On April 5, 2012, President Obama signed the JOBS Act into law. Now, more than four years later, the regulatory changes required by the law have gone into full effect—and new potential investors and entrepreneurs in search of capital should be aware of the opportunities and risks that come with their new options. Two major changes in the investing landscape that have resulted from the JOBS Act are: (1) the elimination of the general solicitation/advertising ban for some “private offerings” via SEC Regulation D Rule 506, and (2) the authorization for and subsequent creation of the new Regulation Crowdfunding securities rule.
See our post about the various Regulation D exemptions.
Expansion of Permitted Securities Sales
The new Rule 506(c) is the result of changes mandated by the JOBS Act. Under 506(c), the typical prohibition against general solicitation and advertising for unregistered sales of securities has been eliminated for sales meeting two conditions: (1) all purchasers are accredited investors and (2) the issuer has taken reasonable steps to verify that the purchasers are accredited investors. Purchasers under any Rule 506 sale will receive restricted securities. Additionally, Rule 506 private offerings remain exempt from state registration and review requirements concerning the sale of securities, although still subject to state fees and required notice filings. This major change set the stage for what has come to be known as “Regulation Crowdfunding.”
Regulation Crowdfunding Basics
Another major change mandated by the JOBS Act was the creation of Regulation Crowdfunding. A fusion of several pieces of legislation brought together the worlds of securities offerings and crowdfunding. Conceptually, crowdfunding brings to mind Kickstarter, Indiegogo, GoFundMe, and other similar platforms that allow large numbers of people to contribute (usually) small amounts of money in exchange for everything from early access to specific services to niche products. With the new rules promulgated under the JOBS Act, companies can take the crowdfunding model and expand it into the realm of raising capital via selling securities to a larger number of smaller investors. Regulation Crowdfunding is the name of the final rule adopted by the SEC on October 30, 2015, which permits companies to sell securities in the company directly to non-accredited investors via SEC-registered online portals, and which became effective on May 16, 2016.
So what does that mean? In basic terms, the new rule permits companies to raise up to $1 million annually via offering securities in the company to the general public without becoming an SEC-registered reporting company—and allows for the sale of these securities to people who do not qualify as “accredited investors.” Specifically, any investor may now invest via crowdfunding platforms either $2,000 per year, or 10% of the lesser of their annual income or net worth if both or equal to or more than $100,000, whichever is greater, even if they do not meet the old definition of an “accredited investor.” For potential issuers of Regulation Crowdfunding securities, there are both positive and negative aspects of the rule.
Why Crowdfunding is Good for You
Regulation Crowdfunding primarily offers companies an alternative to raising capital from angel investors, VC firms, or other more traditional sources another potential avenue for gathering needed funds. Additionally, holders of securities sold via Regulation Crowdfunding do not count toward the Exchange Act’s Section 12 cutoff for becoming an SEC reporting company. Normally, even companies that have not filed a registration statement with the SEC as part of an IPO can still become “reporting companies” if certain thresholds are met concerning total assets and number of people who hold equity securities (like common stock). The numerical threshold requiring Exchange Act registration normally triggers once a company has 500 or more “persons who are not accredited investors” or 2,000 or more total holders of its securities. SEC reporting companies are subject to a variety of annual, quarterly, and current reporting obligations which are quite costly to fulfill.
Why Regulation Crowdfunding Still Not Make Sense for You
Access to additional capital, without the burden of dealing with VCs and angel investors, and staying outside of heavy SEC reporting requirements? What’s not to love? While you might avoid certain obligations as a “reporting company”, this new opportunity still comes with some fairly hefty restrictions and obligations. First, any transaction seeking to comply with Regulation Crowdfunding must take place through either a “registered broker-dealer” or a “funding portal.” Second, companies that wish to raise capital via Regulation Crowdfunding are subject to substantial public disclosure requirements, both before the initial offering and continuing afterwards. Regulation Crowdfunding-compliant issuers will need to file an “offering statement” with the SEC as well as provide it to their chosen intermediary and investors. These statements must contain a significant amount of information about the company, including but not limited to information about the company’s officers, directors, and major owners of voting securities, a description of the business and how the crowdfunding proceeds will be used, a business plan and the business’ current size, a description of the potential risk factors for potential investors, past tax returns, and, most critically, financial statements that may need to be reviewed or audited by an independent public accountant rather than simply certified by the company’s principal executive. Third, equity purchased through Regulation Crowdfunding cannot generally be resold within a year of its issuance (with a few exceptions), making it a riskier (and perhaps less attractive) investment for potential buyers.
Broker-Dealers; Funding Portals
In order to use Regulation Crowdfunding, issuers must offer their securities via one of two entities: either a “registered broker-dealer” or the newly created “funding portal.” Regulation Crowdfunding-compliant issuers may only offer crowdfunded securities through one intermediary at a time. Funding portals are a new type of entity created by the JOBS Act: internet-based platforms for the sale of securities that may conduct business without having to comply with the extensive regulatory framework already in place for SEC-registered broker-dealers. It became possible for an entity to register as a funding portal on January 29, 2016—and since then, dozens of entities have entered the market. Funding portals must still register with the Financial Industry Regulatory Authority (FINRA) and cannot offer investment advice or recommendations without registering as a broker-dealer—they are essentially limited to serving as a neutral platform for the first-time issuance of crowdfunded securities. Funding portals must also provide investors with educational materials that explain how to invest on the platform, what types of securities are being offered in each offering, and any required information that a company must provide to its investors. Funding portals are required to take measures to reduce the risk of fraud, and must have a reasonable basis for believing that a company complies with Regulation Crowdfunding before acting as the intermediary for the sale of securities. Typically, funding portals are compensated with a percentage of the investment raised on their platform.
Ultimately, Regulation Crowdfunding may provide some businesses seeking to raise capital with a new tool for generating investor interest, but companies considering an offering should make a point of deciding on the type of intermediary they would like to use beforehand, as well as assessing whether complying with the up-front and ongoing disclosure requirements will ultimately be more costly than seeking more traditional sources of growth-stage capital.