Overview of Regulation Crowdfunding
Regulation Crowdfunding – which becomes effective May 16, 2016 -- implements the requirements of Title III of the Jumpstart Our Business Startups (JOBS) Act. The new rules will enable individuals to invest in startup businesses subject to limits on the amount of money they can invest, and will subject issuers and funding portals to disclosure and reporting requirements in order to use the exemption.
Regulation Crowdfunding was enacted under new Section 4(a)(6) of the Securities Act of 1933, as amended, and provides a framework for the regulation of registered funding portals and broker-dealers, which issuers are required to use as intermediaries, and conditionally exempts securities sold pursuant to the rule from the registration requirements of Section 12(g) of the Securities Exchange Act of 1934, as amended. Funding portals may register with the Securities and Exchange Commission (SEC) starting January 29, 2016 to take advantage of new federal rules allowing companies to offer and sell securities through crowdfunding.
- Permits a company to raise a maximum aggregate amount of $1 million from accredited and non-accredited investors through crowdfunding offerings in a 12-month period.
- Permits individual investors, over a 12-month period, to invest in the aggregate across all crowdfunding offerings, whether for one company or multiple companies, up to:
- The greater of $2,000 or 5 percent of the lesser of their annual income or net worth if either the investor’s annual income or net worth is less than $100,000, or
- If both annual income and net worth of the investor are equal to or more than $100,000, 10 percent of the lesser of the investor’s annual income or net worth.
- During the 12-month period, the aggregate amount of securities sold to an investor through all crowdfunding offerings may not exceed $100,000. Issuers should verify the amounts of any prior crowdfunding offering that any investor has participated in to ensure that their offering will not cause any individual investor to exceed this limit during the 12-month period.
All issuers other than the following companies are eligible to use the new rules:
- Non-U.S. companies
- Exchange Act reporting companies
- Certain investment companies
- Companies that are subject to disqualification under Regulation Crowdfunding
- Companies that have failed to comply with the annual reporting requirements under Regulation Crowdfunding during the two years immediately preceding the filing of the offering statement
- Companies that have no specific business plan or have indicated that their business plan is to engage in a merger or acquisition with an unidentified company or companies.
Restrictions and Special Requirements
The resale of securities purchased under Regulation Crowdfunding are generally restricted for one year. Additionally, all offerings are required to take place through a broker-dealer or funding portal that must register with the SEC on a new Form Funding Portal and be a member of FINRA. Issuers may only conduct offerings through one intermediary platform at a time.
The rules require intermediaries to:
- Provide investors with educational materials that explain, among other things, the process for investing on the platform, the types of securities being offered, information a company must provide to investors, resale restrictions, and investment limits;
- Take certain measures to reduce the risk of fraud, including having a reasonable basis for believing that a company complies with Regulation Crowdfunding and that the company has established means to keep accurate records of securities holders;
- Make information that a company is required to disclose available to the public on its platform throughout the offering period and for a minimum of 21 days before any security may be sold in the offering;
- Provide communication channels to permit discussions about offerings on the platform;
- Provide disclosure to investors about the compensation the intermediary receives;
- Accept an investment commitment from an investor only after that investor has opened an account;
- Have a reasonable basis for believing an investor complies with the investment limitations;
- Provide investors notices once they have made investment commitments and confirmations at or before completion of a transaction;
- Comply with maintenance and transmission of funds requirements;
- Comply with completion, cancellation and reconfirmation of offerings requirements; and
- Comply with significant advertising restrictions that only allow issuers to publish short “tombstone” type notices directing investors to the intermediary’s portal for further information.
The rules also would prohibit intermediaries from engaging in certain activities, such as:
• Providing platform access to companies they reasonably believe have the potential for fraud or other investor protection concerns;
• Having a financial interest in a company that is offering or selling securities on its platform unless the intermediary receives the financial interest as compensation for the brokerage/portal services, subject to certain conditions; and
• Compensating any person for providing the intermediary with personally identifiable information of any investor or potential investor.
To take advantage of Regulation Crowdfunding, an issuer is required to undertake significant disclosures by filing certain information with the SEC and providing information to investors and the intermediary facilitating the offering. Disclosures include:
- The price to the public of the securities or the method for determining the price, 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;
- A discussion of the company’s financial condition, a description of the business, and the intended use of proceeds from the offering;
- Financial statements of the company 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. A company offering more than $500,000 but not more than $1 million of securities relying on these rules for the first time would be permitted to provide reviewed rather than audited financial statements, unless financial statements of the company that have been audited by an independent auditor are available. This exemption only applies the first time an issuer conducts an offering using Regulation Crowdfunding, and issuers offering more than $500,000 thereafter are required to submit audited financial statements;
- Information about officers and directors and certain related-party transactions, as well as the name and ownership level of each person who is the beneficial owner of 20 percent or more of the issuer’s outstanding voting equity securities;
- A description of the capital structure of the company, which includes the terms of the securities being offered and each other class of security of the issuer, whether or not the securities have voting rights, a description of other investor rights related to outstanding securities and how they may materially limit or dilute the securities being offered; and
- An annual report filed with the SEC and provided to investors, although smaller issuers’ obligation to file annual reports may terminate if (i) the issuer has filed at least one annual report and it has fewer than 300 holders of record; and (ii) the issuer has filed annual reports for at least the three most recent years and it has total assets of $10 million or less.
Companies considering making an offering under Regulation Crowdfunding should be aware that, while the new rules would permit selling to a large number of non-accredited investors, there are downsides to this new fundraising method. Having a large number of non-accredited investors leads to a more complicated capital structure and may make it difficult to get institutional investors to commit to follow-on offerings. Further, the commissions to the intermediary, reporting costs, and additional professional fees for accountants and lawyers may make the aggregate costs of an offering pursuant to Regulation Crowdfunding not conducive to satisfying the issuer’s funding goals.
In addition to the relatively heavy reporting requirements, some commentators have expressed concerns about the risks of investor fraud in offerings conducted under Regulation Crowdfunding. As the new regulation would not limit access to crowdfunding to accredited or sophisticated investors, there is a new risk for inexperienced investors to fall victim to fraud, since the level of due diligence and scrutiny in the crowdfunding market is expected to be far weaker than that exercised by sophisticated private equity firms and venture capitalists. While the SEC believes that the individual caps on investments and disclosure and reporting requirements on issuers and intermediaries alleviate this problem, it will take years of actual experience to determine the effectiveness of these protective mechanisms. This stigma may deter investors from participating in crowdfunding offerings.