The Legal Intelligencer

Editor's note: This article is based in part on the forthcoming book by Frederick D. Lipman titled "New Methods of Financing Your Business with U.S. Investors."

Crowdfunding has created a revolution in the raising of funds for startup companies and for other projects, including both for-profit and not-for-profit projects. Crowdfunding is a process by which a company or project can raise capital with relatively small individual contributions from a large number of contributors using the Internet and other social media. Crowdfunding sites include, but are not limited to, Kickstarter, Indiegogo, GoFundMe and many others, and can be reward-based or donation-based.

For example, using the crowdfunding Web portal Kickstarter, approximately 10,000 people contributed over $2 million during 2012 and 2013 to help Palmer Luckey (now 22 years old), the creator of a virtual reality headset, transform a prototype into a finished product. Unfortunately for these 10,000 people, not one of them received any money when Luckey's entity, Oculus Rift, was sold to Facebook for $2 billion on March 25, 2014. That was because the U.S. Securities and Exchange Commission had not adopted final regulations permitting the sale of investment securities by Oculus Rift to these 10,000 backers pursuant to Section 4(a)(6) of the Securities Act of 1933.

At a time when the unemployment rate exceeded 9 percent, Congress passed, and the president signed on April 5, 2012, the Jumpstart Our Business Startups Act, and gave the SEC until Dec. 31, 2012, to enact final regulations under Section 4(a)(6). Congress believed that facilitating the raising of capital by small and startup businesses through securities crowdfunding would create jobs.

Unfortunately, the SEC had other priorities that it deemed more important than creating crowdfunding jobs pursuant to Section 4(a)(6). As a result, as of this month, when the unemployment rate is now just over 5 percent, the SEC has still not finalized its Section 4(a)(6) crowdfunding rules. However, they are promised by the end of 2015. When finalized, these rules will permit small and startup businesses to raise up to $1 million every 12 months through securities crowdfunding. Funds raised from contributors in non-securities crowdfunding will not count against the $1 million limitation under the SEC's proposed rules.

As a result of the lengthy delay by the SEC of finalizing its rules under Section 4(a)(6), more than 20 states have already enacted state crowdfunding legislation.

What is Investment Securities Crowdfunding?

There are two major forms of crowdfunding:

• Non-securities crowdfunding in which the contributor receives a reward (the final product, a T-shirt, movie cast parties, etc.) or merely makes a donation, but does not receive either debt or equity investment securities in exchange for the contribution. Kickstarter is a prominent funding platform for creative projects, including films, games, music, art, design and technology. Even gourmet potato salad raised capital on Kickstarter. The "Veronica Mars" and "Wish I Was Here" movie projects were funded to the tune of $5.7 million and $3 million, respectively. Kickstarter claims that since its launch on April 28, 2009, over $1.8 billion has been pledged by 5 million people for funding more than 88,000 creative projects. These projects could not, prior to the adoption of the SEC rules, legally include investment securities under Section 4(a)(6) as part of the rewards to contributors.
• Securities crowdfunding is where the contributor to the project receives either debt or equity investment securities in return for the contribution. This form of crowdfunding cannot be legally used under Section 4(a)(6) until the SEC adopts its final rules, but can be used for accredited investor offerings under SEC Rule 506(c).

Prior to the adoption of the final crowdfunding rules under Section 4(a)(6), so-called accredited investors can still purchase such securities in a "crowdfunding" offering over the Internet or other social media, which is made solely to accredited investors pursuant to Rule 506(c) under the 1933 act. This rule was adopted by the SEC effective Sept. 23, 2013, pursuant to the JOBS Act. In contrast to Section 4(a)(6) crowdfunding, which will permit investments in limited amounts by non-accredited investors as well as accredited investors, investment securities can be purchased under Rule 506(c) solely by accredited investors. In addition, the qualification of the investor as "accredited' is subject to an intrusive verification requirement. This requirement seriously limits the use of Rule 506(c). However, crowdfunding solely to accredited investors under Rule 506(c) has major advantages, including the ability to raise unlimited funds (versus $1 million every 12 months under Section 4(a)(6)), with no dollar limit on investments by accredited investors, as well as the absence of very prescriptive disclosure and reporting requirements applicable to Section 4(a)(6) under the SEC's proposed rules.

For example, on July 22, 2014, the owner of the Hard Rock Hotel Palm Springs closed on what is touted as the first major crowdfunding campaign for a U.S. hotel, having raised more than $1.5 million within 90 days from accredited investors who took an equity stake in the project. The funds were raised from investors through a website limited to accredited investors called Realty Mogul located at www.realtymogul.com and, therefore, technically is considered "crowdfunding." Realty Mogul advertises itself as providing "crowdfunding" for real estate and as a "marketplace for accredited investors to pool money online and buy shares of pre-screened real estate investments." To satisfy Rule 506(c), investors registering with Realty Mogul have to provide supporting documentation that proved they were an "accredited investor," including the verification requirement necessary to satisfy this rule. The equity stakes in the hotel were sold by WealthForge LLC, a securities broker-dealer registered with the SEC.

State-sanctioned "crowdfunding" relies upon an exemption from the 1933 act contained in Section 3(a)(11) of that statute, which limits the offer and sale to residents of that state and contains other very strict requirements. These strict requirements will likely make state crowdfunding a less useful method of raising capital for small and start-up businesses.

The term "accredited investors" is defined in Rule 501 under the 1933 act and includes, among others, the following:

• "A natural person whose individual net worth, or joint net worth with that person's spouse, exceeds $1 million." The investor's primary residence is not included in determining their net worth and mortgage indebtedness up to the fair market value of their primary residence is excluded from their liabilities (subject to a minor exception).
• "Any natural person who had an individual income in excess of $200,000 in each of the two most recent years or joint income with that person's spouse in excess of $300,000 in each of those years and has a reasonable expectation of reaching the same income level in the current year."

Transactions pursuant to Section 4(a)(6) must be conducted through an intermediary satisfying in the requirements of Section 4A(a) of the 1933 act, which is either a registered securities broker or registered funding portal, and the transaction must be conducted exclusively through the intermediary's "platform." The term "platform" means an Internet website or other similar electronic medium through which a registered broker or a registered funding portal acts as an intermediary in a transaction involving the offer or sale of securities in reliance on the securities crowdfunding exemption. The issuer must also comply with the disclosure requirements and other applicable provisions of Section 4(a)(6) and Section 4A(b) of the 1933 act.

Sales under Section 4(a)(6) may be made through the intermediary to any investor, whether or not they are an accredited investor. However, the total amount sold to any single investor by the "issuer" (including all entities controlled by or under common control with the issuer, plus their predecessors under the SEC-proposed rules) in reliance on the securities crowdfunding exemption (Section 4(a)(6)) during the 12 months preceding the transaction, including the current sale, must not exceed the greater of:

• If both the annual income and net worth of the investor are below $100,000, the greater of $2,000 or 5 percent of the annual income or net worth of that investor.
• If either the annual income or net worth of the investor is $100,000 or more, 10 percent of the greater of the annual income or net worth of the investor, up to a maximum aggregate amount sold of $100,000.

A natural person's annual income and net worth may be calculated jointly with the annual income and net worth of the person's spouse. The company is permitted to rely on the intermediary to ensure that investor limitations are not exceeded.

Unfortunately, Congress has created a complicated and expensive method of raising capital through securities crowdfunding under Section 4(a)(6). It remains to be seen how successful it will be in creating new jobs.

“SEC Regulations on Investment Securities Crowdfunding,” by Frederick D. Lipman was published in The Legal Intelligencer on July 16, 2015. Please click here to read the article online. Reprinted with permission.