit investors. The JOBS Act will permit general solicitation of accredited investors, but the crowdfunding rules will also permit the solicitation of sales to non-accredited investors. A company will be able to raise up to US$1 million in a crowdfunding offering conducted through an SEC registered funding portal or broker-dealer, as described below.
Qualifying the Offering Under the Crowdfunding Exemption
The JOBS Act amends the Securities Act by adding a new Section 4(6). Section 4(6) provides an exemption from registration for transactions that meet the following criteria:
- The total amount sold to all investors in the offering under this exception during the preceding twelve-month period does not exceed US$1,000,000.
- The total amount sold to a single investor during the preceding twelve-month period does not exceed:
- if the investor’s annual income or net worth is below US$100,000, the greater of US$2,000 or five percent of the investor’s annual income or net worth;
- if the investor’s annual income or net worth is US$100,000 or more, ten percent of the investor’s annual income or net worth, up to a maximum of US$100,000.
- The transaction is conducted through a broker or funding portal that complies with the requirements of new Section 4A(a) of the Securities Act.
- The issuer complies with the requirements of new Section 4A(b) of the Securities Act relating to disclosure and other requirements of crowdfunding issuers.
Crowdfunding must be conducted through a broker or funding portal. These brokers or funding portals will be required, among other things, to:
- Register with the SEC and an applicable self-regulating organization (likely to be FINRA).
- Provide any disclosure that the SEC may require.
- Ensure that each investor confirms that the investor understands the risk of loss of its investment and can bear such loss and answers questions demonstrating that the investor understands the risks inherent in investing in startup companies, as well as other matters that the SEC may require by rule.
- Take measures to reduce the risk of fraud.
- No later than 21 days before the first sale to investors, make available to the SEC and potential investors any disclosure information provided by the issuer to meet the requirements of Section 4A(b).
- Ensure that the issuer may only receive the offering proceeds after the aggregate capital raised exceeds the targeted offering amount, as well as permit all investors to cancel their commitment to invest, as provided by the SEC (there is no color yet on how these cancellation provisions will function).
- Ensure that no investor exceeds the per-investor limits in any twelve-month period.
- Comply with privacy and information protection requirements adopted by the SEC.
- Not compensate promoters, finders or lead generators.
- Prohibit its directors, officers or partners from having any financial interest in any company that utilizes the broker or funding portal.
Disclosure and Other Requirements for the Issuing Company
As discussed above, the broker or funding portal intermediaries will be required to perform background checks on issuing companies to reduce fraud and ensure that potential investors understand the risks involved. In addition, the issuing company will need to file with the SEC and publicly disclose information related to the offering, such as the company’s capital structure, plans for the funds and a description of the financial condition of the issuing company for the preceding year. The level of detail to be required will vary depending on the size of the offering: companies raising over US$500,000 will need to provide audited financial statements; companies raising between US$100,000 and US$500,000 will need to provide financial statements reviewed by outside auditors; and companies raising under US$100,000 will need to provide self-certified financial statements and the company’s last tax return. In addition, issuers will be prohibited from advertising the terms of the crowdfunding offering, with the exception of directing potential investors to their funding portals or broker-dealers.
Crowdfunding investors will not count as holders of record, allowing the company to potentially have thousands of shareholders without triggering public company reporting requirements under the Securities Exchange Act of 1934. Previously, companies with more than 500 shareholders of record were required to register with the SEC, but the JOBS Act expanded the threshold to 2,000 record holders. However, as stated above, the 2,000 record holders will not include crowdfunding investors. That said, a crowdfunded company will need to prepare an annual report for its investors and the SEC. The JOBS Act directs the SEC to prescribe the specifics required in the annual report, but provides little guidance regarding the content. Ultimately, the benefit of crowdfunding may depend on the rules passed by the SEC regarding the annual report.
Who Would Be a Likely Crowdfunding Issuer?
Crowdfunding will appeal to certain categories of small companies:
- Startup Issuers. Crowdfunding will help most companies during their earliest stages. Many startups are bankrolled by their founder and his or her friends and family. Crowdfunding offers them a potential base for additional equity. They will have access to a new investor base—the “crowd.” Furthermore, crowdfunding will eliminate the geographical boundaries of capital formation. Angel investors tend to cluster in metropolitan areas, forcing many companies to move in order to gain access to startup capital. Crowdfunding will eliminate the need for personal connections for early investors and, thus, spread the availability of startup capital. Because of the internet and social media, rural entrepreneurs may turn to crowdfunding to finance startups that local banks would never entertain.
- Strategic Issuers. Crowdfunding will likely excite a certain kind of person: the Twitter-literate, Facebook-networked, youthful and entrepreneurial. Crowdfunding should be of interest to the companies looking to excite that person. Some small companies may also view crowdfunding as a branding opportunity. It will offer the opportunity to demonstrate a grassroots, anti-big business ethos and, therefore, will be popular with the same companies that market themselves as progressive, green or socially conscious. In addition, crowdfunded companies may have a large number of investors, which means a large group of potential customers who are invested in the company’s success. Investors are more likely to spread the word to their friends and family and purchase those products or services themselves. Web-based businesses should be particularly able to take advantage of this aspect of crowdfunding.
The Drawbacks to Crowdfunding
Crowdfunding might be exciting, but there are some significant risks and potential pitfalls to consider before any fundraising.
- Disclosure and Reporting Requirements. The SEC has the potential to make crowdfunding costly or complicated. Even without additional SEC regulations, crowdfunding requires more disclosure than private offerings conducted to accredited investors under Regulation D’s safe harbors. Moreover, if the crowdfunding rules are too complex, the risk of violating securities law increases, thereby further raising the cost of compliance. The SEC has the ability to limit the utility of crowdfunding with onerous disclosure and reporting requirements under the circumstances. Until the SEC’s rules are released, the expected utility of crowdfunding will remain uncertain.
- Corporate Structure. After a crowdfunding, the number of actual shareholders could potentially increase from a handful to a few thousand. Any company contemplating a crowdfunding will first need to carefully consider its corporate structure in order to arrange strategies for maintaining control and preparing for subsequent investment rounds. A crowdfunding issuer will need to address a host of legal and strategic issues, including choice of entity, corporate governance issues and capital structures, tax elections and anti-dilution mechanisms, in advance of the crowdfunding transaction because obtaining consents to structure changes from these investors can be complex. There is no special exemption described under the tax code for Subchapter S corporations that would enable them to retain their Subchapter S status after a capital raise pursuant to these rules, although a company could choose to only accept capital from investors that could result in it retaining Subchapter S status.
- Big Company Hassles. Although state securities laws are not preempted by the JOBS Act, crowdfunding offerings will now include covered securities for which no state may require registration. The states may, however, require the licensing of those who offer crowdfunding securities and the state where the issuer is located may require notice filings. In addition, in Rule 506 offerings in which there is public solicitation, new state securities law issues will arise.
State corporate law is not preempted by the JOBS Act. Corporations will still need to notify shareholders before annual meetings, regardless of their numbers or the cost. Each state’s corporate code is different and some impose greater costs than others. Some states, like Pennsylvania and Delaware, permit notice by email. Conversely, New Jersey requires a corporation to get a shareholder’s consent before it can email notice and that consent can be revoked at any time.
Furthermore, a larger number of investors who are unknown to the Company’s management means a greater likelihood of unsatisfied investors who might threaten or bring claims, accusing the company of fraud during the crowdfunding or a breach of fiduciary duties. A small investor could claim that the company made a material misstatement during the offering. The JOBS Act defines “issuer” in connection with crowdfunding unusually broadly to include the issuing company’s officers and directors. Potentially, investors can make claims against the management for securities fraud or breaches of fiduciary duties.
Crowdfunding companies may be opening themselves up to the kind of risks that small companies rarely need to consider. However, if properly implemented, crowdfunding may become an important source of startup capital.
Follow-On Financing and Crowdfunding
One of the greatest unknowns in crowdfunding is how venture capital firms will view companies who have raised early capital through crowdfunding. Venture capital firms typically do not like complicated early capital structures, which is a significant risk with crowdfunding. Companies interested in crowdfunding need to carefully consider their need for additional capital and its likely sources. If venture capital is in a company’s future, it will need to be forward-looking with respect to whether to utilize crowdfunding for early capital.