On May 16, 2016, the final rules adopted by the Securities and Exchange Commission (SEC) with respect to Title III of the Jumpstart Our Business Startups Act (JOBS Act) took effect (except for certain forms allowing funding portals to register with the SEC, which became effective on January 29, 2016). These rules (known as Regulation Crowdfunding) are designed to allow companies, such as startups and small businesses, to access the capital markets through low-dollar amount online securities offerings directed to the “crowd”.
The following is an overview of the rules and requirements under Regulation Crowdfunding.
Offering Size and Investment Limitations
The maximum aggregate amount that a company may raise through Regulation Crowdfunding during a 12-month period is $1 million. The maximum aggregate amount that individual investors (whether non-accredited or accredited) may purchase depends on their annual income and net worth. For those with either annual income or net worth below $100,000, the limit is the greater of (a) $2,000 or (b) 5 percent of the lesser of their annual income and net worth. For those with both annual income and net worth over $100,000, the limit is 10 percent of the lesser of their annual income or net worth, up to a maximum of $100,000.
Exclusions from Eligibility
Non-US companies, reporting companies under the Securities Exchange Act of 1934 (the Exchange Act), certain investment companies, companies that are disqualified under Regulation Crowdfunding’s “bad actor” disqualification rules, companies that have failed to comply with annual reporting requirements under Regulation Crowdfunding and companies that have no specific business plan or have indicated their business plan is to engage in a merger or acquisition with an unidentified company or companies (e.g., shell companies) are not eligible to use Regulation Crowdfunding.
Companies relying on Regulation Crowdfunding must conduct their offerings through an SEC-registered intermediary, either a registered broker-dealer or a new type of entity called a “funding portal.” Companies are required to conduct a crowdfunding offering exclusively through one such intermediary at a time. Among other things, intermediaries must provide investors with certain educational materials, take measures to reduce the risk of fraud, make available information to investors about the company and the offering during the offering period and for a minimum of 21 days before any sale, provide communication channels to permit offering discussions and facilitate the offer and sale of crowdfunding securities. Intermediaries that are funding portals must register with the Financial Industry Regulatory Authority (FINRA) as well as the SEC and are subject to additional restrictions on their activities over those applicable to broker-dealers (for example, funding portals may not provide investment advice or recommendations, solicit investors, compensate employees or other persons for soliciting sales, or manage or handle investor funds or securities).
A company conducting an offering under Regulation Crowdfunding is required to comply with certain disclosure requirements by filing an offering statement on new Form C with the SEC through its online “EDGAR” filing system in addition to providing investors and the relevant intermediary with the offering statement. In its offering statement, the company must disclose a substantial amount of information with respect to, among other things, its capital structure, management, business operations, and financial condition in addition to information about the offering. The offering statement must also include US generally accepted accounting principles (GAAP) financial statements, and in some cases tax returns, with the level of financial statement disclosure (i.e., whether such financial statements are audited, reviewed or simply certified by the company’s principal executive officer) depending generally on the size of the offering.
If an offering has not yet been completed or terminated, the company must amend its disclosures if there is any material change to the offering terms or to any other disclosure previously provided to investors and provide regular updates on the company’s progress in reaching its target offering amount. In addition, during the course of an offering, the company must provide to investors and the relevant intermediary certain progress updates including its progress in meeting the target offering amount when the company reaches 50 percent and 100 percent of the target offering amount.
To advertise the terms of an offering under Regulation Crowdfunding, a company or any person acting on its behalf may only provide a notice that includes limited “tombstone ad” type information about the company and the terms of the offering and directs investors to the platform of the intermediary. All other forms of advertising by the company are prohibited.
Restrictions on Resale
An investor that purchases securities issued in reliance on Regulation Crowdfunding may not resell or otherwise transfer such securities for one year after the date of purchase, except to the company it purchased securities from, to an accredited investor, as part of a registered offering, to a family member or the equivalent, or in connection with certain events, such as the investor’s death or divorce.
Ongoing Reporting Requirements
Once the company has sold securities under Regulation Crowdfunding, the company will be required to file regular annual reports with the SEC containing similar information to the offering statement (with applicable updates), including financial statements, no later than 120 days after the end of each fiscal year and post copies of the annual reports on its website. Regardless of the size of the offering, the company’s financial statements included with the annual reports need only be certified by its principal executive officer (unless reviewed or audited financial statements are available). A company will continue to be subject to ongoing reporting requirements until it becomes a reporting company under the Exchange Act, it or another party purchases or repurchases all of the securities issued pursuant to Regulation Crowdfunding or it liquidates or dissolves. Further, if a company has filed at least one annual report and has less than 300 stockholders of record or has filed at least three annual reports and has total assets that do not exceed $10 million, it will no longer be subject to ongoing reporting requirements.
Under Section 4A(c) of the Securities Act of 1933, an “issuer” that conducts an offering made in reliance on Regulation Crowdfunding will be liable to investors for material misstatements or omissions in its offering documents and other communications, unless the issuer did not know, and in the exercise of reasonable could not have known, of such misstatements or omissions. The term “issuer” is defined broadly to include not only the company selling the securities but also directors and certain principal officers of the company among others. The SEC specifically declined to exempt intermediaries from such liability or interpret Section 4A(c) as categorically excluding intermediaries as “issuers” for purposes of such liability.
State Securities Law Preemption
Offerings under Regulation Crowdfunding are not subject to state securities law, or “blue sky,” registration and qualification requirements. Despite the preemption of state securities law, the antifraud provisions of state securities law will continue to apply where applicable.
Regulation Crowdfunding seeks to balance the competing interests of creating a mechanism that allows low-cost, low-dollar amount online securities offerings while at the same time providing protection to investors who have greater exposure to unscrupulous and fraudulent activity. Companies considering whether to conduct an offering under Regulation Crowdfunding should assess whether they will have the resources to comply with the burdensome disclosure and other requirements under Regulation Crowdfunding, as well as weigh the benefits and risks of raising money from the “crowd” compared to the alternatives such as raising money under Regulation D or Regulation A+. Crowdfunding intermediaries should consider whether it is possible to develop a viable business model that accounts for the burdens of acting as stewards of equity crowdfunding in a marketplace of low-dollar amount securities offerings.
Only time will tell whether Regulation Crowdfunding achieves its goal of helping jumpstart access to capital for startups and small businesses.