On October 30, 2015, the Securities and Exchange Commission (“SEC”) released its highly anticipated final rules regarding equity crowdfunding, which will permit companies to raise up to $1 million per year from investors on online crowdfunding platforms. This provides companies with a new tool for capital raising as it permits the sale of securities to small, non-accredited investors, whose ability to participate in investments in early stage ventures is currently restricted by limitations on the number of non-accredited investors and disclosure requirements to such investors.
Though the final crowdfunding rules are less onerous than the proposed rules the SEC released in October 2013, the regulations still impose costs and burdens on companies attempting to raise capital through this method. Before any securities may be sold on a crowdfunding platform, issuers will have to prepare filings with details about the company and the offering, as well as certain financial statements, which is similar to what would be included in a prospectus or private placement memorandum. The associated costs and efforts of preparing these filings may deter many companies from utilizing crowdfunding, but it could still prove to be useful for certain issuers that are willing to comply with the requirements.
In 2012, Congress passed the Jumpstart our Business Act (the “JOBS Act”), which was intended to encourage funding for small businesses by easing certain securities regulations. Title III of the JOBS Act created the basic framework for crowdfunding under newly created Section 4(a)(6) of the Securities Act of 1933 (the “Securities Act”), and the SEC was tasked with drafting the accompanying regulations. Though the SEC was given 270 days to finalize the regulations under the JOBS Act, it did not release the proposed regulations until October 2013 and the final regulations until October 30, 2015. The final regulations do not go into effect until 180 days after they are published in the Federal Register.
Since the JOBS Act was passed, equity crowdfunding has been the subject of intense interest and speculation. Over the last few years, a number of websites have been formed as crowdfunding platforms to fill the demand for this type of investment. Since crowdfunding under Title III of the JOBS Act (“Title III Crowdfunding”) was not available, these websites were only open to “accredited” investors (that is, generally, investors with a net worth of over $1 million not including their primary residence, or income of $200,000 per year by themselves or $300,000 per year with their spouse), utilizing Rule 506 of the Securities Act, which is the exemption from registration typically used for private placements. Now that Title III Crowdfunding will be available soon, some of these websites have announced that they will open up certain campaigns to non-accredited investors utilizing the new regulations.
Overview of the Final Rules
The Title III Crowdfunding regulations are fairly extensive, as the SEC release was over 600 pages long. This advisory only provides a brief overview of the final rules.
Title III Crowdfunding is only available to issuers organized in the United States who are not subject to the reporting requirements under the Securities Exchange Act of 1934. Registered investment companies, private equity funds, hedge funds, blank check companies, special purpose acquisition companies, and certain “bad actors” are prohibited issuers under the regulations.
Individual investors are subject to the following aggregate annual limitations in all Title III Crowdfunding offerings:
- If annual income or net worth is less than $100,000 per year: greater of (a) $2,000 or (b) 5% of the lesser of (i) annual income or (ii) net worth.
- If both annual income and net worth are $100,000 or more: 10% of the lesser of (a) annual income or (b) net worth, up to an annual investment in all Title III Crowdfunding offerings of $100,000 per year.
Offering Limitations and Financial Statement Requirements
The aggregate offering limitation in Title III Crowdfunding is $1 million per 12 month period. However, based on target offering size, the issuer is subject to the following financial statement requirements:
- $100,000 or less: amount of total income, taxable income and total tax, as reported in the federal income tax returns (if applicable) certified by the principal executive officer, and financial statements certified by the principal executive officer.
- More than $100,000 but not more than $500,000: financial statements reviewed by independent public accountant.
- More than $500,000: financial statements reviewed by independent public accountant; provided, that if the issuer has previously sold securities under Title III Crowdfunding, then financial statements audited by an independent public accountant are required.
Note that if audited or reviewed financial statements are available, the issuer must provide those instead. The final rules differ slightly from the proposed rules, which required audited financials for all issuers offering more than $500,000.
Other Initial Disclosure Requirements
The issuer must file a Form C with the SEC and the crowdfunding platform in advance of the offering which is available to the public and includes broad disclosure about the company and its business. In addition to the financial statement disclosure discussed above, the Form C requires disclosure regarding, among other things:
- Narrative describing business and business plans
- Information about directors, officers, and 20% stockholders
- Information about offering (minimum/maximum size) and use of proceeds
- Capital structure of company
- Prior exempt offerings of securities
- Related party transactions
- Financial condition and trends (similar to the management’s discussion and analysis)
- Description of securities offered, including transfer restrictions thereon
- Risk factors regarding the company and the offering
The issuer must file an amendment to the Form C to disclose material updates or changes. In addition, the issuer must file progress updates with the SEC on Form C-U when it reaches certain milestones in the offering, including reaching 50% and 100% of the funding goal.
These regulations essentially require issuers to provide an offering memorandum containing the disclosure referred to above in advance of the offering. The SEC estimates that the initial Form C will require approximately 100 total hours of work.
Periodic Disclosure Requirements
After the completion of an offering, each year the issuer must file with the SEC and post on its website an annual report on Form C-AR containing substantially all of the disclosure required in Form C, as well as its financial statements certified by its executive officer. The issuer may terminate its reporting obligations after filing one annual report if it has fewer than 300 holders of record.
Right to Cancel Investment
Investors have an unconditional right to cancel their investment commitments for any reason until 48 hours prior to the deadline in the offering materials. However, if there is a material change to the terms of the offering, the investor must affirmatively reconfirm such investor’s commitment or else it will be automatically cancelled. If an issuer meets its target subscription amount, it may close the offering early, but must give notice to investors of such, who must still be afforded the opportunity to cancel their investment commitments.
Securities sold via Title III Crowdfunding may not be transferred by the purchaser for one (1) year from the date of purchase, except for sales to the issuer, accredited investors, a family member or trust, or in an offering registered with the SEC.
Title III Crowdfunding offerings may only be made through a single intermediary that is a registered broker-dealer or a funding portal registered with the SEC (which is a less extensive process than registering as a broker-dealer) and a member of FINRA. The intermediary serves as a sort of gatekeeper for issuers seeking to solicit investments via crowdfunding.
The intermediary may not have a financial interest in an issuer other than securities issued as compensation for the offering, which must have the same terms as offered to the public. The intermediary is required to vet the issuer and its filings, as it must have a reasonable basis for believing the issuer is compliance with the relevant regulations in order to list the issuer’s securities. Furthermore, the intermediary has the burden of ensuring that investors do not exceed the investment limitations under the regulations. In addition, the intermediary is charged with ensuring that investors’ subscriptions are not released to the issuer until it meets its minimum target amount in the offering.
Since funding portals are not broker-dealers, they are subject to various restrictions such as not being able to solicit securities displayed on their platform, not holding investor funds directly, or offering investment advice or recommendations regarding offerings listed on their website.
Title III Crowdfunding offerings will not be integrated with other contemporaneous exempt offerings of securities, and therefore are not considered a single offering under federal securities laws. Accordingly, an issuer may do a private placement offering under Rule 506 of the Securities Act that is only open to accredited investors and which is not subject to an investment cap, while at the same time offering up to $1 million of securities to non-accredited investors via Title III Crowdfunding. As the Title III Crowdfunding rules require an issuer to prepare almost all of the information that would typically be in a private placement memorandum, similar documents could be used for the Rule 506 offering, particularly if the same securities are offered in both.
Title III Crowdfunding provides a regulatory framework that offers issuers a new method for raising capital, particularly for early stage companies. However, issuers must evaluate the anticipated cost of compliance against the annual $1 million cap for Title III Crowdfunding when evaluating its usefulness. A Rule 506 offering to only accredited investors will likely have lower compliance costs and will not be subject to an investment cap.