“A Close Look At Arizona’s New Crowdfunding Law”
Law360 06/29/15 By Kevin J. Walsh
On April 15, 2015, Arizona Gov. Doug Ducey signed into law new crowdfunding legislation intended to give small companies in the local Arizona economy greater access to capital. When the law takes effect on July 3, 2015, Arizona will join a growing number of states that have recently enacted laws permitting some form of equity crowdfunding. For startups and other emerging growth businesses that may not have ready access to traditional sources of funding, equity crowdfunding may be an attractive option for raising capital. However, certain drawbacks exist that any company considering an offering under Arizona’s new crowdfunding law should evaluate before commencing an offering.
What is equity crowdfunding?
Crowdfunding is the process by which companies raise capital with relatively small individual investments from a large number of investors, typically through the Internet and social media. Historically, crowdfunding has existed primarily in reward-based or donation-based models. These types of models are often associated with platforms like Kickstarter, which allows individuals to contribute funds to particular projects, either as donations or in exchange for certain products or prizes. By comparison, equity crowdfunding is the process by which a company raises capital through crowdfunding in exchange for equity interest in the company.
How is equity crowdfunding regulated?
The offer and sale of securities by issuers in Arizona is subject to regulation by the U.S. Securities and Exchange Commission under the Securities Act of 1933 (the “Securities Act”) and by the Arizona Corporation Commission (ACC) under the Arizona Securities Act. Issuances of securities in Arizona must be registered with the SEC and the ACC unless an exemption from registration is available.
In 2012, the Jobs Act, formally known as the Jumpstart Our Business Startups Act of 2012, was enacted partly to facilitate capital raises for smaller companies by easing the regulatory burdens imposed by federal securities law. In particular, Title III of the Jobs Act creates an exemption from registration under a new Section 4(a)(6) of the Securities Act for crowdfunding offerings. Congress tasked the SEC with adopting rules for crowdfunding offerings under the Jobs Act. The SEC released proposed rules on Oct. 23, 2013, but has not yet issued the final rules. Until final rules are issued and take effect, equity crowdfunding under the Jobs Act remains unlawful.
In the meantime, states have acted where the SEC has failed to do so. Arizona and several other states have adopted laws intended to exempt securities sold in crowdfunding offerings from registration under both federal and state securities law, not as a crowdfunding offering under new Section 4(a)(6) of the Securities Act — which is not yet available — but rather, as an intrastate offering under Section 3(a)(11) of the Securities Act. For this reason, Arizona’s crowdfunding law has very stringent intrastate requirements with which companies must strictly comply.
How is an offering conducted under Arizona’s crowdfunding law?
Under Arizona’s crowdfunding law, a company can raise up to $2.5 million dollars if it provides investors with its audited financial statements, or up to $1 million otherwise, from investors in an offering. An investor can invest up to $10,000 in any company, or if he or she is an “accredited investor” under the Securities Act (typically wealthy individuals), an unlimited amount.
The offering must be conducted through a website operated either by a registered broker or by a person who does not receive any compensation in connection with the offering and who makes a notice filing with the ACC. The website operator may not be affiliated with any company that conducts an offering under Arizona’s crowdfunding law, and the ACC must be given access to the website at all times during the offering.
Prior to commencing an offering, the company must specify the offering period and the target offering amount. The offering period must end no less than 21 days and no more than one year after the offer is first made. All funds invested during the offering period must go to an escrow account maintained by a financial institution authorized to do business in Arizona, and are held by the escrow agent (and cannot be used by the company) until the end of the offering period. If the company raises at least 80 percent of the targeted investment amount before the end of the offering period, it can elect to terminate the offering early. If the company fails to raise at least 80 percent of the target investment amount, the offering is deemed a failed offering and all funds must be returned to investors.
An investor may cancel its commitment at any time prior to 48 hours before the expiration of the offering period, or if the company elects to terminate the offering early, at any time within 72 hours after the company provides the investor with notice of the offering’s early termination. Consequently, companies considering an offering under Arizona’s crowdfunding law must be aware of the risks of a failed offering and give thoughtful consideration when determining the target offering amount and the length of the offering period.
What companies are eligible to conduct an offering under Arizona’s crowdfunding law?
In order for an offering to qualify for exemption under Arizona’s crowdfunding law, the company must be a business entity organized under Arizona law, be authorized to do business in Arizona, and be “doing business” in Arizona pursuant to Rule 147 of the Securities Act. In order to be “doing business” in Arizona under Rule 147, a company must:
(1) derive at least 80 percent of its gross revenues from operating a business or rendering services in Arizona;
(2) have at least 80 percent of its assets located within Arizona;
(3) use at least 80 percent of the net offering proceeds in connection with operating a business or rendering services in Arizona; and
(4) maintain its principal office in Arizona.
For startups that had gross revenues of less than $5,000 for their most recent 12-month fiscal period, the gross revenue requirement does not apply. Although many local companies will satisfy these requirements, businesses with a more regional or national presence will likely not qualify.
The exemption is not available to public companies, investment companies and companies affiliated with any person that is subject to certain federal and state “bad-boy” disqualifiers.
Who can invest in an offering under Arizona’s crowdfunding law?
Under Arizona’s crowdfunding law, companies can only offer and sell securities to Arizona residents. Companies are required to confirm the residency of each investor and cannot rely solely on representations from the investor. Residency can be established from a valid driver’s license, a current voter registration or general property tax records.
Not only must the company ensure that no securities are sold to out-of-state residents, but the company also cannot offer to sell securities to non-Arizona residents. On Oct. 2, 2014, the SEC offered guidance on this matter, and cautioned that although whether a particular communication is an "offer" of securities will depend on all of the facts and circumstances, using websites and social media presence to convey information about specific investment opportunities would likely involve offers to residents outside the particular state in which the company does business. The SEC advised that companies could implement technological measures to limit communications that are offers only to those persons whose IP address originates from a particular state. In conformance with the SEC’s guidance, Arizona’s crowdfunding law requires that any website through which crowdfunding offers or sales occur must limit site access to Arizona residents only.
What are the reporting and disclosure obligations for companies conducting a crowdfunding offering?
The company must provide to each prospective investor a disclosure document that contains details of the offering and certain information regarding the company and its owners, including the identity of all persons owning more than 10 percent of the ownership interests of any class of the company’s securities. For so long as any securities issued under the offering remain outstanding, the company must make available on its website a quarterly report that discloses all compensation received by each of the company’s directors and executive officers, including bonuses, equity compensation and certain fringe benefits (e.g., use of company vehicle). The report must also include an analysis by management of the company’s business operations and financial condition. In addition, the company must maintain all books and records related to the offering for at least three years after the offering closes.
Although the company is not required to make any filings with the SEC in connection with an offering under Arizona’s crowdfunding law, it remains subject to federal and state securities law regarding fraud and misrepresentation in the offer or sale of securities.
Can investors resell the securities after they are purchased in a crowdfunding offering?
If an investor wishes to sell any securities that he or she purchases in an offering under Arizona’s crowdfunding law, unless those securities are registered with the SEC any resale of those securities also must qualify for an exemption under federal and state securities law. While resales to Arizona residents will generally be permitted, resales to non-Arizona residents are only allowed beginning nine months after the last sale of the securities by the company, and even then investors may find it difficult to find a buyer if there is no market for the securities.
As part of a broader effort to support local business, state Sen. David Farnsworth, R-Mesa, who introduced the Arizona crowdfunding bill in the state Senate, and others are exploring various opportunities to increase the availability of capital to entrepreneurs and startups. Discussions have included the establishment of state-sponsored exchanges designed to create a market for the securities, which would be open to Arizona residents only. But unless and until a market for these securities develops, whether through an initial public offering (the odds of which are exceptionally rare) or a state-sponsored exchange, investors should be aware that they could be holding their investment indefinitely.
Are there any downsides to conducting a crowdfunding offering?
One of the primary drawbacks of conducting an offering under Arizona’s crowdfunding law is the risk that the offering could be deemed “integrated” with another offering by the company, which could restrict companies that conduct a crowdfunding offering from raising additional capital for six months after the offering ends. Integration occurs when a company conducts two or more similar offerings that the SEC combines for regulatory purposes. Because of the strict intrastate requirements under Arizona’s crowdfunding law and Section 3(a)(11) of the Securities Act, the integration of offerings by the SEC could disqualify the integrated offerings from registration exemptions.
The SEC has advised that a crowdfunding offering under the new Section 4(a)(6) of the Securities Act will not be integrated with other offerings that are otherwise exempt from registration, but that offers little comfort as long as the exemption under Section 4(a)(6) remains unavailable. In the meantime, companies can rely on an existing safe harbor under Rule 502 of the Securities Act, which provides that separate offerings occurring six months or more apart will not be integrated. However, for many startups and emerging growth companies, abstaining from raising capital for six months might not be a viable option. If a company does offer or sell additional securities within six months of a crowdfunding offering, then whether those two offerings will be integrated depends on the facts and circumstances of the offerings. For companies considering an offering under Arizona’s crowdfunding law, it is imperative that they consider their long-term capital needs before commencing any offering.