Depending on who you are, upon hearing that the SEC has adopted final crowdfunding rules, you may either shriek with joy or shrug your shoulders and return to whatever was previously occupying your time. Whichever camp you fall into, October 30, 2015 was the day to shriek or shrug as the SEC adopted, subject to public comment and publication, long-awaited final rules permitting companies to crowdfund (Regulation Crowdfunding, as it is known, or “RC”). Personally, I shrugged. Now, this shouldn’t be taken as an indictment on my part of what the SEC did or didn’t do. There is most definitely a contingent of companies that will benefit from RC. My lack of enthusiasm has more to do with the needs of the types of companies I’ve historically represented rather than any moral objection I have to seeing Joe or Jane invest part of their paycheck in the next Facebook or Twitter.
With these rules, the Commission has completed all of the major rule-making mandated under the JOBS Act. – SEC Chair Mary Jo White
I know that many people have held out hope that these new rules would help fill the ever-widening funding gap that exists between formation and scale, a gap that has grown over the years as a result of Series A money trending to later than early stage. Personally, I never really saw that as the goal of RC, nor do I believe it is designed for it. I do not think the new crowdfunding rules as adopted by the SEC will significantly change or alter how money is raised for the majority of technology, life science and biotech companies on track for angel, venture capital or private equity funding (i.e., the companies feeling the pain of the ever-widening funding gap). More likely, these new rules will provide an alternative for companies that would never have otherwise qualified for angel, venture capital or private equity funding. It is these types of companies that stand to benefit the most from RC. Maybe it’s a restaurant that needs $150,000 to launch and believes it has a clear path to positive cash flow to fund the business beyond the crowdfunding stage. Or maybe it’s a single SKU consumer products company that picked up early concept money through Kickstarter and now desires to raise $200,000 to pay for an initial product run, or to pay for a production mold. In the end, the outcome remains to be seen.
Why The Need for New Rules? What Prevented Crowdfunding From Happening Under the Current System?
Under the system as it exists today, why couldn’t a company sell $250,000 of equity to 334 people (at $750 a pop) rather than $250,000 to 2 people? Well, actually, it could. Nothing prevented such a deal from happening, however, there are limitations that would have made it less than practical. First, finding 334 people while being prohibited from generally soliciting or advertising your financing round probably would have been impossible (Rule 506(c) now permits general solicitation and advertising, but it comes at a price). Second, it’s likely that the investors could only invest $750 each because they had limited funds which might mean they did not meet the SEC’s rules around being “accredited” (in short, $1,000,000 net worth, or $200,000 in annual income or $300,000 in annual income combined with your spouse). Selling equity to non-accredited investors carried with it burdensome disclosure requirements, some seemingly impossible to fulfill for a pre-revenue or early-stage company. The company could have used other federal securities exemptions to avoid the disclosures, but those exemptions had caps on the dollar amount you could raise and it was difficult to find state securities exemptions that worked. For these reasons, prior to Title III of the JOBS Act, crowdfunding was conducted solely through gifts and donations, which meant that companies raising money did not have to comply with federal or state securities rules. Plus, platforms like Kickstarter, for instance, had been formed which made it easier to find 334 people that were interested in making such a gift or donation. I am not sure that RC has remedied all of these issues (in particular, the burdensome disclosures), but it certainly provides an additional, alternative approach.
The rules . . . limit the amount of money an issuer can raise using the crowdfunding exception, impose disclosure requirements on issuers for certain information about their business and securities offering, and create a regulatory framework for the broker-dealers and funding portals that facilitate the crowdfunding transactions. – SEC
The sale of any security must comply with both federal and state securities laws which means the security must either be registered (i.e., think IPO) or satisfy an exemption. Registration is not realistic for an early stage company, so all companies look for a valid exemption. Rule 506(b) has for many many years been the staple favorite. Rule 506 of Regulation D is a safe harbor private offering exemption that codifies the private offering exemption under Section 4(a)(2) of the Securities Act of 1933. RC will also be an exemption.
Under Rule 506(b), if a company sold securities only to accredited investors then it could (i) raise an unlimited amount of funds from an unlimited amount of investors, and (ii) decide what information it needed to disclose to investors, with the bare minimum being anything viewed as material and not violating anti-fraud prohibitions. In addition, as a result of federal preemption, it’s incredibly easy to find state securities law exemptions for a Rule 506 deal. However, the company could not generally solicit or advertise (viewed as the only downside of using Rule 506(b)). As you will see, RC capably removed the accredited requirement and established rules that allow non-accredited investors to put money behind RC companies. The counterbalance, however, is increased disclosure, filing requirements and intermediary requirements. So, as much as RC can be seen as an advance, it still tightly a grip on some of the negative requirements of earlier exemptions. One potential upside is that RC appears to federally preempt state regulations similar to Rule 506(b) meaning that it could solve the state securities exemption issue in the crowdfunding context.
The following is a summary of some of the requirements for complying with RC. For a slightly more detailed summary, including a description of some of the requirements of the funding portals, feel free to check out the SEC’s Release found here. Again, these are only summaries and the actual rules themselves are quite numerous and intricate, particularly around how the funding portals function and the disclosure requirements of the companies. Please consult the actual rules for a full and complete understanding.
In order for the company issuing securities to comply with RC, the company must:
- Not raise more than $1,000,000 in the aggregate during any 12-month period through crowdfunding;
- Not run afoul of eligibility requirements (e.g., non-U.S. companies, Exchange Act reporting companies, companies that have failed to comply with annual report requirements under RC during the two years immediately preceding the filing of the offering statement, companies with no specific business plan, etc.);
- Conduct the offering through an SEC-registered intermediary like a broker-dealer or a funding portal (only one portal intermediary platform can be used at a time, and the intermediaries have a fulsome set of rules that they themselves must follow);
- File an annual report with the SEC and provide it to investors; and
- File the following information with the SEC and provide this information to both investors and intermediaries facilitating the offering:
- Price per share and method of determination, target offering amount, deadlines and whether or not the company will allow over-subscriptions;
- Discussion of the company’s financial condition;
- Financial statements that, depending on the amount offered and sold during a 12-month period, are accompanied by information from the company’s tax returns, reviewed by an independent public accountant, or audited by an independent auditor. If a company is offering more than $500,000 but not more than $1,000,000 and relying on RC for the first time it will be permitted to provide reviewed rather than audited financial statements unless audited statements are available;
- Description of the business and use of proceeds;
- Information about officers and directors as well as owners of 20% or more of the company; and
- Certain related-party transactions.
Notice that the requirements for RC are very different from those required to sell securities to just accredited investors under Rule 506(b).
Over a 12-month period, investors participating in RC offerings are permitted to invest across all crowdfunding offerings up to:
- The greater of $2,000 or 5% of the lesser of their annual income or net worth, if either their annual income or net worth is less than $100,000; or
- Ten percent (10%) of the lesser of their annual income or net worth, if both their annual income and net worth are equal to or exceed $100,000.
In any event, during the 12-month period, an investor is not permitted to invest more than $100,000 in the aggregate across all crowdfunding offerings. Again, very different from what constitutes an accredited investor.
How Can You Utilize RC If You Desire to Raise Angel or Venture Capital Financing?
My gut tells me that angel networks or institutional venture funds may not be interested in funding companies that already have 100, 200, 300 or more crowdfunding investors prior to seeking early stage financing – I could be wrong on this, but it’s what my gut tells me today. It’s just an unwieldy number and presents some practical issues around governance and administrative burden of keeping all those chefs out of the kitchen. So, if you utilize RC for early stage financing, but you think you want to preserve the ability to raise money from angel investors or venture capital funds, then at the very least I would keep the number of investors in the low double digits. Also, be careful not to offer investment terms under RC that would torpedo your ability to attract angel investors or venture capital funds at a later date. Of course, all of this presumes that your company has a business model that fits the venture capital model (i.e., 5-7 year exit, at least 3-5x return on investor money but hopefully higher, scalable and growing 100% or more year-over-year).
The rules will be subject to public comment for 60 days after they are published in the Federal Register, and 180 days after such publication the rules will be effective. The forms enabling funding portals to register with the SEC, a necessary component of the new crowdfunding rules, will be effective January 29, 2016.