On October 30, 2015, the SEC issued final rules to implement Title III of the Jumpstart Our Business Startup (JOBS) Act, which amended the Securities Act of 1933 to provide an exemption from registration for certain crowd-funding transactions (i.e., a method to raise capital using the Internet). The final rules—which are referred to as “Regulation Crowdfunding” and will become effective in May 2016—were long in the making.
To qualify for the exemption, Title III of the JOBS Act imposes requirements concerning 1) the maximum amount of capital that can be raised over a 12-month period; 2) the mandatory use of a new type of entity, referred to as a funding portal, to conduct the sales; 3) the maximum amount of sales that can be made to any individual investor; and 4) the information that must be filed with the SEC and made available to investors.
A Brief Review of the New Rules
Regulation Crowdfunding is available only to U.S. companies that are not subject to the continuous reporting requirements of the Securities Exchange Act of 1934. Requirements generally include the following:
- The aggregate amount of securities sold in a 12-month period may not exceed $1 million.
- The aggregate amount of securities that can be sold to any single investor in a 12-month period may not be more than the greater of 1) $2,000 or 5% of the investor’s annual income or net worth, whichever is more, if either annual income or net worth is less than $100,000, or 2) 10% of the lesser of the investor’s annual income or net worth, but not exceeding $100,000, if both the investor’s annual income and net worth are equal to or greater than $100,000.
- Crowdfunding transactions must be conducted through a broker or funding portal (i.e., the intermediary). Intermediaries are required to effect crowdfunding transactions entirely via an online platform.
- For offerings of $100,000 or less, an issuer is required to disclose 1) the amount of total income, taxable income, and total tax, as reflected in the issuer’s federal income tax returns certified by the principal executive officer, and 2) financial statements certified by the principal executive officer to be true and complete in all material respects.
- For offerings of more than $100,000 but not more than $500,000, reviewed financial statements must be provided.
- For first-time crowdfunding offerings of more than $500,000, reviewed financial statements are required; audited financial statements are required only if the issuer has previously sold securities in a crowdfunding transaction.
- In addition to the financial statements themselves, a discussion is required along the lines of (but not as detailed as) a management’s discussion and analysis (MD&A) presentation.
- An annual report must be filed with the SEC and posted on the issuer’s website within 120 days following the end of the entity’s most recent fiscal year. The annual report is required to contain essentially an update to the information included in the original offering statement (except, of course, for offering-specific disclosures). The issuer’s principal executive officer must certify that the financial statements are true and complete; reviewed or audited statements are not required unless they have been prepared for other purposes.
- Securities issued in a crowdfunding transaction may not be transferred within one year following the purchase, except to the issuer itself, to an accredited investor, as part of a registered offering, or to a member of the purchaser’s family.
The Purpose of the JOBS Act
Apart from the crowdfunding exemption, the JOBS Act created a new class of public companies, identified as emerging growth companies. It also required the SEC to amend rules to allow general solicitations in Regulation D and Rule 144A offerings, amended Regulation A to increase (from $5 million to $50 million) the amount of securities that may be issued over a 12-month period, and increased the threshold that triggers SEC periodic reporting requirements. As a package, all of these initiatives were intended to help ease the regulatory burden of raising capital for startups and smaller companies, ultimately leading to increased economic growth and job creation.
Crowdfunding Pros and Cons
Of all the JOBS Act initiatives, crowdfunding was, by far, the most controversial. From an investor’s standpoint, nonac-credited investors will be able to invest in small businesses and startups along with accredited investors. From an issuer’s perspective, the rules provide small businesses and startups with an entirely new means of raising capital. This is especially advantageous for companies with plans for more “mundane” products or services in which most venture capitalists show little interest.
On the downside for issuers, an early-stage entity without infrastructure or sufficiently trained and experienced staff could quickly find itself inundated with legal issues and end up in a costly state of regulatory noncompliance—eventually leading to its downfall. Issuers must always keep in mind that crowdfunding transactions, though exempt from registration, are not exempt from the antifraud provisions of the Securities Acts; specifically, newly created section 4A(c) of the Securities Act makes an issuer (which includes its officers and directors) liable for making an untrue statement of a material fact or omitting a material fact.
For investors, the downside is that crowdfunding investments are rife with obstacles, and all manner of fraud leads the list. With that in mind, the new rules essentially make intermediaries the first line of defense for preventing and detecting fraud. Among other requirements, intermediaries must have a reasonable basis for believing that an issuer is in compliance with the requirements of Regulation Crowdfunding and has established procedures to keep accurate records of the holders of the securities it offers and sells through the intermediary’s platform. While the rules do not prescribe the specific steps an intermediary should take, the SEC expects that intermediaries will conduct more rigorous compliance reviews and background checks as risk factors increase. It is important to note that intermediaries have a vested business and reputational interest in accepting high-quality proposals and rejecting outright those for which the suspicion of fraud is present.
Apart from fraud, investors of course face the risk of loss. Although risk is part and parcel of virtually every investment, it could be especially high in a crowdfunding transaction, given the absence of a track record and the startup nature of many of the companies likely to take advantage of the crowdfunding exemption. Crowdfunding might provide investors with the chance to get in on an early-stage Twitter or Facebook, but it will also provide them the chance to get in on the ground floor of a Flooz.com, eToys, or WebTV—all of which failed dramatically. Though statistics vary, it is estimated that the failure rate for startups is between 80% and 90% (Yan Revzin, “The Major Reasons Startups Fail—and How You Can Avoid Them,” http://www.forbes.com/sites/theyec/2015/03/05/the-major-reasons-startups-fail-and-how-you-can-avoid-them/). In addition, even though the limits on amounts that can be invested are controlled and fairly low, a total loss for some investors could turn out to be a financial hardship.
And, of course, once investors are in, there is the not-so-insignificant matter of getting out. Scott Shane, professor of entrepreneurial studies in the Weatherhead School of Management at Case Western Reserve University, points out that for nonaccredited equity investors, there won’t be enough initial public offerings or acquisitions to provide all of the needed liquidity. Moreover, he notes that many of the companies that will seek investments from nonaccredited investors will not be the type that typically go public or get acquired. For nonaccredited investors to sell their shares to other nonaccredited investors, it would thus require the development of a secondary market that does not currently exist. Finally, Shane cautions that, even if the right type of secondary market were to emerge, it would be far from efficient without analysts to provide research and valuation advice (“Will Equity Crowdfunding Buyers Be Able to Sell Their Shares?,” http://www.entrepreneur.com/article/247832).
The Encouraging European Experience
At the moment, Europe is the center of equity crowdfunding—mainly because, until the SEC’s final rules were issued, equity crowdfunding was not allowed on a national basis in the United States (although some U.S. states already permit it). Equity crowd-funding in Europe is allowed under a 2010 European Union (EU) directive; however, because a directive only outlines broad principles and gives EU member states the leeway to implement them as they see fit, a patchwork of rules has emerged (e.g., the upper limit of funds is €1 million in France, compared with €5 million in the United Kingdom). What is encouraging, though, is that, based on the experience of the top five European investment crowdfunding platforms over the past five years covering nearly 400 funding projects, no incidence of fraud has been reported (J. D. Alois, “Investiere Publishes List of Top 5 European Investment Crowdfunding Platforms, http://www.crowdfundinsider.com/2015/03/64423-investiere-publishes-list-of-top-5-european-investment-crowdfunding-platforms/).
Even more encouraging is that Seedrs, one of the largest and most successful equity crowdfunding platforms in the United Kingdom, has expanded its reach beyond Europe and has now entered the United States in anticipation of a robust U.S. equity crowdfunding market.
Maybe crowdfunding in the United States will work after all. q