The President Favors Crowdfunding, But Is It Good Enough?

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The President is in favor of crowdfunding, and is “calling for a national framework that allows entrepreneurs and small businesses to raise capital through crowdfunding. (See the President’s proposal here).  This is exciting news to crowdfunding enthusiasts. Crowdfunding would allow early stage and small businesses to raise small amounts of money from the public at large.

Why can’t startups use crowdfunding now?

Under current securities law, crowdfunding is not possible for a couple of different reasons. First, Rule 506 of Regulation D, the securities law exemption most commonly used by startups to raise capital, precludes the use of general solicitation, which generally means companies cannot use the Internet or broadcast or similar media to advertise the fact that they are raising money.

Second, Rule 506 offerings disallow non-accredited investors from participating without the company having to comply with very detailed and comprehensive disclosure obligations. In contrast, if you are raising money from only accredited investors, there are no specific disclosure obligations required.

Rule 502(b) states, “The issuer is not required to furnish the specified information to purchasers when it sells . . .to any accredited investor.” Whereas non-accredited investors require “disclosure documents that are generally the same as those used in registered offerings.” (See the rules and regulations here:

http://taft.law.uc.edu/CCL/33ActRls/rule502.html; and a reference to the second quote here: http://www.sec.gov/answers/rule506.htm.)

This is one of the reasons why most startups limit their fundraising to all accredited investor offerings (that and the fact that federal law preempts state securities regulation in Rule 506 offerings except for Form D notice filings). What this means as a practical matter is that if you are not an “accredited investor,” it is generally not possible for you to invest in startups. (The income test to qualify as an “accredited investor” is at least $200,000 in income or $300,000 in income with your spouse in each of the last 2 years with the expectation of the same in the current year, or $1M net worth excluding your primary residence.)

To give you an idea of how prevalent the Rule 506 exemption is relative to other securities law exemptions in private securities offerings, in its most recent proposed “bad actor” regulations, the SEC reported...

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