“The Wait Is Over – The Rules Permitting Federal Crowdfunding Take Effect”
InsideCounsel 06/08/16 By Kevin J. Walsh
On May 16, the final rules to permit equity crowdfunding that were adopted by the U.S. Securities and Exchange Commission (SEC) under Title III of the Jumpstart Our Business Startups (JOBS) Act finally took effect. Under the new rules, companies now are permitted to raise up to $1 million in crowdfunding offerings during any 12-month period from all investors, including unaccredited investors. The new rules fundamentally affect the ability of startups and emerging growth businesses to reach out to the public in their efforts to raise capital.
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. Until recently, crowdfunding has existed primarily in reward-based or donation-based models, such as Kickstarter, which allow 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.
Crowdfunding allows companies to use technology to make capital raises more efficient and reach a broader audience of potential investors. For companies that may not have ready access to traditional sources of funding, equity crowdfunding may be an attractive option for raising capital. Over a span of only a few years, crowdfunding has brought about dramatic changes to capital formation.
Title III of the JOBS Act creates an exemption from registration under a new Section 4(6) of the Securities Act for crowdfunding offerings. The JOBS Act was enacted partly to facilitate capital raises for smaller companies by easing the regulatory burdens imposed by federal securities law. Other reforms under the JOBS Act intended to assist companies with capital building have already taken effect. But by far the most anticipated of these reforms has been the legalization of equity crowdfunding under Title III.
The single biggest impact for start-ups and growing companies is that under the new rules, entrepreneurs may now, subject to the limitations and conditions in the rules, reach out much more broadly to the public during capital raises through online funding portals registered with the appropriate regulators. Funding portals are a new concept in securities law created under Title III of the JOBS Act. Crowdfunding portals facilitate the offer and sale of crowdfunded securities and are required to take measures to reduce the risk of fraud. Ever since accredited-investor crowdfunding under Title II of the JOBS Act began in 2013, online portals facilitating crowdfunding offerings have ballooned in number. Many of these platforms will now likely enter into the Title III crowdfunding market as well.
There are limitations on the amount of funds that a company can raise and on the amount that a particular investor can invest in a crowdfunding offering. Companies are able to raise up to $1 million from all investors. The maximum amount that an individual is permitted to invest under the rules ranges from $2,000 to $100,000, depending on his or her annual income and net worth. There is no limitation on the number of investors that may participate in a crowdfunding offering. Notably, securities sold in a crowdfunding offering under Title III do not count towards the registration threshold under Section 12(g) of the Exchange Act, which may otherwise require a private company to register a class of its securities with the SEC upon the company having a certain amount of record holders.
A company that conducts a crowdfunding offering will be required to disclose certain information with the SEC and to share such offering statement with prospective investors. The company must disclose information about its officers and directors, and the owners of 20 percent or more of its securities. The company also must describe its business and the use of proceeds from the offering, and discuss its financial condition. In addition, companies will be required to amend the offering document during the offering period to reflect material changes and provide updates on their progress toward reaching the target offering amount. In addition to the initial offering statement, a company that has conducted a crowdfunding offering must file an annual report with the SEC after the offering concludes. This ongoing reporting requirements do not terminate unless: (1) the company is acquired; (2) the company has filed at least one annual report and has fewer than 300 holders of record; or (3) the company has filed at least three annual reports and has total assets that do not exceed $10 million.
Additionally, a company conducting a crowdfunding offering must provide its financial statements to investors. For a company with crowdfunding offerings over $500,000, such financial statements typically must be audited by an independent auditor, although a company commencing its first crowdfunding offering is permitted to provide reviewed rather than audited financial statements.
Securities purchased in a crowdfunding offering cannot be resold for a period of one year, other than for certain exempt transfers, such as transfers to the company, accredited investors or family members of the purchaser or as part of an SEC-registered offering. As a practical matter, moreover, investors will have difficulty liquidating their investment even after that period if there is no active market for the securities.
Investors should be aware of the risks of any crowdfunding offering. Most startups go out of business within a few years of launching, and even investors who invest in successful companies may find it difficult to achieve liquidity for their investment unless and until a market for these securities develops or the company is acquired.
The new crowdfunding rules represent a fundamental shift in the securities regulatory landscape. While crowdfunding undoubtedly will present both challenges and opportunities, it opens up a whole new approach for raising capital that likely will have a significant impact on the capital formation industry in general and the startup and entrepreneurial community in particular.
Kevin J. Walsh is an attorney in the Business Law Group at Quarles & Brady in Phoenix.