CROWDFUNDING UPDATE: The SEC Regulations
If you are thinking about raising capital for your business using Crowdfunding, you need to know about the final SEC regulations, released October 29, 2015 (“Regulation Crowdfunding,” Section 4(a)(6) of the Securities Act of 1933).
Background: Crowdfunding, such as Kickstarter, has become a popular way of raising money for small ventures. A whole industry has been spawned around Crowdfunding, including dedicated websites, marketing firms, “how to” instructions, Crowdfunding consultants, and Crowdfunding presentation videographers.
Entrepreneurs all know the SEC regulates sales of securities by businesses in capital raising transactions. Regulation Crowdfunding applies only to the sale of a “security” using Crowdfunding; Crowdfunding that does not involve selling securities is not regulated. Simply put, equity-based Crowdfunding (selling stock or LLC interests) is a sale of a security; reward-based Crowdfunding (giving swag in exchange for donations in a Kickstarter campaign) is probably not.
In April 2012, the Jumpstart Our Business Startups (JOBS) Act was signed into law. The JOBS Act required the SEC to implement a new exemption to the federal securities laws to allow crowdfunding. The SEC finally released these regulations last week.
Summary. Regulation Crowdfunding treats Crowdfunding sales of securities basically in the same way as current regulations do: requiring the company to make filings with the SEC, prepare disclosure documents, financial statements, and making ongoing formal SEC reports. The result is, selling stock using Crowdfunding is less attractive in many ways than existing ways of selling stock to raise capital for a business.
The Basic Rules. The basic rules for Regulation Crowdfunding include:
- Limits on Sales. A company may not sell more than $1,000,000 of securities in a 12 month period under Regulation Crowdfunding.
- Limits on Purchases. A purchaser’s amount is limited. Anyone can invest up to $2,000. To invest more than $2,000, you need to meet requirements based on percentages of annual income and net worth. The maximum an investor can purchase is $100,000 in a year.
- Disclosure Statement. The company must make an initial filing with the SEC, which includes a disclosure statement, and must provide the disclosure statement to investors. The disclosure statement must contain information and financial statements similar to that required in a Regulation A filing.
- Financial Statements. The disclosure statement must include financial statements. For capital raises of more than $100,000 but less than $500,000, the financial statements must be reviewed by an independent accounting firm. If the company is raising capital under Regulation Crowdfunding for the first-time, and the amount is over $500,000, the financial statements need only be reviewed; but for subsequent offerings over $500,000, the financial statements must be audited by an independent accounting firm.
- Target Amount. The company must state, in its disclosure document, the target amount it wants to raise. If the target amount is not raised, the money that was raised must be returned to the investors. The disclosure statement must include a description of what happens if the company receives more than the target amount.
- Progress Reports. The company must file with the SEC, and provide to investors, an update on the progress towards meeting the target offering amount, when the company reaches 50% and again at 100% of the target amount.
- Ongoing Reporting Requirements. The company must file with the SEC, and post on the company’s website, an annual report containing required disclosure information and financial statements. The annual reporting requirements continue until one of several termination events occurs.
- SEC Registered Intermediary. The Crowdfunding must be done on a platform of an intermediary that meets the SEC intermediary requirements. Intermediaries must be registered with the SEC as a broker or as a funding portal.
- Advertising. Any advertising about the offering must comply with Regulation Crowdfunding requirements.
Conclusion. Regulation Crowdfunding doesn’t really deliver on the hope of increased access to a wide range of small investment capital in an economic and efficient way. Through Regulation Crowdfunding, the SEC is maintaining its basic function: to protect investors by requiring filings and disclosures in a sale of securities, unless the investor is “accredited” (i.e. has the economic means and knowledge to protect his or her own interests). The SEC is not ready to allow anyone who can access a Crowdfunding website to buy stock without disclosure and regulation.
Companies will have to weigh the costs and ongoing administrative burden of Regulation Crowdfunding against the benefits of being able to reach small (think up to $2,000 each) investors. Companies will need to pay lawyers and accountants, just as if they were doing a PPM for a private placement under Regulation A or Regulation D, and must use an SEC licensed broker / intermediary with the associated intermediary costs. The ongoing reporting requirements mean expense and administrative burden for some time in the future.
While Regulation Crowdfunding may become popular over time, as a practical matter, most startups will likely continue to use Regulation D for capital raising. If you want to go down the Regulation Crowdfunding road, you have about 180 days to get prepared before the regulations become effective.
November 3, 2015
David Peteler is the founder and principal of Peteler Law Office, with offices in Los Angeles and Minneapolis. He specializes in technology start-ups, capital raising, and mergers and acquisitions. He can be reached at firstname.lastname@example.org; or 952.300.6700. Visit www.petelerlaw.com for other posts on startups and capital raising.