By Rajnish Puri |
Regulation Crowdfunding issued under the Securities Act of 1933 (Securities Act), became effective on May 16, 2016, six months after the Securities and Exchange Commission (SEC) published the final rules relating to Section 4(a)(6) of the Securities Act. The regulation provides guidance to startups and small businesses on how to raise money from smaller investors via the Internet. But, is raising capital through a crowdfunding mechanism for everyone? This article briefly examines the background for the regulation, provides an overview of the key rules, and makes certain practical observations about the effectiveness of the crowdfunding process.
The term “crowdfunding” is designed to allow (and encourage) “crowds” to “fund” businesses with relatively low dollar investments. Broadly speaking, federal and state securities laws, make it unlawful for persons to sell securities unless sold pursuant to a registration statement effective under the Securities Act or under one of the several exemptions authorized under the Securities Act. To facilitate raising capital for startups and small businesses using the Internet and social media platforms, and to provide individual (including non-accredited) investors an opportunity to invest in those entities, Congress established a regulatory framework for crowdfunding by enacting the Jumpstart Our Business Act (JOBS Act) on April 5, 2012. The legislation was codified in Section 4(a)(6) of the Securities Act, with Regulation Crowdfunding providing guidance on the finer aspects. When sold in compliance with Section 4(a)(6) and Regulation Crowdfunding, the securities qualify as an exempt transaction (Crowdfunding Exemption) obviating the need for a registration statement.
Who Is Eligible? Only companies organized under the laws of a state or territory of United States are permitted to raise capital using the Crowdfunding Exemption, so long as they are not subject to the reporting requirements of the Securities Exchange Act of 1934. Foreign companies, investment companies, companies with no specific business plans and companies that have failed to comply with the reporting requirements of Regulation Crowdfunding during the two-year period immediately prior to the crowdfunding offering, are not authorized to avail themselves of the Crowdfunding Exemption.
Rules for the Issuer. The Crowdfunding Exemption caps the amount an issuer may raise in a 12-month period to $1 million using crowdfunding offerings. (Note: Crowdfunding offerings are not integrated with other types of offerings – for example, a Regulation D offering – and an issuer is free to raise capital independent of the Crowdfunding Exemption so long as it complies with the requirements of the other exemption.) The offering must be transacted using only one intermediary online-platform that must be registered with the SEC. For each offering, issuers must file Form C with the SEC using EDGAR, the SEC’s electronic filing system. The disclosures accompanying Form C include, among other things, the filing of the company’s reviewed or audited financial statements (depending on the size of the offering), a description and discussion of the business, information about officers, directors and owners of 20% or more of the company, and related party transactions. If there are any material changes or updates to the information included in the original Form C, issuers are required to file amendments using appropriate forms prescribed for such purposes. The rules also require that, after a crowdfunding offering has been completed, issuers file financial statements with the SEC and post the statements and other disclosures on the issuer’s website on an annual basis.
Limitations for Investors. Individual investors are subject to certain limitations with respect to their investments in a crowdfunding offering. Securities acquired may not be resold for a one year period. The amount an individual may invest during a 12-month period in all crowdfunding offerings is limited by the individual’s annual income and net worth (without taking into account the value of the individual’s primary residence). If either the annual income or the net worth of an individual is less than $100,000, the maximum amount that can be invested is the greater of (a) $2,000, or (b) the lesser of 5% of the individual’s annual income or net worth. If the annual income and the net worth are equal to or greater that $100,000, the maximum amount that can be invested is 10% of the lesser of the individual’s annual income or net worth, subject to an annual limit of $100,000 for all crowdfunding offerings.
Costs versus Benefits. Because Regulation Crowdfunding went into effect only about a week ago, there isn’t enough data out there, as yet, to accurately determine its impact on the business community or perform a thorough cost-benefit analysis of the legislation. As a preliminary observation, however, it appears that the costs and administrative burdens of compliance associated with the regulation seem to outweigh the benefits. For starters, the SEC estimates the preparation and filing of Form C to take about 100 hours, with about 25% of that time being attributed to outside professionals. Adding to the preparation and filing costs is the compensation an issuer would pay an intermediary for the listing as well as the accountants’ fee for the preparation of reviewed and audited financials – a practice not prevalent among early stage companies. Apart from the costs, by posting the financial statements and other material disclosures about the business on its website, a startup or a small business might be at a disadvantage by making the information available to the competition. Of course there are protections that can be built to secure the data, but, those, too, carry a cost. With the ability to invest as little as $2,000, arguably, the number of shareholders in a crowdfunded business might exceed a manageable figure which could add to the administrative burdens of management dealing with shareholder matters – be it information dissemination or simply seeking shareholder approvals for governance issues. Depending on the size of the proposed offering, alternative exemptions available under the securities laws might be more attractive to the issuers. By contrast, businesses less willing to work with, or facing difficulty in successfully raising capital through, traditional channels of funding, utilizing the Crowdfunding Exemption could be desirable, so long as they are willing to comply.
Hope you found the above discussion helpful. In my upcoming posts, I plan to share with the readers practical knowledge and trends on a variety of corporate finance topics applicable to early stage and established businesses. Stay tuned for another conversation on ClarkTalk!!
Thank you for joining us on ClarkTalk! We look forward to seeing you again on this forum. Please note that the views expressed in the above blog post do not constitute legal advice and are not intended to substitute the need for an attorney to represent your interests relating to the subject matter covered by the blog. If you wish to consult with the author of this post or another attorney at Clark & Trevithick, please contact Raj Puri by email at firstname.lastname@example.org or telephonically by calling the author at (213) 341-1322.