sec-logoFollowing the popularity of gift-based fundraising sites Kickstarter and Indiegogo and micro-loan portals Kiva and Zidisha, there was much excitement when Congress created a new exemption to federal securities laws allowing companies to issue securities via crowdfunding – i.e., collecting small amounts from a large number of investors in exchange for ownership stakes in the business itself – as part of its Jumpstart Our Business Startups Act (the “JOBS Act”). The bill was signed into law by President Obama on April 5, 2012. On October 23, 2013, a year and a half later, the SEC released a 585 page document containing its much anticipated Proposed Rules for Crowdfunding (note: here’s the press release and a short version). After 90 days of public comment, companies can finally start issuing stock and other securities through online crowdfunding “portals” and brokerages. Alas, given the cost of compliance with these burdensome regulations, it is doubtful there will be much interest in this type of crowdfunding.

Generally, an offer or sale of securities must be registered with the SEC unless an exemption is available. Title III of the JOBS Act creates a registration exemption under the 1933 Securities Act, so that crowdfunding can be used to offer and sell securities, and establishes a regulatory structure for this funding method. To qualify for the exemption, companies must meet the following limitations and disclosure requirements.

Investment Limits

  • A company can raise a max aggregate amount of $1 million through crowdfunding in a 12 month period;
  • Limits on how much an individual investor may invest via crowdfunding (note: Annual income and net worth can be calculated jointly with a spouse):

Investor status

Investment limit (per 12 month period)

Both annual income and net worth less than $100K $2, 000 or 5% of annual income or net worth, whichever is greater
Either annual income or net worth greater than $100K 10% of annual income or net worth, whichever is greater, to a maximum of $100K

 

  • Securities purchased under the crowdfunding exemption cannot be resold 1 year
    • Some exemptions include transfers back to the issuer, to accredited investors, as part of an offering registered with the SEC, to a family member in connection with certain events (death or divorce), or to a trust controlled by the investor or created for the benefit of an investor’s family member
  • Certain companies are not eligible to use the crowdfunding exemption, including: Non-US companies, Companies that already are SEC reporting companies, Certain investment companies, Companies that are disqualified under the proposed disqualification rules, Companies that have failed to comply with the annual reporting requirements in the proposed rules, and Companies that have no specific business plan or have indicated their business plan is to engage in a merger or acquisition with an unidentified company or companies
  • Companies are not allowed to advertise terms of the offering except for notices which direct investors to the funding portal or broker
  • Companies are able to raise money simultaneously through private placements without those funds counting towards the $1 million crowdfunding cap.

Disclosure Requirements

  • Companies must file certain disclosures with the SEC, provide it to investors and the relevant intermediary, and make it available to potential investors. The Information that MUST be disclosed includes
    • Information about officers and directors and owners of 20% or more of company
    • Description of business and use of proceeds
    • Price to the public of the securities being offered, the target offering amount, deadline to reach target offering amount, and whether the company will accept investments in excess of target offering amount
    • Certain related-party transactions
    • Description of company’s financial conditions
    • Financial statements that would have to be accompanied by a copy of tax returns or reviewed or audited by an independent public accountant or auditor
  • Companies raising more than $500k a year must provide audited financial statements
  • Description of investors’ rights
  • Companies must amend offering document to reflect material changes and provide updates on progress toward reaching target offering amount
  • Companies must file an annual report with the SEC and provide it to investors. This requirement continues until 1) the issuer becomes a reporting company; 2) the issuer no longer has any shareholders who purchased securities through the crowdfunding exemption; or 3) the issuer liquidates or dissolves.
    • An issuer would be barred from conducting a crowdfunding offering if it has failed to file annual reports for a previous crowdfunded offering during the two years immediately preceding the filing of a new offering statement.

Intermediary Requirements

  • Crowdfunding transactions must take place through an online SEC-registered intermediary, either a broker-dealer or a “funding portal” (the latter being a new type of SEC registrant)
  • An issuer would be restricted to using only one intermediary for its offerings at any one time

Photo Attribution: Coda2 via Flickr. "Marillion Weekend Montreal 2009. Night 3."

Costs Outweigh the Benefits

On the positive side, the new rules give companies a chance to raise additional funds in supplement to all other types of finance and access to many small investors through online “portals” they would not be able to reach through traditional private placements. Deloitte even expects all forms of crowdfunding to hit $3 billion globally this year and to grow at a compound annual growth rate of 100% over the near term. Unfortunately, the general consensus among most securities lawyers who published reactions to the new rules are that the cost of complying with burdens of the new rules likely outweigh their benefits vis-a-vis other investment methods. Namely,

  • The high costs (i.e. producing offering documents, enlisting with a qualified funding portal or broker, initial and continuous disclosure requirements, financial audits, annual report filing, etc.) compared to the low maximum amounts that can be raised and invested by an individual make crowdfunding one of the costliest forms of fundraising. Proper compliance with such complex rules will cost issuers both time and money, and such costs may be prohibitive for offerings under $500.
  • Difficulty of allocating the appropriate percentages of equity in a business based on the pool of funds raised, and the challenges of administering distributions to many owners.
  • Higher risk of securities lawsuits from a greater number of unsophisticated investors. If the company does not comply with the new rules properly, it cannot benefit from the registration exemption under the ’33 Act. Even if it has complied and is exempt from the Securities Act of 1933, crowdfunding will still be subject to Section 10(b) anti-fraud provisions and Section 17, as well as “prospectus” liability provisions of Sections 12(b) and 13, of the of the Securities Act of 1934.
  • Besides federal securities law, companies are still subject to state “blue sky” securities laws which may prohibit crowdfunding equity that is not qualified or registered with the appropriate state regulatory agency.
  • The existing regulatory framework – including the intrastate offering exemption and private placements under section 4(4), Regulation A and Regulation D – are easier and less risky to qualify for than the new crowdfunding rules.

To be fair, the SEC needs to balance promoting business startups with preventing fraud and these rules implement the crowdfunding exemption without much variation from how Congress originally passed the law. But the SEC acknowledged that “Among other things, the JOBS Act was intended to help alleviate the funding gap and accompanying regulatory concerns faced by startups and small businesses in connection with raising capital in relatively low dollar amounts.” These rules hinder rather than help achieve that intention. Regardless of who is responsible, the burdensome new crowdfunding rules are least likely to help the types of companies they are meant to help: startups and small businesses.

Not too Late for the SEC to Modify these Rules

Since securities fraud is better traceable online than ever before, less burdensome disclosure requirements would have better helped jumpstart our business startups. The SEC is accepting public comment for 90 days before it officially adopts the new rules. Many businesses have already filed critical comments. If you are a business owner who could benefit from more efficient crowdfunding regulations, you can submit your comments to the SEC here.
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If you are considering crowdfunding as an option for your finance needs, consult an experienced securities lawyer who understands these new rules and can help you compare them to legal requirements of other forms of finance.
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About Author

A. James Boyajian is an attorney in downtown Los Angeles practicing Intellectual Property, Corporate, and Entertainment law. He previously interned at the FCC's Office of Strategic Planning and edited for the Federal Communications Law Journal. J.D. Indiana University Maurer School of Law. Contact: [email protected]

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