The new federal crowdfunding rules go into effect May 16, 2016. Now startups and other growth-oriented companies can raise up to $1 million dollars per year from the general public, provided the company (the Issuer) follows the new rules adopted by the Securities and Exchange Commission (SEC). In contrast to the donative-models of crowdfunding commonly associated with Kickstarter, Indiegogo, and GoFundMe (where participants may receive, for example, a T-Shirt or early release of a product in exchange for a donation), equity crowdfunding investors are like micro-venture capitalists who could enjoy a return on their investment if the business is successful.
Known as “Regulation Crowdfunding”, the new federal rule provides another exemption from the default requirement that any offer or sale of a security must be registered under the Securities Act of 1933. Because the process of registering a securities offering (commonly referred to as “going public”) is complicated and expensive, Issuers most often rely on the “all accredited investor” private placement exemption found in Regulation D. That exemption, Rule 506, exempts offers and sales to accredited investors (e.g., individuals with net worth in excess of $1 million, and others).
However, with Regulation Crowdfunding expanding permissible potential investors to virtually everyone in the United States, proponents hope that entrepreneurs can spend less time seeking out high net worth potential investors capable of writing large checks, and rely instead on the power of a compelling business idea or plan, modern technology, and small aggregate investments. A successful crowdfunding campaign could allow entrepreneurs to invest more of their time on their core business, thus potentially increasing their likelihood of success.
To comply with Regulation Crowdfunding, an Issuer must meet stringent requirements, including filing an offering statement on Form C (available here). A completed Form C will include, among other items, the following:
- description of the Issuer’s company and business plan;
- identification of officers, directors, and principal existing stockholders or members,
- provision of financial statements in US GAAP (in some cases must be reviewed by a public accountant),
- disclosure of significant risks to the company and/or its business.
In addition to the cap of raising $1 million in any 12-month period by any Issuer, Regulation Crowdfunding allows limits the amount any investor can invest across all crowdfunding Issuers in any 12-months.
For example, an investor with income or net worth below $100,000 may invest only the greater of:
- $2,000, or
- 5% of the lesser of his annual income or net worth.
An investor with net worth and income greater than $100,000 may invest 10% of the lesser of her:
- annual income, or
- net worth.
No individual may invest more than $100,000. In addition to these requirements, an Issuer relying on Regulation Crowdfunding must use a registered broker-dealer or funding platform to facilitate the securities offering, and take reasonable steps to verify compliance with the limitations on the investment amounts. As for ongoing reporting requirements, the Issuer must also file a crowdfunding-specific annual report (Form C-AR) each year that provides updated information including financial statements.
Any securities offering, including a crowdfunding, is a serious endeavor requiring planning and careful observance of the legal requirements (which are only summarized in part here). Anyone considering using Regulation Crowdfunding should be mindful of anti-fraud Rule 10-b5. That rule prohibits making untrue statements or withholding or omitting material information. An investor is entitled to know all information about a potential investment that could reasonably be deemed important to a potential investor in making its investment decision. A violation of anti-fraud rules impose joint and several liability for all members of the selling group (e.g., officers and directors).
For that reason, it is important for any Issuer to thoughtfully analyze its business and the risks it faces and be prepared to provide detailed, written, disclosure that will mitigate issues in the future. Successful Issuers often use that disclosure as a sales opportunity. Properly crafted disclosures can encourage trust and confidence by demonstrating the Issuer’s command of the core of its business. Furthermore, Regulation Crowdfunding is only one possible offering structure among several that could be available to an Issuer. It is important to find the structure that best suits an Issuer’s needs.