Crowdfunding is a totally new way to raise capital to support new ventures where an entity or individual seeks small contributions from a large number of people. Individuals interested in the crowdfunding campaign—members of the “crowd”—may share information about the project with the “crowd” or with management on discussion boards or otherwise, and members of the public can use the information to decide whether to fund the campaign based on the collective wisdom of the crowd. This concept was the subject of a 2012 piece of legislation called the Jumpstart Our Business Startups Act (the “JOBS Act”) which establishes a regulatory structure for startups and small businesses with capital by making relatively low dollar offerings of securities, featuring relatively lower dollar amount investments by the “crowd” less costly.
Regulation Crowdfunding prescribes rules governing the offer and sale of securities under new Section 4(a)(6) of the Securities Act of 1933. Regulation Crowdfunding also provides a framework for the regulation of registered funding portals and broker/dealers that issuers are required to use as intermediaries in the offer and sale of securities in reliance on Section 4(a)(6).
When Congress passed the JOBS Act, they built in certain provisions into the legislation that attempted to protect investors engaging in crowdfunding transactions, such as investment limits, required disclosures by issuers, and a requirement to use regulated intermediaries (aka funding portals) required to register with FINRA and regulated by the SEC.
Someone who operates a website to facilitate the purchase and sale of equity for businesses (sort of like eBay or equity kickstarter) would ordinarily be required to register with the SEC and FINRA as a broker/dealer. However, Congress recognized that such websites would be impractical since broker/dealers are subject to so many regulatory obligations. Hence, the JOBS Act specifically exempts crowdfunding transactions. Keep in mind that just because funding portals are authorized to host and facilitate these types of investments, it is my understanding of the laws that broker/dealers are ALSO authorized from establishing and running equity crowdfunding portals. It is entirely possible that we will see the big broker/dealers launch equity crowdfunding platforms under their broker/dealer umbrella.
Investment Amount Restrictions
Companies and investors have certain restrictions, namely:
- The amount raised must not exceed $1 million in a 12-month period;
- Individual investments are limited in a 12-month period to: (1) the greater of $2,000 or 5% of annual income or net worth (if annual income or net worth is less than $100,000); and (2) 10% of annual income or net worth (not to exceed $100,000), if the investor’s annual income or net worth is $100,000 or more; and
- Transactions must be conducted through a registered broker/dealer or “funding portal.”
Ineligible Companies
The SEC excluded non-U.S. companies, companies who are already public (after all, this is intended for startups), and public companies who failed to comply with U.S. securities reporting requirements within two years of the proposed raise.
The securities are also restricted for one year.
Required Disclosures by the Companies Raising Money from the Crowd
The final rules require companies who are trying to raise funds through crowdfunding to disclose certain items, including:
- Information about officers and directors and 20% or more owners;
- A description of the business and the use of proceeds;
- A methodology of how the company determined the price per share and information about the target amount being raised and whether the company will allow more funds to be raised than the target (this information has to be continually updated);
- Some related party transactions;
- Financial statements accompanied by the company’s tax returns reviewed by an independent CPA or audited; and
- An annual report which goes to the SEC and the investors.
If you read closely, this means that companies without a formal business plan are not going to be able to qualify to raise money. In fact, the SEC takes the position that if your business plan is to merge with another business, and you are raising money to do that, then you are excluded from crowdsourcing. As an example, take Lavar Burton’s incredibly successful Kickstarter campaign to bring back “Reading Rainbow.” It is my understanding that if he was raising the capital to acquire the entity that owned “Reading Rainbow” and then bring it back, then it would have been excluded from equity crowdfunding. However, it is entirely possible that he solicited these donations in exchange for no equity, and acquired the rights to “Reading Rainbow” and it would have been entirely within the rules.
Crowdfunding Platform Requirements
Offerings must be done exclusively through a Funding Portal, which is a new SEC regulated entity. The final rules require funding portals to:
- Provide investors with educational materials;
- Take measures to reduce the risk of fraud;
- Make available information about the issuer and the offering;
- Provide communication channels to permit discussions about offerings on the platform; and
- Facilitate the offer and sale of crowdfunded securities.
Funding portals are prohibited from the following:
- Offering investment advice or making recommendations;
- Soliciting purchases, sales, or offers to buy securities offered or displayed on its platform;
- Compensating promoters and others for solicitations or based on the sale of securities; and
- Holding, possessing, or handling investor funds or securities.
Three Year Follow-up Study by the SEC
The SEC staff will complete a report and submit it to the SEC within three years of the effective date of Regulation Crowdfunding on the impact of capital formation and investor protection.
Companies May Not Use More than One Funding Portal
Companies who will be using Funding Portals to crowdfund are required to use the same Funding Portal because the SEC determined that using the same Funding Portal would help centralize that company’s “crowd” which is essential to this type of investment platform. My own thinking is that if a company were using more than one Funding Portal then they could raise more money than the required $1 million per 12-month period. They might even accidentally raise more than $1 million if they used more than one portal.
The SEC believes in the centralization of a “crowd” that the SEC states in their explanatory memorandum to the final rules that “We also do not believe that funding portals should be permitted to physically meet with investors to solicit investments and offerings on its platform, or host launch parties…because these activities likely violate the statutory prohibition on funding portals soliciting and providing investment advice and recommendations.”
