When President Obama signed the JOBS Act almost a year ago it introduced a new era of startup financing. But until the SEC makes the required rules, the fundraising bonanza known as crowdfunding that will allow companies to solicit investors via all manner of advertising is not yet with us. As a recap, a large part of what Congress did with the JOBS Act was introduce two entirely new provisions that will change the way issuers offer unregistered securities. First, the statute called on the SEC to issue rules that will allow general solicitation in all accredited investors offerings, a drastic shift from preexisting securities law. Second, crowdfunding will allow issuers to solicit funding from sources that previously were limited, or altogether barred, from participating in the offering of unregistered securities. Crowdfunding, once fully legal, will allow business owners to issue unregistered securities to a large number of non-accredited investors in a manner that was not possible before. Assuming the SEC promulgates the required rules regulating the use of crowdfunding, many entrepreneurs and small businesses will rush to use this mechanism for seed and series A financing.
In spite of the warranted optimism surrounding crowdfunding it is unclear if it will be a more desirable way to raise money than a Rule 506 offering under the safe harbor provided by Regulation D of the Securities Act of 1933, as amended. Currently Rule 506 is the most commonly used exemption when issuing unregistered securities. To understand how Rule 506 differs from crowdfunding let us look at some key areas where the two diverge.
Limitations on the size of an offering
Under Rule 506 there is no limitation on the size of an offering that qualifies for the exemption. Naturally, this is the exemption you want to use when raising large sums of money. However, if an issuer chooses to use the crowdfunding exemption it will be limited to a cap of $1 million during any 12-month period. The 12-month cap includes any funds that were raised in other equity offerings during the same period. Issuers should keep this in mind as the ease of fundraising using the crowdfunding platform is tempered somewhat by the relatively low cap on the amount of funds a company can raise. In addition, there is a cap on how much an individual investor may invest in a crowdfunding offering; an investor may only invest the greater of $2,000 or 5% of his annual income or net worth, if either is below $100,000, or the lesser of $100,000 or 10% of his annual income or net worth, if either is above $100,000.
Limitations on the number of investors
Rule 506 has no limit on the number of investors permitted so long as all investors in a given offering are accredited investors (typically, individuals with a net worth of more than $1 million, or whose income exceeded $200,000 in the past two years). A Rule 506 offering can have a maximum of 35 non-accredited investors (who alone or together with their purchaser representatives must be sophisticated investors). Strictly speaking, crowdfunding also allows an unlimited number of investors but given that the $1 million cap there is at least an implied limit on how many investors you can expect to have in any given offering. Part of the attraction to crowdfunding is that you can solicit small amounts of money from a large group of people to eventually hit your fundraising target. Keep in mind, however, that smaller checks mean more investors to keep track of. As a small company you may be dealing with the immense administrative burden of keeping track of scores of investors and their separate demands. A Fortune 500 company may have the internal infrastructure and systems in place to track and manage hundreds of investors but as a small operation you are unlikely to have the required bandwidth to take advantage of a crowdfunding platform, unless you are receiving sizeable checks from each investor. In addition, companies may be required to register with the SEC once they have either 2,000 shareholders of record or over 500 shareholders who are not accredited investors.
Disclosure requirements for Crowdfunding and Rule 506
Rule 506 requires no disclosures for an unregistered offering with the exception of required compliance with anti-fraud rules. On the other hand, crowdfunding will come with very specific reporting requirements. Companies will have to provide basic information about the offering, the company, and its officers, directors and major stockholders. Issuers using crowdfunding will also have to provide financial information, depending on the target offering size. For rounds up to $100,000, the company will only need to provide tax returns, if any, and financial statements certified by the chief executive officer. For rounds between $100,000 and $500,000, the financials must be reviewed by a certified public accountant. Above $500,000, the financials must be audited. Further, the crowdfunding exemption will not be available to foreign private companies, public companies, or investment companies. Finally, securities acquired in a crowdfunding offering will have limitations on the buyer’s ability to transfer those securities. Securities acquired in a crowdfunding transaction may not be resold for one year, except to the issuing company, an accredited investor or in a registered offering.
While these restrictions may not prove burdensome for some companies, they are still more than would be required under a traditional Regulation D offering to accredited investors.
Crowdfunding will require the use of third parties in fundraising
Rule 506 does not have a third party requirement and issuers can solicit investments directly from accredited investors. Under crowdfunding an issuer is required to use a registered broker dealer or a “funding portal.” The JOBS Act defines a “funding portal” as any person acting as an intermediary in a transaction involving the offer or sale of securities for the account of others solely pursuant to the new crowdfunding exemption from the registration requirements of Section 5 of the Securities Act added by the JOBS Act. Funding portals, like broker-dealers, must become members of a national securities association (i.e., FINRA). While there is an exemption from the broker dealer registration (outlined in a recently published SEC FAQ), it currently has little to no utility as the exempt platform would not be permitted to conduct a general solicitation. Whether exempt or not the funding portal requirement will certainly increase transaction costs associated with crowdfunding and limit some of its intended benefits.
At its core, crowdfunding allows entrepreneurs who do not have access to wealthy investors to still engage in unregistered securities offerings to get their businesses off the ground. The spirit of the law is in the right place and Congress should be applauded for this initial step. The worry is that the attendant reporting requirements and fundraising limitations that come with crowdfunding may not offer entrepreneurs and small businesses the kind of relief they expect. In addition, many unanswered questions remain. It is unclear what disclosures will be required on crowdfunding websites or how companies will enforce transfer restrictions or protect unsophisticated shareholders who may participate in these offerings from being diluted. While many will look to crowdfunding as a game changer in fundraising (and it will be once the kinks are worked out), those who have access to accredited investors may find it more useful to go the more traditional route utilizing the Rule 506 exemption under Regulation D, as this continues to be an efficient and sound way for issuers to offer unregulated securities.
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