On October 23, 2013, the SEC approved proposed rules enacting the crowdfunding exemption (Section 4(a)(6) of the Securities Act of 1933) created by Congress in Title III of the JOBS Act, permitting non-public companies to offer and sell limited amounts of securities on online “crowdfunding” platforms.
Crowdfunding is a relatively familiar concept. Start-ups have been using “token” or “donation” crowdfunding on online platforms such as KickstarterTM to raise smaller amounts of seed capital or funding for a specific project in exchange for future shipments of initial products, apparel or, in some cases, no return. Because the SEC is concerned only with the sales of securities, these platforms do not fall within their regulatory purview. “Equity” crowdfunding, where companies offer and sell securities, however, is currently only available to accredited investors in issuer offerings that comply with traditional SEC private security issuance rules and regulations.
The proposed rules permit the sale of equity securities through online portals to unaccredited investors, marking a significant departure from traditional restrictions on private offerings. Congress hopes that the new crowdfunding platforms and the permissible sale to unaccredited investors will democratize start-up funding and increase the potential sources of capital for early-stage companies. This concept is philosophically contrary, however, to the central pillar of the SEC’s traditional private security offering regime, namely the limitation of the unregistered offering and sale of securities to accredited or sophisticated investors.
In permitting sales to unaccredited investors on crowdfunding portals, the SEC has conceptualized an entirely novel regime comprised of new (i) investor qualification requirements, (ii) participating company disclosure requirements and (iii) online portal registration requirements.
Under the proposed rules, investors (who may be unaccredited) are only permitted to invest:
$2,000 or 5% of annual income or net worth, whichever is greater, if both annual income and net worth are less than $100,000; and
10% of annual income or net worth, whichever is greater (capped at $100,000 in a 12-month period), if either annual income or net worth is equal to or more than $100,000.
Both thresholds apply to individuals that cannot satisfy the requirements for accredited investor status, which requires either (i) $200,000 of annual income or (ii) over $1 million in net worth, excluding primary residence. In the traditional private offering regime, there are no investing limitations for accredited investors
Under the proposed rules, a company could raise a maximum of $1 million in a 12-month period through Section 4(a)(6) crowdfunding offerings.
In order to comply with the proposed rules, a company would need to disclose information (i) to the SEC (on a new Form C) and (ii) to its investors through its online offering documents. The new disclosure requirements include, but are not limited to, the following:
Information about officers, directors and holders of 20% or more of company securities;
Description of the business and financial condition of the company;
Price of securities being offered, the target offering amount, the offering deadline, whether the company would accept investments above target offering amount, and progress updates;
Details about transactions entered into with directors, officers or major shareholders; and
The following financial information
Offerings of less than $100,000 – latest year’s tax returns
Offerings of $100,000 to $500,000 – financial statements reviewed by independent public accountant; and
Offerings of more than $500,000 – audited financial statements.
In addition, a company would need to file an annual report with the SEC and provide such reports to investors upon filing.
All crowdfunding portals would need to be an SEC-registered intermediary, namely either (i) a traditional broker-dealer or (ii) a registered crowdfunding portal, a new type of SEC registrant conceived for the purpose of such offerings.
Under the proposed rules, such intermediaries would be required to:
Provide educational materials to investors;
Take measures to reduce the risk of fraud;
Make issuer information available to investors; and
Provide communication and comment channels on their platform.
Under the proposed rules, such intermediaries would be prohibited from:
Offering investment advice or making recommendations;
Soliciting purchases, sales or offers to buy the securities offered or displayed;
Compensating individuals for soliciting certain securities; and
Holding, possessing, or handling investor funds or securities.
The proposed rules contain a safe harbor to avoid inadvertent violations of the prohibition against offering of investment advice, establishing a presumption of compliance when portals apply certain objective criteria in determining which offerings to facilitate.
The proposed rules will be open for public comment for 90 days, at the close of which the SEC will take comments under review and determine whether, and in what form, to adopt the proposed rules. Regardless of the final product (which could be 6 months or more away), this process provides issuers, investors and their advisors with the first glimpse at how the SEC will implement the Congressional mandate to (i) provide start-ups with new sources of capital and (ii) open equity investing in private companies to the pool of the millions of non-accredited individuals currently without access to private securities markets.
The challenge before the SEC is large. The SEC has long predicated its anti-fraud regulatory regime on the principle that only accredited or otherwise sophisticated investors are either qualified to assess or can afford to bear the risk associated with the securities of non-public companies. This philosophy is potentially poised for disruption by Title III of the JOBS Act, forcing the SEC to reconsider how it balances the risk of fraud against the facilitation of access to markets, an exercise in which the SEC has historically erred on the side of caution.
Without final rules and prior to the development of the crowdfunding markets, it is difficult to predict how crowdfunding campaigns will interact with, and whether they will develop into a viable alternative to, the traditional accredited investor-based private offerings.
Regardless of the final complexion of the crowdfunding rules, issuers would be advised to consult counsel, both financial and legal, to develop an efficient and effective capital raising strategy in today’s environment of additional choice and accompanying risks.