CROWDFUNDING – WHAT IS IT?

The “Jumpstart Our Business Startup Act” (JOBS Act) is commonly or sometimes referred to as the “Crowdfunding Act”.  The Act was signed into law on April 5, 2012 and required the SEC to write rules and regulations and issue studies on capital formation, disclosure and registration requirements.

The purpose of the Act was to allow companies of all sizes to gain access to capital in a cost-effective manner by lessening the unnecessary and burdensome regulation that have been imposed on such companies.

The Act introduced several historic changes to facilitate capital raising.  This includes new exceptions under Section 4 of the Securities Act of 1933 (the “Securities Act”) which permits crowdfunding in raising capital for a business.  Crowdfunding is the offering of unregistered securities by a company through a registered internet intermediary website or a broker to raise up to $1,000,000 from a large pool of investors.

While the Act was signed into law in April of 2012, The SEC has taken from that time to develop rules and regulations for implementing the law and is still working on it.

As of the date of this writing, the SEC is requesting comments on the SEC Regulatory Initiatives under the JOBS act.  

Rule 506(c) General Solicitation

However, one very significant change has been thus far been made in the fundraising rules.  On September 28, 2013, the SEC rule permitting general solicitation and advertising of private offerings conducted under SEC Rules Sub(c) and Rule 144A went into effect, opening a key door to capital for U.S and global companies.  

This important change in the Act thus far is referred to General Solicitation.  Prior to September, a company raising capital was under very strong restrictions as to how they could advertise or let anyone know about their offering.  They were banned from publicly disclosing information relating to securities offering unless the offerings were registered with the SEC, such as an S-1 memorandum.  The amendment, called Rule 506(c), lifted the ban on General Solicitation, thus allowing a company to advertise their offering, under certain circumstances and constraints.  In effect, the SEC, by implementing Rule 506(c), has created an entirely new form of a public offering, which will not be subject to registration with SEC..

Usually, offerings made under Rule 506(c) are technically considered a private placement of corporate stock, by lifting the ban on general solicitation and being able to advertise, companies can now widely advertise their securities being offered under Rule 506(c) in all kinds of media, including television, in newspapers, and, what could turn out to be most effective, over the internet.

However, there are some constraints and rules pertaining to a company raising capital in a private placement through Rule 506(c).  It is very important that the principals of a company know exactly what the rules and restrictions are and that they work with experienced legal counsel.  

Some of these rules might include:

1.  require issuers and investors to provide additional information on Form D.

2.  require a company issuing stock to file a Form D at least 15 days prior to engaging in any general solicitation and to file a final amendment to that Form D not later than 30 days from the end of the offering.

3.  eliminate the ability of an issuer to use Rule 506 exemptions if it failed to file a required Form D during the prior five-year period (with certain cure provisions).

4.  for an initial two-year period, require issuers engaging in general solicitations under Rule 506(c) to submit their solicitation materials to the SEC on a confidential basis.

5.  impose legending requirements on any general solicitation materials.

6.  extend the advertising guidance in Rule 156 applicable to public funds to private funds.

7.  purchasers in a Rule 506(c) offering must be “accredited investors”.

Accredited Investor:

The SEC defines the term “accredited investor” in Rule 506(c) if they have a net worth greater than $1 million (excluding their primary residence) or incomes in excess of $200,000 in the last two years with the expectation of the same in the current year (or $300,000 with a spouse).

Under the new 506(c) rule, companies are required to take “reasonable steps” to verify an investor is accredited by doing things like review W-2 Forms or other personal financial statements of investors.  This is likely to be an onerous process for companies and off-putting to many investors, so a number of investor accreditation-verification services have arisen to help companies surmount this challenge.  Companies should talk to a qualified securities attorney prior to determining an investor’s accredited status.

TITLE III

Title III of the JOBS Act Amends Section 4 of the Securities Act to create a new exemption for offerings of “crowdfunded” securities.  Specifically, the JOBS Act amends Section 4 of the Securities Act to exempt issuers from the requirements of Section 5 of that Act when they offer and sell up to $1 million in securities, provided that individual investments do not exceed certain thresholds and the issuer satisfies other conditions in the JOBS Act.  
As of this writing (November 1, 2013 the SEC is still in the process of determining exactly what the rules will be.  They are still accepting comments on the rules which you can see on the SEC.gov website.  

However, under the presently proposed rules the following will probably apply:

1.  A company would be able to raise a maximum aggregate amount of $1 million through crowdfunding offerings in a 12-month period.

2.  Investors, over the course of a 12-month period, would be permitted to invest up to:

$2,000 or 5 percent of their annual income or net worth, whichever is greater, if both their annual income and net worth are less than $100,000.

10 percent of their annual income or net worth, whichever is greater, if either their annual income or net worth is equal to or more than $100,000.  During the 12-month period, these investors would not be able to purchase more than $100,000 of securities through crowdfunding.

Title III of the JOBS Act also mandates that securities purchased in a crowdfunding transaction could not be resold for a period of one year.  These securities would be “restricted” as defined in Rule 144.  Holders of these securities would not count toward the threshold that requires a company to register with the SEC under Section 12(g) of the Exchange Act.

Companies that would be ineligible for crowdfunding  would be non-U.S. 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.

Disclosure required by Companies for Crowdfunding

Under Title III of the JOBS Act, the proposed rules would require companies conducting a crowdfunding offering to file certain information with the SEC.  The proposed rules as stated below, provide it to investors and the relevant intermediary facilitating the crowdfunding offering, and make it available to potential investors. 

In its offering documents, among the things the company would be required to disclose: 

• Information about officers and directors as well as owners of 20 percent or more of the company.

• A description of the company’s business and the use of proceeds from the offering.

• The price to the public of the securities being offered, the target offering amount, the deadline to reach the target offering amount, and whether the company will accept investments in excess of the target offering amount.

• Certain related-party transactions.

• A description of the financial condition of the company.

• Financial statements of the company that, depending on the amount offered and sold during a 12-month period, would have to be accompanied by a copy of the company’s tax returns or reviewed or audited by an independent public accountant or auditor. 

Companies would be required to amend the offering document to reflect material changes and provide updates on the company’s progress toward reaching the target offering amount. 

Companies relying on the crowdfunding exemption to offer and sell securities would be required to file an annual report with the SEC and provide it to investors.

Companies relying on the crowdfunding exemption to offer and sell securities would be required to file an annual report with the SEC and provide it to investors.

Crowdfunding Platforms

One of the key investor protections Title III of the JOBS Act provides for crowdfunding is the requirement that crowdfunding transactions take place through an SEC-registered intermediary, either a broker-dealer or a funding portal.  Under the proposed rules, the offerings would be conducted exclusively online through a platform operated by a registered broker or a funding portal, which is a new type of SEC registrant. 

The proposed rules would require these intermediaries to:

• Provide investors with educational materials.

• Take measures to reduce the risk of fraud.

• Make available information about the issuer and the offering.

• Provide communication channels to permit discussions about offerings on the platform.

• Facilitate the offer and sale of crowdfunded securities.

The proposed rules would prohibit funding portals from:

• Offering investment advice or making recommendations.

• Soliciting purchases, sales or offers to buy securities offered or displayed on its website.

• Imposing certain restrictions on compensating people for solicitations.

• Holding, possessing, or handling investor funds or securities.

The proposed rules would provide a safe harbor under which funding portals can engage in certain activities consistent with these restrictions.