THE NEW “CROWDFUNDING” EXEMPTION
WHAT IT IS AND WHAT IT IS NOT
Eugenie D. Rivers
Eugenie Rivers at Cairncross , Inc.
In the common vernacular, “Crowdfunding” has come to mean a large group of people making individually small investments in a company, usually via the Internet on such sites as Kickstarter. There, people of all levels of financial sophistication pay a relatively low amount in advance for a company’s goods, or a discount on products, to be delivered at a later date after development. However, companies cannot currently offer to sell their equity (i.e. stock or LLC interests) or debt (i.e. multiple promissory notes) under this model. Both equity and debt are “securities” and are therefore subject to the substantial restrictions of both federal and state securities laws.
Current Securities Law. The basic rule under our securities laws is that companies must register any securities offering, and become a public company, unless the offering qualifies for one of the numerous exemptions from registration. However, before the JOBS Act, once a Company had more than 500 shareholders, it had to register as a public company anyway, even if a Company didn’t do any offerings, or conducted all of its offerings under exemptions from registration.
Currently, the exemptions most widely used to fund start-up companies are those found Regulation D under the federal Securities Act of 1993 (Reg D), and in each states’ small offering exemptions. Reg D does not permit “general solicitation” in connection with exempt offerings, which includes any type of general advertising. In addition, federal Reg D does not permit more than 35 “non-accredited” investors to participate in any offering. Internet offerings can only be shown after a potential investor has confirmed their “accredited investor” status through tightly controlled internet portals and a waiting period has passed.
Crowdfunding Exemption. Until the JOBS Act, there has been no exemption from registration available for a Crowdfunding-style securities offering. However, the process of grass roots investments allowed under the JOBS Act’s Crowdfunding exemption is very different than the current Kickstarter model. The limitations in the Crowdfunding exemption (see below) make it primarily useful only in raising start-up capital to fund operations until a company is able to successfully raise money from strategic partners, angel investors or venture capital funds under Reg D or other available exemptions.
Offering Limitations. Under the JOBS Act’s Crowdfunding exemption, eligible companies may sell their securities in order to raise capital only if they comply with the following rules:
- Advertisements of a Crowdfunding offering must be limited to directing potential investors to a specified broker or funding portal. Advertisements may not include the specific terms of the offering.
- The company may not raise more than $1 million, under the Crowdfunding exemption, in any 12-month period. (However, offerings under other available exemptions may be permitted during that period.)
- Crowdfunding investors may not purchase more than the following amounts, in any 12-month period:
- (1) the greater of $2,000 or 5% of the investor’s annual income or net worth (for investors with either an annual income or net worth of less than $100,000), or
- (2) 10% of the investor’s annual income or net worth with a cap of $100,000 (for investors with either an annual income or net worth of $100,000 or more).
- Investors may not transfer the purchased securities for at least one year, except for transfers (1) to the company, (2) to an accredited investor, (3) as part of an SEC-registered offering or (4) to a family member of the investor or in connection with the investor’s death or divorce under rules to be prepared by the SEC.
- The securities acquired in a Crowdfunding offering will also be subject to any other limitations that the SEC deems necessary.
Company Filing Requirements. Under the JOBS Act, the company must file its anticipated business plan, financial condition, financial statements and ownership and capital structure with the SEC, as well as provide that same information to all potential investors, brokers and funding portals, before selling securities in a Crowdfunding offering. In addition, the Company must file reports, at least annually, of the Company’s results of operations and financial statements with the SEC and investors, brokers and funding portals. However, the SEC has not yet issued rules regarding the implementation of these conditions, as required under the JOBS Act.
Broker and Funding Portal Requirements. Crowdfunding offerings can only be conducted through brokers or funding portals that are registered as a broker or funding portal with the SEC, and any state regulators, unless the broker or funding portal is exempt from those filing requirements. However, Crowdfunding brokers and funding portals are not allowed to (1) offer investment advice or recommendations, (2) solicit purchasers, sales, or offers to buy the securities displayed on its website or portal, (3) compensate anyone for solicitation or based on the sale of securities displayed on its website or portal, (4) holding, managing or handling investor funds or securities, or (4) engaging in any other activities specified by the SEC.
Prohibited Investors. The following investors cannot participate in an offering under the Crowdfunding exemption: (1) non-US companies, (2) public reporting companies, (3) investment companies and companies excluded from the definition of investment company by Sections 3(b) or 3(c) of the Investment Company Act of 1940, and (4) any other company that the SEC determines appropriate.
Liability for Material Misstatements. The Crowdfunding exemption imposes (a) liability for material misstatements and omissions on the company, and (b) personal liability on any director, partner, principal executive officer, principal financial officer, controller or principal accounting officer of the company, or any other person that offers or sells the company’s securities under the Crowdfunding exemption. Under current securities laws, that liability may be up to three times the amount of damages incurred by the complaining investor(s).
State Securities Regulation. Under the JOBS Act, Crowdfunding offerings would be exempt from registration with state securities commissions, except for (a) the state of the company’s principal place of business and (b) any state in which purchasers of 50% or more of the aggregate amount of the Crowdfunding offering are residents. Those states are permitted to require a notice filing and an associated fee in connection with the Crowdfunding offering. In addition, all state securities commissions would retain the authority to investigate and take enforcement action against any company or intermediary for fraud, deceit or other unlawful conduct in connection with one of their residents.
Number of Shareholders. The JOBS Act provides that Crowdfunding investors receive shares will not be counted as “shareholders of record” when determining if a company has to register as a public company. This exclusion will allow companies to conduct a Crowdfunding offering without having to worry about triggering public company reporting requirements as a result. However, there remain downsides to a Company having the large shareholder base that would presumably be caused by a Crowdfunding offering: (a) future later-stage investors may shun crowdfunded companies due to the presumably high number of small shareholders, and (b) a large, diverse base of shareholders with voting rights could make shareholder approval very difficult for subsequent corporate actions such as additional fundraising rounds, mergers and acquisitions.
The Crowdfunding exemption contained in the JOBS Act is the first major change in our securities regime in a very long time. Using the Crowdfunding model in the securities context is an exciting prospect for start-up and small company capitalization. However, some commentators have expressed concern that eligible companies may be deterred by the cost of complying with the numerous investor protections and regulatory requirements contained the Crowdfunding exemption, plus those that are sure to be added by SEC rules. At the least, I am sure that many companies that have been eagerly awaiting a Crowdfunding exemption are disappointed by its lack of resemblance to the easy Kickstarter model.
As a securities lawyer working with many start-up companies, I totally understand that frustration and the desire to have a simple click-through process for internet offerings. Unfortunately, by necessity, the Crowdfunding exemption will need to be very carefully implemented by the SEC and state securities regulators. Without the investor protections required under the JOBS Act, the unscrupulous among us will undoubtedly use the Crowdfunding exemption to recreate the rampant fleecing of unsophisticated people that caused the adoption of our securities laws and regulations in the first place.
 The JOBS Act also increased the number of shareholders that a Company may have before having to register as a public Company from 500 to 2,000 shareholders (not counting Crowdfunding investors), so long as there are no more than 500 non-accredited investors.