The Securities and Exchange Commission (the “SEC”) adopted final rules under the JOBS Act that permit crowdfunded offerings. As of May 16, 2016, companies can now use Regulation Crowdfunding to offer and sell securities to the general public to raise up to $1 million in a 12-month period.
Brief Summary of Equity Crowdfunding
While equity crowdfunding was designed to help businesses raise capital by reducing the costs of the offerings and boosting efficiency, there are numerous requirements that must be met, including some of the following:
- Companies that raise funds via equity crowdfunding must use registered broker dealers or SEC-registered portals to raise funds from investors.
- The intermediaries must be registered with the SEC via a new form (Form Funding Portal), be a member of FINRA (Financial Industry Regulatory Authority) and comply with many requirements related to the offering and information provided to investors.
- Companies using a crowdfunded offering must complete and file Form C with the SEC. Form C is a newly created form which requires the disclosure of business and financial information, including financial statements prepared in accordance with GAAP.
- Companies must file reports disclosing any material changes with the company, additions or updates to the information provided to investors for an offering that has not yet been completed or terminated.
- Companies must provide updates about its progress toward meeting the target offering amount which may be publicly posted by the intermediary on its platform or filed by the issuer on the SEC’s EDGAR system.
- The offering must be open for at least twenty-one (21) days and potential investors are allowed to cancel their commitment for any reason up to 48 hours prior to the specified deadline.
- Issuers will be subject to ongoing reporting requirements, such as filing an annual report with the SEC at the end of the fiscal year and posting the report on its website.
- Depending on the amount raised, financial statements included in the annual report must be certified by a principal executive officer or audited by an independent certified public accountant
- Issuers are prohibited from advertising the terms of an offering, except for notices directing investors to the funding portal or broker-dealer.
While there are no restrictions on the number of unaccredited investors who may participate in a crowdfunded offering, there are limits to the amounts individuals can invest in a 12-month period, which is determined by an investor’s net worth and annual income.
Crowdfunded securities are subject to numerous restrictions. Investors are prohibited from reselling crowdfunded securities for one (1) year, unless the securities are transferred, which is only allowed in limited situations.
Now that the rules have been implemented, one question continues to be asked:
“Is this a viable solution for small companies seeking to raise funds from the general public?”
The simple answer is … MAYBE.
There’s real tension between how much the issuer can raise and the cost to the issuer to raise funds while remaining compliant with the on-going reporting requirements.
For startups with little or no operating capital, Regulation Crowdfunding is not ideal. It will require a significant expenditure of funds before the company can even begin to raise money. The issuing company will need to secure the services of the following professionals:
- Securities attorney who can prepare the documents necessary for the offering and assist the company in completing Form C. Estimated cost for legal services – $15,000 to $30,000.
- CPA who can prepare financials required by equity crowdfunding rules. Estimated cost for accounting services – $10,000 to $30,000.
- Transfer agent who will keep a record of the investors. Estimated cost for services is unknown, will vary depending on agent, the services provided, and the number of shareholders.
- Crowdfunding platform that serves as the intermediary for the offering. Estimated costs for services is unknown, but intermediaries may charge issuers a flat fee, but not a commission on the investment.
With the amount raised limited to $1 million, the upfront legal and other expenses, and the on-going reporting requirements for hundreds of shareholders, issuers could burn through a significant portion of the capital raised just complying with rules. This would leave very little money for growing or operating the business, putting a company back at square one.
A possible solution is for the issuing company to raise a lower amount to keep some of the costs contained. For example, a company that raises $500,000 or less would only need financial statements reviewed by a CPA (versus audited financials if the company raises more than $500,000). Given that this is an on-going requirement, the savings for the company could be considerable over time. Also, there may be fewer investors for that same company, reducing the fees for a transfer agent and the costs of corporate governance.
Investment in startups and small companies is speculative and businesses often fail. Angel investors and venture capitalists may be reluctant to invest in companies that use equity crowdfunding to raise funds due to increased risks of dealing with unaccredited investors.
Because companies can have an unlimited number of unaccredited investors, there is a fear of investor lawsuits should a company fail and the investors lose their money. A shareholder lawsuit, even one lacking legal merit, could sink a small company, risking the investment of every shareholder.
With the vast reporting and disclosure requirements, companies must weigh the costs and benefits of compliance with the rules, including whether it wants to publicly disclose financial statements and other information about its business, as mandated by Form C. Another concern is the impact on corporate governance from possibly having hundreds of shareholders.
Given the cost of raising up to $1 million, many companies will likely shy away from equity crowdfunding until a system is developed that streamlines the process and cuts costs while maintaining compliance with the crowdfunding rules.
Furthermore, Congress should revisit this soon and increase the limit to $5 million to make it worthwhile for startups and small companies. Clearing these considerable hurdles just to raise $1 million is hardly worth it in today’s economy where a startup company can burn through that amount in a few months.
Until these things happen, it is unlikely that many companies will avail themselves of the new equity crowdfunding rules. They will likely continue to use other securities exemptions to raise funds from accredited investors (and a limited number of unaccredited investors) or seek funds from friends and family.