At an open meeting on October 30, 2015, the Securities and Exchange Commission by a three-to-one vote adopted final rules for equity crowdfunding under Section 4(a)(6) of the Securities Act of 1933, as mandated by Title III of the Jumpstart Our Business Startups Act. The final rules and forms are effective 180 days after publication in the Federal Register.
Crowdfunding is an evolving method of raising funds online from a large number of people without regard to investor qualification and with each contributing relatively small amounts.[i] Until now, public crowdfunding has not involved the offer of a share in any financial returns or profits that the fundraiser may expect to generate from business activities financed through crowdfunding. Such a profit or revenue-sharing model – sometimes referred to as the “equity model” of crowdfunding – could trigger the application of the federal securities laws because it likely would involve the offer and sale of a security to the public. Equity crowdfunding has the potential to dramatically alter the landscape of capital markets for startup companies. It has also been the subject of a contentious debate ever since it was included in the JOBS Act, pitting those who want to allow startups to leverage the internet to reach investors and to permit ordinary people to invest small amounts in them against those that view crowdfunding as a recipe for a fraud disaster.
The SEC had issued proposed rules in October 2013 (see my blog post here), and received hundreds of comment letters in response. When the final rules become effective (early May 2016), issuers for the first time will be able to use the internet to offer and sell securities to the public without registration. Here’s a brief summary of the new crowdfunding exemption rules and where they deviate from the original proposal.
Issuer and Investor Caps
- Issuers may raise a maximum aggregate amount of $1 million through crowdfunding offerings in any 12-month period.
- Individual investors, in any 12-month period, may invest in the aggregate across all crowdfunding offerings up to:
- The greater of $2,000 or 5% of the lesser of annual income or net worth, if either annual income or net worth is less than $100,000, or
- 10% of the lesser of their annual income or net worth if both their annual income and net worth are equal to or more than $100,000.
- Aggregate amount an investor may invest in all crowdfunding offerings may not exceed $100,000 in any 12-month period.
Many commenters believed that the proposed $1 million offering limit was too low, but the SEC in the end believed the $1 million cap is consistent with the JOBS Act. The SEC did state in the final rules release, however, that Regulation Crowdfunding is a novel method of raising capital and that it’s concerned about raising the offering limit of the exemption at the outset of the adoption of final rules, suggesting that it would be open to doing so down the road.
As for the individual investment limit, the final rules deviate from the original proposal by clarifying that the limit reflects the aggregate amount an investor may invest in all crowdfunded offerings in a 12-month period across all issuers, and also specifies a “lesser of” approach to the income test.
Financial disclosure requirements are based on the amount offered and sold in reliance on Section 4(a)(6) within the preceding 12-month period, as follows:
- For issuers offering $100,000 or less: disclosure of total income, taxable income and total tax as reflected in the federal income tax returns certified by the principal executive officer, and financial statements certified by the principal executive officer; but if independently reviewed or audited financial statements are available, must provide those financials instead.
- Issuers offering more than $100,000 but not more than $500,000: financial statements reviewed by independent public accountant, unless otherwise available.
- Issuers offering more than $500,000:
- For issuers offering more than $500,000 but not more than $1 million of securities in reliance on Regulation Crowdfunding for the first time: financial statements reviewed by independent public accountant, unless otherwise available.
- For issuers that have previously sold securities in reliance on Regulation Crowdfunding: financial statements audited by independent public accountant.
The financial disclosure requirements contain a number of changes from the proposal that hopefully will help reduce the costs and risks associated with preparing the required financials. Instead of mandating that issuers offering $100,000 or less provide copies of their federal income tax returns as proposed, the final rules require an issuer only to disclose total income, taxable income and total tax, or the equivalent line items, from filed federal income tax returns, and to have the principal executive officer certify that those amounts reflect accurately the information in the returns. This minimizes the risk of disclosure of private information which would exist if tax returns had to be provided. In addition, reducing the requirement for first time issuers of between $500,000 and $1 million from audited financials (as had been proposed) to reviewed financials is a sensible accommodation inasmuch as the concern about the cost and burden of the audit relative to the size of the offering is even greater for first timers who would need to incur the audit expense before having proceeds from the offering.
- Offerings must be conducted exclusively through one platform operated by a registered broker or funding portal.
- Intermediaries required to provide investors with educational materials, take measures to reduce the risk of fraud, make available information about the issuer and the offering and provide communication channels to permit discussions about offerings on the platform.
- Funding portals prohibited from offering investment advice, soliciting sales or offers to buy, paying success fees and handling investor funds or securities.
- Funding portals must register with the SEC by filing new Form Funding Portal, which will be effective January 29, 2016.
The rationale behind the requirement to use only one intermediary is that it helps foster the creation of a “crowd”. Having one meeting place enables a crowd to share information effectively, and minimizes the chances of dilution or dispersement of the crowd. This in turn supports one of the main justifications for equity crowdfunding, which is that having hundreds or thousands of investors sharing information increases the chances that any fraud will be exposed, thus the “wisdom of the crowd”. The one platform requirement also helps to minimize the risk that issuers and intermediaries would circumvent the requirements of Regulation Crowdfunding. For example, allowing an issuer to conduct an offering using more than one platform would make it more difficult for intermediaries to determine whether an issuer is exceeding the $1 million aggregate offering limit.
One important deviation from the proposed rules is that funding portals will be permitted to curate offerings based on subjective criteria, not just based on perceptions of fraud risk. A second important deviation is that all intermediaries will be allowed to receive as compensation a financial interest in the issuers conducting offerings on their platforms, which will expand the options available to cash-starved startups.
The ink is still wet on the SEC’s 686 page release, but here are some preliminary thoughts. Equity crowdfunding has the potential to create new capital raising opportunities for many startups and early stage companies by removing antiquated regulatory barriers and allowing companies to leverage the internet and social media to reach and sell to prospective investors without regard to accredited investor status. The federal securities laws were written over 80 years ago when investors had no access to information about issuers. In the internet age, prospective investors have many sources of information at their fingertips and the “wisdom of the crowd” can both steer dollars to the most promising companies and ensure that ample information is spread to interested parties.
As I’ve stated before, however, the SEC’s preoccupation with investor protection has created a disconnect between the potential of equity crowdfunding and its reality, now expressed in the final rules. To be fair, the framework for most of the rules was predetermined by what Congress enacted in Title III of the JOBS Act and the final rules do contain some welcome relief from the original proposal. Nevertheless, I fear that the burden and expense associated with some of the rules will make Regulation Crowdfunding far less attractive to most companies than traditional offerings under Rule 506 notwithstanding the latter’s pro-accredited investor bias. For example, the requirement to produce audited financial statements for offerings above $500,000 (except for first time Regulation Crowdfunding issuers) will seem prohibitively expensive when compared with accredited investor-only Rule 506 offerings where no financials are mandated at all. It’s also unclear how the burdensome rules governing intermediaries will attract established investment banks, or even boutiques, and will likely leave the field open primarily to persons with scant resources and experience. Lastly, even in the context of a successful crowdfunded offering, companies will also need to consider carefully the negative consequences associated with a shareholder base consisting of potentially thousands of individual investors. Those consequences include the expense associated with keeping them informed, the difficulties of securing quorums and votes and the inevitable misgivings VCs will have of investing in a crowdfunded startup.
In the final analysis, though, Title III equity crowdfunding will finally become law, meaning that issuers will for the first time be allowed to leverage the internet to sell securities to an unlimited number of investors without registration and without regard to accredited investor status, and that is decidedly a treat.
 The term “crowdfunding” has also been used more broadly as a somewhat generic term for any campaign to raise funds through an online platform. These include non-equity crowdfunding (i.e., rewards or pre-order based), “accredited” crowdfunding (in reliance on Rule 506(b) or 506(c)) and registered crowdfunding (in reliance on Regulation A+). This post will use the term only as it applies to small equity offerings to many investors, each contributing relatively small amounts, and soon to be available under Regulation Crowdfunding.