Regulation Crowdfunding Rules Part II: What Companies Raising Capital Must Disclose
This blog post is the latest in a series of blog posts about Regulation Crowdfunding. Part I is linked here. If you have any questions about crowdfunding, capital raises, or funding portals email firstname.lastname@example.org or call (917) 830-6517 and we will give you a free consultation.
Regulation Crowdfunding will go live 180 days after the rules are published in the Federal Register. I’m not sure precisely when this will be, but the forms allowing funding portals to register with the SEC will go live on January 29, 2016.
One of the key investor protections of Title III of the Jumpstart our Business Startups Act (the “JOBS Act”) is the requirements imposed on issuers (or companies) that raise capital by selling securities through intermediaries or funding portals.
In general, when a company wants to sell securities they are required to “register” those securities with the SEC. This is a very complicated and expensive process that generally doesn’t make sense for smaller businesses. Thus, the SEC created an exemption for non-public offerings of securities.
Section 4(a)(2) of the Securities Act exempts from registration “transactions by an issuer not involving any public offering.” To qualify for this exemption, which is sometimes referred to as the “private placement” exemption, the purchasers of the securities must:
- either have enough knowledge and experience in finance and business matters to be “sophisticated investors” (able to evaluate the risks and merits of the investment), or be able to bear the investment’s economic risk;
- have access to the type of information normally provided in a prospectus for a registered securities offering; and
- agree not to resell or distribute the securities to the public.
In general, public advertising of the offering, and general solicitation of investors, is incompatible with the non-public offering exemption (which is why Regulation Crowdfunding is so different than normal).
The precise limits of the non-public offering exemption are not defined by rule. As the number of purchasers increases and their relationship to the company and its management becomes more remote, it is more difficult to show that the offering qualifies for this exemption. If your company offers securities to even one person who does not meet the necessary conditions, the entire offering may be in violation of the Securities Act.
Rule 506(b), which is the most common offering, provides objective standards that your company can rely on to meet the requirements of the Section 4(a)(2) non-public offering exemption.
However, Regulation Crowdfunding eases even the restrictions of a private offering under Rule 506(b). However, Regulation Crowdfunding still requires companies raising capital to abide by certain requirements which are very similar to the private placement exemption above.
Securities Act Section 4A(b)(1) sets forth specific disclosures that an issuer offering or selling securities in reliance on Section 4(a)(6) must “file with the Commission and provide to investors and the relevant broker or funding portal, and make available to potential investors.” These disclosures (to be filed on Form C) include:
- the name, legal status, physical address and website of the issuer;
- the names of the directors and officers and each 20% shareholder;
- a description of the business and the anticipated business plan;
- a description of the financial condition of the company raising capital;
- a description of the stated purpose and intended use of the proceeds of the offering sought by the company;
- the target offering amount and the deadlines (along with regular updates);
- the price to the public and method for determining the price;
- a description of the ownership and capital structure of the issuer;
The SEC reserves the right to require additional disclosures. As you can see, many companies trying to raise capital on funding portals might still need to hire a securities attorney to prepare parts of their documentation, especially until we know what kind of scrutiny will be given to companies who are crowdfunding.
DESCRIPTION OF THE BUSINESS
The SEC has explicitly stated that they decided to keep the description of the business section flexible so that a variety of businesses at different operating stages can take advantage of crowdfunding.
USE OF PROCEEDS
Rule 201(i) of Regulation Crowdfunding requires an issuer to provide a description of the purpose of the offering and intended use of the offering proceeds. Such disclosure would provide a sufficiently detailed description of the intended “use of proceeds” to permit investors to evaluate the investment.
This is where so many companies commit fraud, knowingly or unknowingly. In standard private offerings, the SEC is reluctant when a company doesn’t describe in concrete terms how they will deploy the capital. Those who fail to disclose their “use of proceeds” or deviate from what they told investors can be deemed fraudulent. The reason that I have seen when I have worked with clients who have been investigated or charged by the SEC or CFTC (obviously, for actions taken before they engaged me), was that by not specifying how they would use the funds to investors the entrepreneurs activities switched from “raising capital for a company” to “soliciting investments for a blind fund.” Applying this logic (however irrational), has helped guide me to emphasize particularity in assisting my clients prepare a “use of proceeds” section.
The SEC proposed that companies raising capital (or the issuer) is required to provide a separate, reasonably detailed description of the purpose the purpose and intended use of any excess proceeds with similar specificity.
The SEC gives an example of how the “use of proceeds” should operate:
“For example, an issuer may intend to use the proceeds of an offering to acquire assets or businesses, compensate the intermediary or its own employees or repurchase outstanding securities of the issuer. In providing its description, an issuer would need to consider the appropriate level of detail to provide investors about the assets or businesses that the issuer anticipates acquiring, based on its particular facts and circumstances, so that the investors could make informed decisions. If the proceeds will be used to compensate existing employees or to hire new employees, the issuer should consider disclosing whether the proceeds will be used for salaries or bonuses and how many employees it plans to hire, as applicable. If the issuer will repurchase outstanding issuer securities, it should consider disclosing its plans, terms and purpose for repurchasing the securities. An issuer also should consider disclosing how long the proceeds will satisfy the operational needs of the business. If an issuer does not have definitive plans for the proceeds, but instead has identified a range of possible uses, then the issuer should identify and describe each probable use and the factors the issuer may consider in allocating proceeds among the potential uses.165 If an issuer indicates that it will accept proceeds in excess of the target offering amount, the issuer must provide a reasonably detailed description of the purpose, method for allocating oversubscriptions, and intended use of any excess proceeds with similar specificity.
Obviously, the SEC is really trying to avoid the type of companies who raise capital for their own personal use then later claim that the company failed and therefore, the entrepreneur can’t return the investors’ funds.
TARGET OFFERING AMOUNT AND DEADLINE
Rule 201(g) of Regulation Crowdfunding requires issuers to disclose the target offering amount and deadline to reach this amount. Companies raising capital also must disclose whether it will accept oversubscriptions, or money in excess of the target amount.
The SEC would also require companies raising capital to disclose and implement a process within which the investor can cancel their investment. The following requirements would be implemented:
- Investors may cancel an investment commitment until 48 hours prior to the deadline identified in the offering materials;
- The intermediary (e.g., funding portal) will notify investors when the target offering amount has been met;
- If the investor doesn’t cancel the investment within 48 hours prior to the offering deadline the funds will be released to the company and the investor will receive their securities in exchange for their investment.
Rule 201(k) requires that if the material change is made to the offering (for example, in the use of proceeds description), then if an investor doesn’t reconfirm their investment the investor’s commitment amount will be canceled.
OWNERSHIP AND CAPITAL STRUCTURE
Rule 201(m) of Regulation Crowdfunding will require the following:
- Terms of the securities being offered and a description of the other classes of securities of the company raising capital, descriptions of voting rights and differences between classes of stock;
- A description of how the majority shareholders could impact the purchasers of the securities;
- The name and ownership level of those who hold 20% or more in the company (or could exercise options to reach that level);
- How the securities are being valued;
- Risks to the purchasers of the securities relating to minority ownership;
- Description of the restrictions on transfer of the stock.
Additional Disclosure Requirements
The company raising capital must also disclose:
- the SEC file number of the intermediary (e.g., funding portal);
- the amount of compensation paid to the intermediary (including referral fees)(this can be in dollars or as a percentage of the offering (or a good faith estimate));
- disclosure of current number of employees working for the company raising the capital;
- a discussion of the material factors that make an investment risky;
- a description of any outstanding debts by the company (no need to identify names of creditors);
- disclosure of private offerings made in the past three years;
- disclosure of related party transactions
The company raising capital must disclose their financial condition, including “liquidity, capital resources, and historical results of operations.” This narrative disclosure of their financial condition for each period discussed by the financial statements discussed below.
The company must put together financial statements, which have different requirements depending on how much capital they are raising.
- If they are raising less than $100,000 of capital then they need to file income tax returns for the most recently completed fiscal year (if any) and financial statements certified by the executive officer to be true and complete.
- If they are raising more than $100,000 but less than $500,000 then they need to file financial statements reviewed by an independent auditor.
- More than $500,000 then the financial statements must be audited by an independent public accountant.
There are a lot of instructions to this Rule that I can’t get into here.
Part III will focus on ongoing reporting requirements, Form C and filing requirements, and advertising terms of the offering.