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Bloomberg reported on October 16 that over $3 billion dollars have been raised in over 200 initial coin offerings so far this year. It remains to be seen whether the pace of ICOs will slow down in the face of regulatory headwinds such as the outright ICO bans in China and South Korea. Here in the United States, the Securities and Exchange Commission has been sounding alarm bells. On July 25, the SEC’s Division of Enforcement issued a Report of Investigation finding that tokens offered and sold by a virtual organization known as “The DAO” were securities and therefore subject to the federal securities laws. I blogged about it here. On the same day the SEC issued the report, its Office of Investor Education and Advocacy issued an investor bulletin to make investors aware of potential risks of participating in ICOs.  Then on September 29, it charged a businessman and two companies with defrauding investors in a pair of ICOs purportedly backed by investments in real estate and diamonds. And on November 1, it issued a “Statement on Potentially Unlawful Promotion of Initial Coin Offerings and Other Investments by Celebrities and Others”, warning that any celebrity or other individual who promotes a virtual token or coin that is a security must disclose the nature, scope, and amount of compensation received in exchange for the promotion.

Needless to say, the days of ICOs flying below the SEC’s radar are over, and developers conducting token sales to fund the development of a network need to be aware of the securities law implications of the sale.  In its Report of Investigation, the SEC made clear (what most of us suspected all along) that the traditional Howey test for determining whether a funding mechanism is an ”investment contract” and thus a “security” applies to blockchain based tokens. I won’t go into a deep dive here. For those wanting to jump into the weeds, Debevoise has done a pretty good job on this. But the basic test under Howey is that an agreement constitutes an investment contract that meets the definition of a “security” if there is (i) an investment of money, (ii) in a common enterprise, (iii) with an expectation of profits, (iv) solely from the efforts of others.

It’s useful to consider that blockchain tokens fall generally into two broad categories. “Securities tokens” are basically like shares in a corporation or membership interests in a limited liability company where the purchaser receives an economic right to a proportional share of distributions from profits or a sale of the company. On the other hand, “utility tokens” don’t purport to offer purchasers an interest or share in the seller entity itself but rather access to the product or service the seller is developing or has developed. Unfortunately, there exists virtually no SEC or case law guidance on securities law aspects of utility tokens. The token at issue in the SEC’s investigative report on The DAO was a securities token. The DAO was a smart contract on the Ethereum blockchain that operated like a virtual venture fund. Purchasers would share in profits from the DAO’s investments and so the tokens were like limited partnership interests.

The question of whether utility tokens are securities may turn on whether the blockchain network for which the tokens will function is fully functional or still in development, and an interesting debate has emerged as to whether there should be a bright line test on that basis.

One side of the debate, advanced by Cooley (Marco Santori) and Protocol Labs (Juan Batiz-Benet and Jesse Clayburgh), is that purchasers of utility tokens prior to network launch and before genuine utility necessarily rely on the managerial and technical efforts of the developers to realize value from their tokens. Accordingly, agreements for the sale of pre-functional tokens meet the “expectation of profit” and “through the efforts of others” prongs of Howey and should be characterized as securities. On the other hand, fully functional utility tokens should not be considered securities because they fail the “through the efforts of others” prong of Howey and maybe even the “expectation of profit” prong.  Purchasers of fully functional tokens are likely to be people seeking access to the seller’s network as consumers or app developers with any expectation of profit from appreciation of the tokens being a secondary motivation, so the expectation of profit prong of Howey fails as to those purchasers. The same conclusion should apply even as to the other type of purchaser who is motivated primarily by the prospect of a token resale for profit because the profit that is hoped for is not expected to come through the managerial or entrepreneurial efforts of the developers, but rather through the many different independent forces that drive supply and demand for the tokens. There is a line of cases involving contracts for the purchase of commodities holding that they are not securities because the expectation of profit was solely from fluctuations in the secondary market, and not from any efforts on the part of the producer. Fully functional tokens are analogous to commodities in that the token developers have completed development of the network, and so there should not be any expectation that profit will result from any further efforts by the seller.

On the other side of the debate is Debevoise, which advocates for a facts and circumstances approach, rejects the bright line test of whether or not a utility token is fully functional and offers several arguments. The determination of whether an agreement is an investment contract and thus a security has long been based upon a facts and circumstances analysis. A blockchain token is not a homogenous asset class; a token could be a digital representation of an equity or debt security but it could also represent things like hospital records or a person’s identity, and that particular character of the token is unaffected by whether the network is or is not fully functional. Also, there is an implicit recognition in the JOBS Act that pre-order sales on non-equity crowdfunding sites like Kickstarter and Indiegogo are not sales of securities, and that pre-functional utility token sales should be analyzed the same way.  It also questions whether agreements by a mature company to presell a new product in development would automatically be deemed an investment contract. Finally, there’s the difficulty of determining when exactly a token is fully-functional given the complexity of software and network development.

Seems to me that the arguments on both sides of the utility token debate have merit.  I do think there’s a distinction, though, between pre-order sales of product by a mature company and a sale of pre-functional tokens, in that the tokens most likely can be sold on a secondary market, with any profit likely resulting from the entrepreneurial efforts of the developer.  I also think that until we have guidance from the SEC and/or judicial opinions on the issue, the better approach is to treat clearly pre-functional tokens as investment contracts and conduct their sale under an exemption from registration.

On June 8, 2017, the House of Representatives passed the Financial CHOICE Act of 2017 on a vote of 233-186. Congress loves acronyms, and here “CHOICE” stands for Creating Hope and Opportunity for Investors, Consumers and Financial Choice ActEntrepreneurs. Although the thrust of the bill is focused on repeal or modification of significant portions of the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 and addresses a number of other financial regulations, it also includes a broad range of important provisions aimed at facilitating capital formation, including:

  • Exemption of private company mergers and acquisitions intermediaries from the broker-dealer registration requirements of the Exchange Act;
  • Expansion of the private resale exemption contained in Section 4(a)(7), which codified the so-called “Section 4(a)(1½)” exemption for resales of restricted securities by persons other than the issuer, by eliminating information requirements and permitting general solicitation, so long as sales are made through a platform available only to accredited investors;
  • Exemption from the auditor attestation requirement under Section 404(b) of Sarbanes-Oxley of companies with average annual gross revenues of less than $50 million;
  • Creation of SEC-registered venture exchanges, a new class of stock exchanges that can provide enhanced liquidity and capital access to smaller issuers;
  • Exemption of small offerings that meet the following requirements: (i) investor has a pre-existing relationship with an officer, director or shareholder with 10 percent or more of the shares of the issuer; (ii) issuer reasonably believes there are no more than 35 purchasers of securities from the issuer that are sold during the 12-month period preceding the transaction; and (iii) aggregate amount of all securities sold by the issuer does not exceed $500,000 over a 12-month period;
  • Exemption from the prohibition in Regulation D against general solicitation for pitch-type events organized by angel groups, venture forums, venture capital associations and trade associations;
  • Streamlining of Form D filing requirements and procedures with the filing of a single notice of sales and prohibiting the SEC from requiring any additional materials;
  • Exemption from the Investment Company Act for any VC fund with no more than $50 million in aggregate capital contributions and uncalled committed capital and having not more than 500 investors;
  • Exempting Title III crowdfunding shareholders from the shareholder number trigger for Exchange Act registration;
  • Amendment of Section 3(b)(2) of the Securities Act (the statutory basis for Regulation A+) to raise the amount of securities that may be offered and sold within a 12-month period from $50 million to $75 million; and
  • Allowing all issuers, not just emerging growth companies, to submit confidential registration statements to the SEC for nonpublic review before an IPO, provided that the registration statement and all amendments are publicly filed not later than 15 days before the first road show.

In the coming weeks, I intend to blog in greater detail about a few of these reform efforts, including the proposed broker-dealer exemption for M&A intermediaries, venture exchanges and crowdfunding fixes.

NYSEThe fate of the Financial CHOICE Act is unclear. A variety of interest groups have expressed strong opposition to the bill, and it appears unlikely the Senate will pass it in its current form. My hunch is that the more controversial aspects of the bill relate to the Dodd-Frank repeal and other financial services reforms. I also believe that there is greater potential for general consensus building around capital markets reform, as was demonstrated in connection with the passage of the JOBS Act five years ago, so that any final version that ultimately gets passed will hopefully include much if not all of the reforms summarized above.

On March 22, the Subcommittee on Capital Markets, Securities, and Investment of the Financial Services Committee conducted a hearing entitled “The JOBS Act at Five: Examining Its Impact and Ensuring the Competitiveness of the U.S. Capital Markets”, focusing on the impact of JOBS Act at 5the JOBS Act on the U.S. capital markets and its effect on capital formation, job creation and economic growth. The archived webcast of the hearing can be found here. Most people won’t have the patience to sit through two hours and 44 minutes of testimony (although the running national debt scoreboard on the right side of the home page showing in real time the national debt increasing by $100,000 every three seconds, and by $1 million every 30 seconds, etc., is eyepopping). At the risk of being accused of having too much time on my hands, but as an act of community service, I watched the hearing (or at least most of it) and will offer some takeaways.

Raymond Keating, Chief Economist of the Small Business & Entrepreneurship Council, testified about some disturbing trends in angel and VC investment. The value and number of angel deals is down from pre-recession levels.  VC investment showed the most life but a decline in raymond keating2016 is troubling. So what’s going on?  Keating believes it’s about reduced levels of entrepreneurship stemming in large part from regulatory burdens that limit entrepreneurs’ access to capital and investors’ freedom to make investments in entrepreneurial ventures. He also testified on the need for further reform, particularly in Regulation Crowdfunding under Title III which allows companies for the first time to raise capital from anyone, not just accredited investors, without filing a registration statement with the SEC, and identified the following reform targets:

  • Issuer Cap. Currently, issuers are capped at $1 million during any rolling twelve-month period. There’s been a push to increase that cap, perhaps to $5 million.
  • Investor Cap. Currently, investors with annual income or net worth of less than $100,000 are limited during a 12-month period to the greater of $2,000 or 5% of the lesser of annual income or net worth, and if both annual income and net worth exceed $100,000, then the limit is 10% of the lesser of income or net worth. The proposal here would be to change the application of the cap from the lower of annual income or net worth to the higher of annual income or net worth.
  • Funding Portal Liability. Currently, funding portals can be held liable for material misstatements and omissions by issuers. That poses tremendous and arguably unfair risk to funding portals and may deter funding portals from getting in the business in the first place. The proposal here would be that a funding portal should not be held liable for material misstatements and omissions by an issuer, unless the portal itself is guilty of fraud or negligence. Such a safe harbor for online platforms would be similar to the protection that traditional broker dealers have enjoyed for decades. A funding platform is just a technology-enabled way for entrepreneurs to connect with investors, and they don’t have the domain expertise of issuers and can’t verify the accuracy of all statements made by issuers.  Part of the role of the crowd in crowdfunding is to scrutinize an issuer, a role that should remain with the investors, not with the platform.
  • Syndicated Investments. Many accredited investor crowdfunding platforms like AngeList and OurCrowd operate on an investment fund model, whereby they recruit investors to invest in a special purpose vehicle whose only purpose is to invest in the operating company. Essentially, a lead investor validates a company’s valuation, strategy and investment worthiness. Traditionally, angel investors have operated in groups and often follow a lead investor, a model which puts all investors on a level playing field.
  • $25 Million Asset Registration Trigger.  Under current rules, any Regulation CF funded company that crosses a $25 million asset threshold would be required to register under the Securities Exchange Act and become an SEC reporting company. Seems inconsistent with the spirit of Regulation Crowdfunding, which for the first time allows companies to offer securities to the public without registering with the SEC.

As to the continuing challenge for companies to go and remain public, Thomas Quaadman, Vice President of the U.S. Chamber of Commerce, testified that the public markets are in worse shape today than they were five years ago and that we have fewer than half the public companies quaadmantoday than we had in 1996, a number that has decreased in 19 of the last 20 years. Mr. Quaadman blamed this in part on an antiquated disclosure regime that is increasingly used to embarrass companies rather than provide decision useful information to investors. In order to rebalance the system and reverse the negative trend, he suggested a numbere of reform measures the SEC and Congress should undertake. The disclosure effectiveness proposal should be a top priority for the SEC to bring the disclosure regime into the 21st century. We need proxy advisory firm reform that brings transparency, accountability and oversight to proxy advisory firms. Also, there should be recognition that capital formation and corporate governance are inextricably linked and there should be reform of the shareholder proposal process under Rule 14a-8.

Snap IPOThe just completed IPO of Snap Inc. has received enormous buzz and plenty of press coverage, mostly about its eye-popping valuation and offering proceeds, the big winners among the founders and early investors and the millennials who bought shares. But not nearly as much attention has been given to Snap’s tri-class capital structure and the nature of the shares that were actually issued in the IPO: the shares of Class A Common Stock sold in the IPO are non-voting. By its own admission, Snap may have pulled off the first ever IPO of non-voting stock.

Snap’s capital now consists of the non-voting Class A shares held by public investors, Class B shares snapIPO2with one vote per share held by early round investors, employees and directors and Class C shares with ten votes per share held by the founders. As a result of the Class C common stock that they hold, co-founders Evan Spiegel and Robert Murphy will be able to exercise voting rights with respect to an aggregate of 215,887,848 shares, representing approximately 88.5% of the voting power immediately following the offering. Consequently, Spiegel and Murphy, and potentially either one of them alone (see below), have the ability to control the outcome of all matters submitted to stockholders for approval, including election, removal, and replacement of directors and any merger or sale of all or substantially all of the assets.

Multiple class structures are not unusual, and several high profile companies went public with them in recent years. What’s unusual here is that whereas the shares sold in those other multiple class structure IPOs had at least some voting rights (typically, one vote per share vs. 10 for the founder class), Snap’s public offering shares have no voting rights. Technically, Delaware law would permit holders of Snap’s Class A non-voting stock nevertheless to vote with one vote per share on any proposal to amend the certificate of incorporation in any way that would adversely affect the holders of the Class A. For example, if a proposed amendment provided for the Class A to rank junior to the Class B and Class C with respect to dividends or acquisition proceeds, a Class A vote would be required and the holders of a majority of Class A shares could defeat that amendment. Such a proposal would be extremely rare, however, and the Class A holders would have no say in the much more typical matters of board elections and any proposed sale of the company.

Multiple share classes are especially useful to public technology companies because they give them the freedom to innovate without the constraints of “short termism” and also serve as a deterrence to takeover bids because of activists’ inability to manipulate the voting machinery for election of directors.

Snap’s Class A common stock will be its only class registered under Section 12 of the Securities Exchange Act, and because the Class A is non-voting, Snap will not be required to file proxy statements except for a rare case where a vote of the Class A common stock is required (see above). Nevertheless, Snap indicated in its S-1 that it will provide Class A holders any information that it provides voluntarily to Class B and Class C holders.

What makes Snap’s structure even more unusual is survivability and portability.  According to Snap’s S-1, If Spiegel’s or Murphy’s employment is terminated (which, because of their control, could only happen if they turn on each other), they will continue to have the ability to exercise the same significant voting power and continue to control the outcome of all matters submitted to stockholders for approval. A founder’s Class C shares will automatically convert into Class B shares, on a one-for-one basis, nine months following such founder’s zuckerbergdeath or on the date on which the number of outstanding Class C shares held by such holder represents less than 30% of the Class C (or 32,383,178 shares) held by such holder at the time of the IPO. Facebook, on the other hand, amended its certificate of incorporation so that Mark Zuckerberg’s majority voting control is good only while he is an executive at the company.

Snap’s capital structure has drawn some criticism. In a New York Times piece, Cal Berkley law professor Steven Davidoff Solomon referred to Snap’s IPO as “the most stockholder-unfriendly governance in an initial public offering, ever.” In the Harvard Law School Forum on Corporate Governance and Financial Regulation, Rob Kalb and Rob Yates of Institutional Stockholder Services cited a 2016 ISS study that showed that controlled companies had weaker governance standards and tended to underperform “with respect to total stockholder returns, revenue growth, return on equity, and dividend payout ratios.” And the Council of Institutional Investors sent a letter to Snap’s co-founders objecting to the capital structure and urging them to adopt a single class structure. While acknowledging that similar emerging companies with dynamic leadership and promising products have successfully raised capital despite having dual class structures, Snap’s structure is unusual in that the investors would have no voting rights and dual class company performance has been mixed at best.

When Google, Facebook and Under Armour went public, they each did so with a dual-class share structure that at least afforded public stockholders one vote per share. Nevertheless, each company subsequently requested stockholder approval for the issuance of a third class of non-voting shares. In each case, the purpose of creating a new non-voting class was to maintain founder voting control while simultaneously providing insider liquidity.

Despite the overall positive outcomes achieved by Google and Facebook for their stockholders, going public as a controlled company with an unequal-voting-rights structure is no guaranty for financial success. Groupon, Zynga and GoPro each went public with a dual-class structure, received poor ISS corporate governance scores indicating the highest levels of governance risk, and the share price of all three dropped precipitously since their respective IPOs.

Adding salt to the corporate governance wound, Snap is taking advantage of emerging growth company status under the JOBS Act, meaning that it is not required to comply with the auditor attestation requirements under Sarbanes-Oxley and the reduced executive compensation disclosure requirements and may delay adoption of new public-company accounting principles.

In the final analysis, investors will need to decide which Mark the Snap founders better resemble, Facebook’s Zuckerberg or Zynga’s Pincus. And looking beyond Snap, it remains to be seen whether other emerging companies adopt the Snap IPO playbook by launching IPOs with multiple-class structures that preserve founder control and give public stockholders little or no governance voice.

2016 turned out to be a terrible year for IPOs, both in terms of number of deals and aggregate proceeds.

According to Renaissance Capital’s U.S. IPO Market 2016 Annual Review, only 105 companies went public on U.S. exchanges in 2016, raising only $19 billion in aggregate proceeds. The deal count of 105 IPOs was downrenaissance 38% from 2015 and the lowest level since 2009.  The $19 billion in aggregate proceeds was down 37% from 2015 and the lowest level since 2003.  In fact, if you remove the financial recession years of 2008 and 2009, the 105 IPOs in 2016 were also the lowest since 2003.  And the drop in deal activity was indiscriminate; both VC- and PE-backed IPOs were at their lowest levels by deal count and proceeds raised since 2009.

The temptation would be to blame the weak IPO market on political election 2016uncertainty, with Brexit and the U.S. election being the biggest culprits. But then how to explain the broader U.S. capital markets, which were hot in 2016. The Dow Jones Industrial Average hovered around 20,000 at year end, and the S&P 500 Index was up 9.5% for the year.  One would expect that the market for IPOs would be pretty strong, as bullish markets normally encourage companies to go public.  To be fair, much of the market gains took place in the latter half of the fourth quarter.  But market weakness doesn’t explain the two-year drought in IPOs for technology companies, considered the mainstay of the IPO market.

Another common theory is that over-regulation, particularly Sarbanes Oxley, has made it much more expensive to go and remain public, thus discouraging many growth companies from doing so. The 2012 JOBS Act tried to remedy this by creating an IPO on-ramp for emerging growth companies, allowing for confidential registration statement filings with the SEC, “testing-the-waters” and scaled disclosure.  The immediate results were encouraging: a dramatic increase in IPO deals and aggregate proceeds in 2014.  Yet IPOs plummeted in 2015 and even further in 2016.

Renaissance Capital’s report points the finger squarely at the public-private valuation disconnect. The tech startup space in 2015 was a mystifying series of mega rounds, sky-high valuations, unicorns and unicornbubble fears. But another trend has been IPOs being priced below the company’s most recent private funding round.  In its pre-IPO round, Square Inc. was valued at approximately $6 billion, but IPO’d at just over half that valuation and then plunged further post-IPO.  Etsy Inc. and Box Inc. both reported $5 billion plus private valuations, only to plunge in the days leading up to their IPOs.  Many, including Benchmark Capital’s Bill Gurley, have blamed the late-stage bidding frenzy on institutional public investors such as mutual funds rushing into late-stage private investing.  Another major contributing factor in the escalation of late stage valuations is the trend toward generous downside protections being given to investors in exchange for lofty valuations, such as IPO ratchets and M&A senior participating liquidation preferences.  The former is simply antidilution protection that entitles the investor to receive extra shares on conversion in the IPO if the IPO price is below either the price paid by the late-stage investor or some premium above that price.  The latter means that, in an acquisition, the investor gets first dollars out ahead of earlier series of preferred and then participates with the common pro rata on an as converted basis.

Renaissance maintains that VC-backed tech companies with lofty late round private valuations chose in 2016 to avoid inevitably lower public-market valuations and had the luxury of remaining private due to ample available cash in the private markets. Mergers and acquisitions offered alternate pathways for other tech companies, such as TransFirst, BlueCoat and Optiv, all of which had previously filed S-1s for IPOs.

Although the private-public valuation disconnect was a major impediment to IPOs in 2015 and 2016, Renaissance believes this phenomenon is close to correcting itself and is optimistic about 2017. Many growth companies have seen their valuations flat or down in new funding rounds to levels that will be more palatable to public investors.  Also, the election results will likely bring a dramatic change in fiscal, regulatory, energy and healthcare policies, all of which should be stimulative to equity markets, new company formation and, ultimately, IPOs.

Another reason for tech IPO optimism for 2017 is Snap, Inc.’s highly anticipated IPO in the first half of 2017. It filed confidentially under the snapJOBS Act, and has begun testing the waters with investors.  The Snap IPO is rumored to raise $4 billion at a valuation of over $25 billion. Another one is Spotify, which raised $1 billion in convertible debt in March 2016 which signals a likely imminent IPO. These two IPOs might raise more capital than all VC-backed tech IPOs in the last two years combined.

On July 5, the House of Representatives passed a watered down version of the Fix Crowdfunding Act (the “FCA”) that was initially introduced in March.  The bill seeks to amend Title III of the JOBS Act by expressly permitting “crowdfunding vehicles” and broadening the SEC registration exclusion, but leaves out three important reforms that were part of the original version of the FCA introduced in March and about which I blogged about here. The House bill is part of the innovation initiativeInnovation Initiative which was jointly launched by Majority Leader Kevin McCarthy and Chief Deputy Whip Patrick McHenry.  The bill was passed by the House with overwhelming bipartisan support, so it’s likely to be passed quickly by the Senate.  This post summarizes what was left in the bill from the original and what was dropped from it.

What’s In: Special Purpose Vehicles and the Section 12(g) Registration Exclusion

Special Purpose Vehicles

Title III of the JOBS Act excludes from crowdfunding eligibility any issuer that is an “investment company”, as defined in the Investment Company Act, or is exempt from investment company regulation by virtue of being owned by not more than 100 persons. Several accredited investor-only matchmaking portals such as AngelList and OurCroud utilize a fund business model (rather than a broker-dealer model) for Rule 506 offerings in which investors invest into a special purpose vehicle (“SPV”), which in turn makes the investment into the issuer as one shareholder. Because Title III did not permit issuers to sell shares through SPVs, many growth-oriented startups may be dissuaded from engaging in Title III crowdfunding offerings if they expect to raise venture capital in the future, as VC funds don’t like congested cap tables.

The FCA would create a new class of permitted crowdfunding issuer called a “crowdfunding vehicle”, which is an entity that satisfies all of the following requirements:

  • purpose (as set forth in its organizational documents) limited to acquiring, holding and disposing crowdfunded securities;
  • issues only one class of securities;
  • no transaction-based compensation received by the entity or any associated person;
  • it and company whose securities it holds are co-issuers;
  • both it and company whose securities it holds are current in ongoing Regulation Crowdfunding disclosure obligations; and
  • advised by investment adviser registered under Investment Advisers Act of 1940

Section 12(g) Registration Exclusion

The JOBS Act raised from 500 shareholders to 2000 (or 500 non-accredited investors) the threshold under Section 12(g) of the Securities Exchange Act that triggers registration with the SEC, which subjects the company to periodic reporting obligations (e.g., 10-Ks, 10-Qs, etc.). It also instructed the SEC to exempt, conditionally or unconditionally, shares issued in Title III crowdfunding transactions.  In its final rules, the SEC provided that shareholders that purchased crowdfunded shares would be excluded from the shareholder calculation under Section 12(g), but conditioned the exclusion on, among other things, the issuer having total assets of no more than $25 million.

The $25 million limit on total assets may have the perverse effect of deterring growth companies from utilizing crowdfunding and/or prompting such companies to issue redeemable shares to avoid the obligation to register with the SEC if they cross the shareholder threshold because of a crowdfunded offering.

The original version of the FCA would have removed from the 12(g) exclusion the condition that an issuer not have $25 million or more in assets.

The version of the FCA passed by the House removes the $25 million asset condition but replaces it with two other conditions: that the issuer have a public float of less than $75 million and annual revenues of less than $50 million as of the most recently completed fiscal year.

What’s Out: Issuer Cap, Intermediary Liability and Testing the Waters

The House version of the FCA unfortunately dropped a few of the reforms that were contained in the original version introduced in March, apparently the price paid for securing votes of opponents of the FCA.

Issuer Cap                                                                                    

Title III limits issuers to raising not more than $1 million in crowdfunding offerings in any rolling 12 month period. By comparison, Regulation A+ allows up to $50 million and Rule 506 of Regulation D has no cap whatsoever.

The original version of the FCA would have increased the issuer cap from $1 million to $5 million in any rolling 12 month period. This was scrapped from the House version.

Portal Liability

Title III imposes liability for misstatements or omissions on an “issuer” (as defined) that is unable to sustain the burden of showing that it could not have known of the untruth or omission even if it had exercised reasonable care. Title III also exposes an intermediary (i.e., funding portal or broker-dealer) to possible liability if an issuer made material inaccuracies or omissions in its disclosures on the crowdfunding site. It is over this very concern over liability that some of the largest non-equity crowdfunding sites that have otherwise signaled interest in equity crowdfunding, including Indiegogo and EarlyShares, have expressed reluctance to get into the Title III intermediary business.

The original version of the FCA would have clarified that an intermediary will not be considered an issuer for liability purposes unless it knowingly made a material misstatement or omission or knowingly engaged in any fraudulent act. Presumably then, as proposed, a plaintiff would have had the burden of proving not just the fraud, misstatement or omission but that the intermediary knew at the time. The House version dropped this relief for intermediaries.

Testing the Waters

Securities offerings are expensive and risky with no guaranty that they will generate enough investor interest. Congress and the SEC chose not to allow Title III issuers to “test-the-waters”, i.e., solicit indications of interest from potential investors prior to filing the mandated disclosure document with the SEC, out of concern that unscrupulous companies could prime the market before any disclosure became publicly available.

The original version of the FCA would have allowed Title III issuers to test the waters by permitting them to solicit non-binding indications of interest from potential investors so long as no investor funds are accepted by the issuer during the initial solicitation period and any material change in the information provided in the actual offering from the information provided in the solicitation of interest is highlighted to potential investors in the information filed with the SEC. This too was left out of the version approved by the House.

Although it was disappointing to see the foregoing three reforms dropped from the eventual House bill, half a loaf is better than no loaf. Perhaps the dollar cap, intermediary liability and testing the waters could be revisited at some point down the road.

Ever since the Federal securities laws were enacted in 1933, all offers and sales of securities in the United States had to either be registered with the SEC or satisfy an exemption from registration. The commonly used private offering exemption, however, prohibited any act of general solicitation. The JOBS Act of 2012 JOBS Act signingcreated a new variation to the private offering exemption under Rule 506 of Regulation D that permits online offers and other acts of general solicitation, but issuers selling under this new Rule 506(c) may sell only to accredited investors and must use reasonable methods to verify investor status.

Starting today, companies will be permitted to offer and sell securities online to anyone, not just accredited investors, without SEC registration. This is pursuant to Title III of the JOBS Act and the final crowdfunding rules promulgated by the SEC called Regulation Crowdfunding.  The potential for Title III Crowdfundingequity crowdfunding is enormous and potentially disruptive.  It is believed that approximately 93% of the U.S. population consists of non-accredited investors who have an estimated $30 trillion stashed away in investment accounts.  If only one percent of that amount got redirected to equity crowdfunding, the resulting $300 billion dollars invested would be ten times larger than the VC industry.  Hence the potential.

The reality, however, is not as encouraging. In the interest of investor protection, Congress in JOBS Act Title III and the SEC in Regulation Crowdfunding created a heavily regulated and expensive regime that many fear will severely limit the prospects of equity crowdfunding.  The rules include a $1 million issuer cap, strict dollar limits on investors, disclosure requirements and funding portal liability, registration and gatekeeper obligations.

wefunderSEC registration for funding portals began on January 29. But as of last week, only five portals had completed the registration process: Wefunder Portal LLC, SI Portal LLC dba Seedinvest.com, CFS LLC dba seedinvestCrowdFundingSTAR.com, NextSeed US LLC and StartEngine Capital LLC.  Over 30 others are apparently awaiting approval.  Of the two best known and most successful non-equity crowdfunding portals, only Indiegogo has declared an intention to get in the Title III funding portal business; Kickstarter has so far declined.

The likely reason for the apparent lackluster funding portal activity so far is the restrictive regulatory regime referred to above, the burden of which falls disproportionately on funding portals. None of this should be a surprise.  Several key aspects of the crowdfunding rules were contentiously debated at the Congressional level and later during SEC rulemaking.  Opponents asserted that retail equity crowdfunding is an invitation for massive fraud against those who can least afford it and so believe Title III is a mistake.  Proponents advocated against several of the more restrictive rules but conceded on these points in order to get Title III passed.  And because the legislation itself was so prescriptive and granular, there was only room for marginal improvement in the final SEC rules relative to those proposed in the initial release.

Regrettably, there’s painful precedent for securities exemptions so restrictive that no one used them.  Regulation A allowed for a mini-public offering through a streamlined filing with the SEC.  But issuers were capped at $5 million and were forced to go through merit review in each state where they offered the securities.  The result:  hardly anyone used Reg A.  In recognition of this, Title IV of the JOBS Act reformed Reg A by increasing the cap to $50 million and, more importantly, preempting state blue sky review for so-called Tier II offerings which must satisfy investor protection requirements.

In an effort to prevent Title III from a fate similar to pre-reform Reg A, legislation has been introduced in Congress to increase the issuer cap, allow for special purpose vehicles, remove the $25 million asset cap on the exemption from the 500 shareholder SEC registration trigger and allow issuers to test the waters. See my previous blog post here on the proposed Fix Crowdfunding Act.

It may seem somewhat premature to advocate for reform when the rules have barely gone live. But given the time necessary for the legislative process to run its course, and inasmuch as the indications are already fairly clear that both issuers and funding portals remain skeptical about Title III crowdfunding, it makes sense to begin the process now of introducing necessary common sense reform of Title III.

Beginning on May 16, issuers for the first time will be able to offer and sell securities online to anyone, not just accredited investors, withoutTitle III Crowdfunding registering with the SEC. The potential here is breathtaking.  Some $30 trillion dollars are said to be stashed away in long-term investment accounts of non-accredited investors; if only 1% of that gets allocated to crowdfunding, the resulting $300 billion would be ten times bigger than the VC industry.   But the onerous rules baked into JOBS Act Title III and the SEC’s Regulation Crowdfunding (the statutory and regulatory basis, respectively, for public equity crowdfunding), leave many wondering if Title III crowdfunding will prove to be an unattractive alternative to other existing exemptions and become a largely underutilized capital raising pathway – a giant missed opportunity.

Patrick_McHenry_OfficialBut help may be on the way. Congressman Patrick McHenry recently introduced new legislation to address certain defects in Title III.  The Fix Crowdfunding Act (H.R. 4855)  would seek to improve the utility of Title III crowdfunding by raising the issuer dollar limit, simplifying the Section 12(g)(6) exemption, clarifying portal liability, permitting special purpose entities to engage in Title III offerings and allowing issuers to “test the waters”.  The House Financial Services Committee’s Subcommittee on Capital Markets recently held hearings on the Fix Crowdfunding Act labeled “The JOBS Act at Four: Examining Its Impact and Proposals to Further Enhance Capital Formation”, with witnesses such as Kevin Laws (Chief Operating Officer of AngelList) and The Honorable Paul S. Atkins (Chief Executive Officer of Patomak Global Partners) testifying.  Congress should pass this proposed legislation, and the sooner the better.

Here’s a summary of the proposed legislation, identifying the defect in the original Title III and the proposed fix.

Issuer Cap                                                                                     

Title III limits issuers to raising not more than $1 million in crowdfunding offerings in any rolling 12 month period. By comparison, Regulation A+ allows up to $50 million and Rule 506 of Regulation D has no cap whatsoever.

The new legislation would increase the issuer cap from $1 million to $5 million in any rolling 12 month period.

Portal Liability

Title III imposes liability for misstatements or omissions on an “issuer” (as defined) that is unable to sustain the burden of showing that it could not have known of the untruth or omission even if it had exercised reasonable care. By comparison, a plaintiff in a Rule 506 offering must allege not just a material misstatement or omission but that the issuer either knew or should have known if it made a reasonable inquiry.  Title III defines “issuer” to include “any person who offers or sells the security in such offering.”  In its final rules release, the SEC considered but refused to clarify that intermediaries were not issuers for purposes of the liability provision.  As it currently stands, Title III exposes intermediaries (i.e., funding portals and broker-dealer platforms) to possible liability if issuers commit material inaccuracies or omissions in their disclosures on crowdfunding sites.  It is over this very concern over liability that some of the largest non-equity crowdfunding sites that have otherwise signaled interest in equity crowdfunding, including Indiegogo and EarlyShares, have expressed reluctance to get into the Title III intermediary business.

The Fix Crowdfunding Act would make clear that an intermediary will not be considered an issuer for liability purposes unless it knowingly makes any material misstatements or omissions or knowingly engages in any fraudulent act. Presumably then, as proposed, a plaintiff would have the burden of proving not just the fraud, misstatement or omission but that the intermediary knew at the time.

Section 12(g) Registration Exemption

The JOBS Act raised from 500 shareholders to 2000 (or 500 non-accredited investors) the threshold under Section 12(g) that triggers Exchange Act registration. It also instructed the SEC to exempt, conditionally or unconditionally, shares issued in Title III crowdfunding transactions.  In its final rules, the SEC exempted crowdfunded shares from the shareholder calculation under Section 12(g), but conditioned the exemption on, among other things, the issuer having total assets of no more than $25 million.  The $25 million limit on total assets may have the perverse effect of deterring growth companies from utilizing crowdfunding and/or prompting such companies to issue redeemable shares to avoid the obligation to register with the SEC if they cross the shareholder threshold because of a crowdfunded offering.

The new legislation would remove from the 12(g) exemption the condition that an issuer not have $25 million or more in assets.

Special Purpose Vehicles

Several portals such as AngelList and OurCroud utilize a fund business model (rather than a broker-dealer model) for Rule 506 offerings in SPVwhich investors invest into an SPV which in turn makes the investment into the company as one shareholder. Because of the SPV exclusion, many growth-oriented startups might avoid Title III crowdfunding if they expect to raise venture capital in the future, as VC firms don’t like congested cap tables.

The proposed legislation would make “any issuer that holds, for the purpose of making an offering pursuant to [Title III], the securities of not more than one issuer eligible to offer securities pursuant to [Title III]” eligible for Title III offerings.

Testing the Waters

testing the watersSecurities offerings are expensive and risky with no guaranty that they will generate enough investor interest. Congress and the SEC chose not to allow Title III issuers to “test-the-waters”, i.e., solicit indications of interest from potential investors prior to filing the mandated disclosure document with the SEC.  The concern is that allowing issuers to do so would enable unscrupulous companies to prime the market before any disclosure became publicly available. Without the protection of public disclosure, issuers may be able to use selective disclosures or overly enthusiastic language to generate investor interest.

The Fix Crowdfunding Act would specifically allow Title III issuers to test the waters by permitting them to solicit non-binding indications of interest from potential investors so long as no investor funds are accepted by the issuer during the initial solicitation period and any material change in the information provided in the actual offering from the information provided in the solicitation of interest are highlighted to potential investors in the information filed with the SEC.

One of the key investor protections of Regulation Crowdfunding under JOBS Act Title III is theyou've got funding requirement that offerings must be conducted exclusively through a single platform operated by a registered broker-dealer or a new type of SEC registrant, a funding portal. Although SEC registration for funding portals began January 29, 2016, intermediaries (funding portals and broker-dealers) may not engage in crowdfunding activities until May 16, 2016, the date that Regulation Crowdfunding goes live. It remains to be seen how popular Title III crowdfunding will prove to be given its burdensome rules relative to other available exemptions, but the potential is enormous both for issuers and for the brand new type of financial intermediary it created, the funding portal.

SEC logoThe SEC spent three years trying to reconcile the enormous capital markets potential of the “crowd” with the investor protection concerns voiced by equity crowdfunding’s critics. The SEC believes that requiring an issuer to use only one intermediary to conduct an offering helps foster the creation of a crowd, by facilitating information sharing and avoiding dilution or dispersement of the crowd, and helps minimize the risk that issuers and intermediaries would circumvent the requirements of Regulation Crowdfunding. For example, allowing an issuer to conduct an offering usingcrowd 2 more than one intermediary would make it more difficult for intermediaries to determine whether an issuer is exceeding the $1 million aggregate offering limit. But to mitigate fraud risk concerns, the SEC has also imposed a heavy gatekeeping burden on intermediaries, particularly funding portals.

This blog post will focus on the rules governing funding portals, and will summarize the permitted “safe harbor” activities and compliance rules unique to funding portals, as well as certain requirements common to both types of Regulation Crowdfunding intermediaries (broker-dealers and funding portals).

Unique Funding Portal Requirements

Registration. Funding portals are required to register with the SEC on Form Funding Portal, a stripped-down version of Form BD, the registration form for broker-dealers.  For example, unlike broker-dealer registration, funding portals will not be required to post a fidelity bond to register as a funding portal.  As required under the JOBS Act, SEC registered funding portals are exempt from broker-dealer registration.  The text of the Form currently appears only in the final rules release on pages 623-664 (inclusive of Schedules A-D and general instructions).[i]

All registered funding portals are also required to become members of the Financial Industry Regulatory Authority, or FINRA.  FINRA funding portal registration information can be found here.

A funding portal’s SEC registration becomes effective on the later of: (1) 30 calendar days after the date that the registration is filed with the SEC; or (2) the date the funding portal is approved for FINRA membership.

Form Funding Portal must be filed electronically on EDGAR, although as of this writing the Form has not startenginebeen assigned a submission type or even been listed on the EDGAR forms index. To gain access to EDGAR for the electronic filing of Form Funding Portal, a funding portal will first need to obtain an EDGAR access code and a central index key, or CIK, by submitting a Form ID with the SEC. When a funding portal’s registration becomes effective, the information on Form Funding Portal becomes publicly available except for certain personally identifiable information.  As of this writing, there are no Form Funding Portals shown to have been filed on EDGAR, although at least one portal, StartEngine Capital LLC, put out a press release that it did so on January 29.

Permitted Activities – Safe Harbor. Unlike registered broker-dealers, funding portals are prohibited from giving investment advice, soliciting offers, paying success fees to persons for solicitations or handling investor funds or securities.  To help funding portals navigate these prohibitions while trying to function as effective intermediaries, the rules provide a safe harbor for the following activities:

  • Curating Offerings. A funding portal may use broad discretion to determine whether and under what circumstances to allow an issuer to offer and sell securities through its platform, subject to the prohibition on providing investment advice or recommendations and provided it complies with all other provisions of Regulation Crowdfunding. The SEC believes this kind of discretion is important for the protection of investors, as well as to the viability of the funding portal industry and the crowdfunding market.
  • Highlighting Issuers and Offerings. A funding portal is permitted to highlight particular issuers or offerings on its platform based on objective criteria where the criteria are reasonably designed to highlight a broad selection of issuers offering securities through the platform, are applied consistently to all issuers and offerings and are clearly displayed on the platform. The permissible criteria include type of securities offered (e.g., common stock, preferred stock or debt securities), geographic location of the issuer, industry or business segment of the issuer, number or amount of investment commitments made, progress in meeting the target offering amount and minimum or maximum investment amount.
  • Providing Search Functions. A funding portal may provide search functions on its platform that investors could use to search, sort or categorize available offerings according to objective criteria, and that would allow investors to sort through offerings based on a combination of different criteria, such as by the percentage of the target offering amount that has been met, geographic proximity to the investor and number of days remaining before the closing date of an offering. However, search criteria may not include the advisability of investing in the issuer or its offering, or an assessment of any characteristic of the issuer, its business plan, its management or risks associated with an investment.
  • Providing Communication Channels. A funding portal may provide communication channels by which investors can communicate with one another and with representatives of the issuer through the funding portal’s platform about offerings conducted through the platform, but neither the funding portal nor its associated persons or employees may participate in these communications, other than to establish guidelines about communications and to remove abusive or potentially fraudulent communications. The communication channels must be made available to the general public and must restrict the posting of comments to those who have accounts on the funding portal’s platform. The funding portal must require each person posting comments to disclose clearly with each posting whether he is a founder or an employee of an issuer engaging in promotional activities on behalf of the issuer, or will receive any compensation for promoting an issuer.
  • Advising Issuers. A funding portal may advise an issuer about the structure or content of the issuer’s offering, including preparing offering documentation. For example, a funding portal may provide pre-drafted templates or forms for an issuer to use in its offering, and advice about the types of securities the issuer can offer, the terms of those securities and the procedures and regulations associated with crowdfunding.  Without these services, the SEC believes that crowdfunding as a method to raise capital might not be viable.
  • Paying for Referrals. A funding portal may compensate a third party for referring a person to the funding portal if the third party does not provide the funding portal with personally identifiable information about any investor, and the compensation, other than that paid to a registered broker-dealer, is not a transaction based success fee. The SEC believes the prohibition on success fees will help to minimize the incentive for high-pressure sales tactics and other abusive practices in this area.
  • Compensation Arrangements with Registered Broker-Dealers. A funding portal may pay compensation to a registered broker-dealer for services, including for referring a person to the funding portal, in connection with the offer or sale of securities, provided that the services are provided pursuant to a written agreement between the funding portal and the registered broker-dealer, the compensation is permitted under Regulation Crowdfunding and the compensation complies with FINRA rules.
  • Advertising. A funding portal may advertise its existence and identify one or more issuers or offerings available on its portal on the basis of objective criteria, so long as the criteria are reasonably designed to identify a broad selection of issuers offering securities through the platform and are applied consistently to all potential issuers and offerings, and the funding portal does not receive special or additional compensation for identifying the issuer or offering in this manner. However, a funding portal may not base its decision as to which issuers to include in its advertisements on whether it has a financial interest in the issuer, and any advertising may not directly or indirectly favor issuers in which the funding portal has invested or will invest.
  • Denying Access to Platform. A funding portal may deny access to its platform to an issuer if the funding portal has a reasonable basis for believing that the issuer or the offering presents the potential for fraud or otherwise raises concerns about investor protection.
  • Accepting Investor Commitments.  A funding portal may, on behalf of an issuer, accept investment commitments from investors but may not actually handle the funds.
  • Directing Transmission of Funds. A funding portal may direct investors where to transmit funds and may direct a qualified third party to release proceeds of an offering to the issuer upon completion of the offering or to return investor proceeds when an investment commitment or offering is cancelled. Interestingly, the SEC chose not to impose requirements that would prohibit variations of a contingency offering, such as minimum-maximum offerings, that would establish a fixed deadline for transmission of funds as compared to the proposed requirement to transmit funds “promptly” or that would require funding portals to maintain a certain amount of net capital.

            Compliance.  A funding portal must have written policies and procedures reasonably designed to achieve compliance with the federal securities laws and regulations relating to its business as a funding portal.  In addition, funding portals must follow the same privacy rules as those applicable to brokers.  Finally, funding portals are required to preserve certain records for five years, with the records retained in a readily accessible place for at least the first two years.

Rules Governing Crowdfunding Intermediaries Generally

The following rules apply to all Regulation Crowdfunding intermediaries, i.e., funding portals and broker-dealers:

  • Receiving Financial Interests in Issuers. The intermediary entity (but not its directors, officers or partners) is permitted to receive a financial interest in an issuer using its services, provided that the financial interest is compensation for the services provided to the issuer in connection with the offering and the financial interest consists of the same security as being offered to investors in the offering. This was as an accommodation in the final rules that will better enable issuers to pay intermediary upfront fees (through stock) and also have the added benefit of aligning the interests of issuer, intermediary and investors.
  • Measures to Reduce Risk of Fraud. There are several measures that intermediaries are required to take that are designed to reduce the risk of fraud in crowdfunding transactions. An intermediary is required to have a reasonable basis for believing that the issuers on its platform comply with Regulation Crowdfunding and have established means to keep accurate records of the holders of the securities, and may reasonably rely on representations of the issuer unless the intermediary has reason to question the reliability of those representations.   An intermediary must deny access if it has a reasonable basis for believing that an issuer, or any of its officers, directors or any 20% owner is subject to a disqualification under Regulation Crowdfunding.
  • Accounts and Electronic Delivery. Intermediaries may not accept an investment commitment unless the investor has opened an account with the intermediary and the intermediary has obtained from the investor consent to electronic delivery of materials.
  • Educational Materials. Intermediaries must deliver certain educational materials to investors, including information on process for purchase of securities, types of securities that may be offered on the intermediary’s platform, risks associated with each type of security, restrictions on resale, types of information that an issuer is required to provide in annual reports, frequency of the delivery of that information, limits on amounts investors may invest and limitations on an investor’s right to cancel an investment commitment.
  • Promoters. Intermediaries must inform investors, at the time of account opening, that promoters must clearly disclose in all communications on the platform the receipt of promotion compensation and the fact that he is engaging in promotional activities on behalf of the issuer.
  • Compensation Disclosure. At the time of opening an account, intermediaries must clearly disclose the manner in which they will be compensated in connection with Regulation Crowdfunding offerings.
  • Issuer Information. Intermediaries must make available to the SEC and investors, not later than 21 days prior to the first day on which securities are sold to any investor, any information provided by the issuer pursuant to Regulation Crowdfunding, and that such information be publicly available on the platform for a minimum of 21 days before any securities are sold in the offering, during which time the intermediary may accept investment commitments, and remain publicly available on the platform until the offering is completed or cancelled.
  • Investor Qualification. Before accepting an investment commitment, an intermediary must have a reasonable basis for believing that the investor satisfies the investment limits under Regulation Crowdfunding. An intermediary may rely on an investor’s representations concerning annual income, net worth and the amount of the investor’s other investments in Regulation Crowdfunding offerings through other intermediaries unless the intermediary has a reasonable basis to question the reliability of the representation. Intermediaries must also confirm that an investor has reviewed the intermediary’s educational materials, understands that the entire amount of his investment may be lost and is in a financial condition to bear the loss of the investment and has completed a questionnaire demonstrating an understanding of the risks of any potential investment.
  • Communication Channels. Intermediaries must provide on their platforms channels through which investors can communicate with one another and with representatives of the issuer about offerings, to make the channels publicly available, permit only those persons who have opened accounts to post comments and require any person posting a comment in the channels to disclose whether he is a founder or employee of an issuer engaging in promotional activities on behalf of the issuer or otherwise compensated to promote the issuer’s offering. Funding portals are prohibited from participating in communications in these channels.
  • Transaction Confirmations. At or before the completion of a transaction, an intermediary must send to each investor a notification disclosing date of transaction, type of security, identity, price and number of securities purchased by the investor, certain specified terms of the security and source, form and amount of any remuneration to be received by the intermediary in connection with the transaction.
  • Completion of Offerings, Cancellations and Reconfirmations. Intermediaries must give investors the right to cancel an investment commitment for any reason until 48 hours prior to the deadline identified in the issuer’s offering materials. If an issuer reaches the target prior to deadline, it could close the offering provided the offering has been open for a minimum of 21 days, the intermediary provided notice about the new offering deadline at least five business days prior to the new offering deadline and investors are given the opportunity to reconsider and cancel their investment commitment until 48 hours prior to the new offering deadline. Finally, if there was a material change to the offering terms or to the information provided by the issuer, the intermediary would be required to give or send to any investors who have made investment commitments notice of the material change, stating that the investor’s investment commitment will be cancelled unless the investor reconfirms his or her commitment within five business days of receipt of the notice.

[i] Although funding portal registration went live on January 29, 2016, Form Funding Portal does not yet appear on the SEC’s website and a Google search came up empty.

SEC logoAt 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 Crowdfunding1financial 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

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.

Intermediaries

  • 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.

Preliminary Thoughts

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 crowdprotection 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.

[1] 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.