By now, most people have heard of “crowdfunding” or have some idea of what the term means. Crowdfunding is a technique for raising small amounts of capital from a large number of people over the Internet.
Less understood, however, is the distinction between (i) crowdfunding on websites like Kickstarter or GoFundMe, which allow companies to fund ideas by giving away “rewards” (thereby avoiding the need to comply with federal and state securities laws), and (ii) crowdfunding on websites that allow people to purchase an ownership interest in a business (“equity crowdfunding”), which involves the purchase and sale of a security.
Facebook’s 2014 acquisition of Oculus, a virtual reality gaming startup, starkly illustrated the difference between rewards-based crowdfunding and equity crowdfunding. In 2012, Oculus raised over $2.4 million on Kickstarter from 9,522 “backers” using rewards-based crowdfunding. For their monetary contributions, which Oculus used to build and market its initial product, Oculus backers received posters, T-shirts and other rewards.
You can imagine the reaction of these backers when less than two years later they learned that Facebook had acquired Oculus for over $2 billion, and they would receive nothing from the sale proceeds. Crowdfunder.com, an equity crowdfunding website, estimated that had the original Oculus backers had the opportunity to purchase equity, they would have received a return of 200 times on their investment.
At the time, federal securities laws only allowed equity crowdfunding sites to accept investments from “accredited investors” – individuals who make more than $200,000 per year or have a net worth of $1,000,000 or more, as well as business organizations with total assets of more the $5,000,000.
On October 30, 2015, the Securities and Exchange Commission (SEC) released final rules to make investing through equity crowdfunding available nationally to all investors. The final rules will go into effect in May 2016.
What funding opportunities does equity crowdfunding present for entrepreneurs and small businesses? How will the new rules work? Here are twelve important questions for companies interested in equity crowdfunding as a potential fund raising vehicle.
Note: The SEC’s release adopting the final rules governing the exemption for crowdfunding offerings is 686 pages long. This article provides a brief introduction to the rules and does not purport to be comprehensive. For more information, please contact Alan MacDonald or Drew Eckman in Frost Brown Todd’s Business Department.
1. How does a company conduct a crowdfunding offering?
A company must conduct a crowdfunding offering through either a registered broker-dealer or a funding portal - a new, less regulated type of broker limited to selling securities through crowdfunding. A company can use only one such intermediary to conduct its crowdfunding offering. In addition, a crowdfunding offering must be conducted online in order to enable the public to access and share information regarding the offering – thereby engaging the collective “wisdom of the crowd.”
Before commencing a crowdfunding offering, a company must file certain information with the SEC. It must also deliver the information to the funding portal that hosts the offering, where the information will be posted on the portal’s website and made available to potential investors. The required information is discussed in more detail in the responses to questions (5) through (7) below.
Any money received by a broker-dealer in a crowdfunding offering must be filed in a separate bank account. Funding portals may not handle money at all, so investors must transmit money directly to a bank or other “qualified third party.” A company may receive the proceeds from an offering only if the target offering amount is met or exceeded.
Finally, after completing a crowdfunding offering, a company must file an annual report and post the report on its website. A company’s post-offering reporting obligations are discussed in the response to question (12) below.
2. Who is eligible to conduct a crowdfunding offering?
The following companies are NOT eligible to use the crowdfunding exemption:
- Companies domiciled outside the United States.
- Public companies registered under the federal Securities Exchange Act.
- Investment funds, whether or not registered under the federal Investment Company Act of 1940.
- Companies disqualified as “bad actors” under applicable SEC rules.
- Companies that previously completed a crowdfunding offering, but failed to comply with the annual reporting requirements during the two years immediately preceding a new crowdfunding offering.
- Companies that have no specific business plan or whose business plan is to engage in a merger or acquisition with an unidentified company or companies.
- Any other company that the SEC, by rule or regulation, determines is not eligible.
3. How much money can a company raise through crowdfunding?
A company can raise a maximum of $1 million through crowdfunding in a 12-month period. The aggregate amount does not include capital raised under any other exemption from securities registration. Also, a crowdfunding offering will not be integrated with any other exempt offering made by the company, provided that the company has met all the conditions for the other exemption.
The amount of securities sold in a crowdfunding offering by a predecessor, an entity controlled by the company, or an entity under common control with the company will be aggregated with the amounts sold in a crowdfunding offering by the company.
4. How much can members of the crowd invest?
Anyone, regardless of his or her annual income or net worth, may invest in a crowdfunding offering. However, the SEC imposes a limit on the amount a person can invest based on the individual’s income and net worth. The maximum investment is an aggregate limit, meaning it limits the total amount an individual may invest in all crowdfunding offerings every 12 months.
During any 12-month period, an investor is limited to investing:
- The greater of $2,000 or 5% of the lesser of the investor’s annual income or net worth, if either annual income or net worth is less than $100,000; or
- 10% of the lesser of the investor’s annual income or net worth, not to exceed $100,000, if both annual income and net worth are $100,000 or more.
Under this approach, an investor with annual income of $50,000 a year and $105,000 in net worth would be subject to an investment limit of $2,500. The attached chart, provided by the SEC in its final rules, illustrates a few examples:
Click here to view table.
A company may rely on the portal’s record of an investor’s investments, provided the company does not have actual knowledge that the investor has exceeded, or would exceed, the investment limits as a result of purchasing shares in the company’s offering.
5. What information must a company provide to prospective investors?
A company must make the following information available to potential investors by filing it with the SEC and posting it on the funding portal’s website:
- The name, legal status, physical address and website address of the company.
- The names of the company’s directors and officers (and any persons of similar status and function), and each person holding more than a 20% interest in the company.
- A description of the business and the anticipated business plan of the company.
- A description of the financial condition of the company.
- The target offering amount, the deadline to reach such amount and regular updates about the progress of the company in meeting the target offering amount.
- A description of the stated purpose and intended use of the proceeds of the offering, based on the target offering amount sought by the company.
- The price of the securities offered or the method for determining the price.
- A description of the ownership and capital structure of the company.Financial statements of the company.
The SEC may require additional disclosures as it deems necessary for the protection of investors and in the public interest.
6. What financial statements must a company provide?
The financial statements a company must provide for a crowdfunding offering depend on the size of the offering and whether the company has previously raised funds through crowdfunding.
- For an offering of $100,000 or less, the company must disclose the amount of total income, taxable income and total tax reflected in the company’s federal income tax returns. In lieu of providing a copy of the tax returns, the company’s principal executive officer must certify that the tax information provided accurately reflects the information in the company’s federal income tax returns.
However, if the company offering $100,000 or less has financial statements that have been reviewed by an independent public accountant, the company must provide those financial statements.
- For an offering of more than $100,000, but not more than $500,000, the company must provide financial statements reviewed by a public accountant that is independent of the company.
- A company offering more than $500,000 in reliance on the crowdfunding exemption for the first time is permitted to provide financial statements reviewed by an independent public accountant. However, if the company offering more than $500,000 has previously sold securities in reliance on the crowdfunding exemption, it must provide financial statements audited by an independent public accountant.
- Whenever a company has financial statements that have been audited by an independent public accountant, the company must provide the audited financial statements.
7. What must a company file with the SEC during the course of its crowdfunding offering?
The company makes its initial filing with the SEC on Form C, and must amend its filing to report any material changes. The Form C requires disclosures regarding the company’s size, location, securities offered, and offering amounts. A copy of the disclosures on Form C must be made available to the funding portal at least 21 days before the crowdfunding offering commences, and must remain on the portal’s website until the offering is completed or cancelled.
In addition, the company must make SEC filings periodically during the course of its crowdfunding offering to report the total amount of securities sold in the offering. This requirement may be satisfied if the funding portal frequently updates its website and makes the information available to the public.
A company must file a report at the end of the offering to disclose the total amount of securities sold in the offering. This final filing is required even if the company is relying on the portal to update the disclosure about the offering’s progress.
8. What is the role of a “funding portal” in a crowdfunding offering?
A funding portal is a new type of securities broker whose activities are limited to facilitating crowdfunding offerings.
The participation of a funding portal in a crowdfunding offering is intended to (i) help ensure that the offering is accessible to the public, (ii) facilitate the sharing of information that will allow the crowd to decide whether or not to fund the idea or business, and (iii) provide safeguards for potential investors.
A funding portal (or a broker serving as the intermediary for a crowdfunding offering) is required to:
- Provide investors with educational materials.
- Take measures to reduce the risk of fraud.
- Make available information about the company and the offering.
- Provide communication channels to permit discussions about offerings on the Internet platform.
- Facilitate the offer and sale of crowdfunded securities.
Like a general securities broker, a portal must register with the SEC and be a member of FINRA, the self-regulatory agency that oversees the securities industry. However, funding portals are subject to more limited regulation than a general securities broker, reflecting the limited activities in which portals may engage.
Funding portals are not permitted to engage in the following activities conducted by general securities brokers:
- Offering investment advice or making recommendations.
- Soliciting purchases, sales or offers to buy securities offered or displayed on its website.
- Imposing certain restrictions on compensating people for solicitations.
- Holding, possessing, or handling investor funds or securities.
9. What educational materials must a funding portal provide to investors?
The funding portal must provide general information about conducting a crowdfunding offering as well as the various risks involved, including the following:
- The process for the offer, purchase and issuance of securities through the funding portal.
- The risks associated with investing in securities offered and sold in a crowdfunding offering.
- The types of securities that may be offered on the portal’s platform and the risks associated with each type of security, including the risk of having limited voting power as a result of dilution.
- The restrictions on the resale of securities offered and sold in a crowdfunding offering.
- The types of information that an issuer is required to provide in annual reports, the frequency of the delivery of that information, and the possibility that the issuer’s obligation to file annual reports may terminate in the future.
- The limits on the amounts investors may invest.
- The circumstances in which the issuer may cancel an investment commitment.
- the limitations on an investor’s right to cancel an investment commitment;
- The need for the investor to consider whether investing in a security offered and sold in a crowdfunding offering is appropriate for him or her.
- That following completion of an offering, there may or may not be any ongoing relationship between the issuer and portal.
10. What must a portal do to reduce the risk of fraud?
A funding portal must have a reasonable basis for believing that a company seeking to conduct a crowdfunding offering through the funding portal’s platform:
- Complies with the applicable statutes and SEC rules.
- Has established means to keep accurate records of its securities, both with respect to the initial crowdfunding offering and subsequent transfers.
A funding portal is permitted to reasonably rely on representations of the company, absent knowledge or other indications that the representations are not true.
A portal must deny a company access to its platform if the portal has a reasonable basis for believing that the company, any of its officers, directors, or any holder of 20% of the company’s equity is subject to a disqualification under SEC rules. To do this, the portal must conduct a background check on the company, as well as on each of the company’s officers, directors and 20% equity holders.
More generally, a portal must deny access if it believes that the company or the offering presents the potential for fraud or otherwise raises concerns regarding investor protection.
11. How can a portal be paid for its service?
A funding portal, when opening an account for an investor, must clearly disclose the manner in which the portal will be compensated in connection with crowdfunding offerings. A funding portal can charge a straight fee for its services. However, the rules prohibit certain forms of compensation that could give rise to conflicts of interest when the persons facilitating a crowdfunding transaction have a financial stake in its successful outcome.
A funding portal and its directors, officers or partners are specifically prohibited from receiving a financial interest in the company as compensation for services provided to the company in connection with a crowdfunding offering.
In addition, a funding portal and its directors, officers or partners are prohibited from having any financial interest in a company using the portal’s services. “Any financial interest in a company” means direct or indirect ownership of, or economic interest in, any class of the company’s securities.
12. What are a company’s ongoing filing obligations after completing a crowdfunding offering?
A company that has sold securities in a crowdfunding offering must file an annual report with the SEC and post the report on its website, no later than 120 days after the end of the fiscal year covered by the report.
The company will be required to file the annual report until the earliest of the following events occurs:
- The company is required to file SEC reports under Securities Exchange Act.
- 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 that do not exceed $10 million.
- The company or another party purchases or repurchases all of the securities issued pursuant to the crowdfunding exemption.
- The company liquidates or dissolves in accordance with state law.
The final rules require the annual report to include financial statements of the company, certified by its principal executive officer to be true and complete in all material respects. However, companies that have available financial statements that have been reviewed or audited by an independent certified public accountant because they prepare them for other purposes must provide them and will not be required to have the principal executive officer certification.