While the prospect of crowdfunding has captured the imagination of many, it remains to be seen if government rules will actually allow small businesses to access this new form of funding as readily as proponents tout.
In the past, federal and state securities laws, and the costs of complying with them, made it difficult for small and midsize businesses to sell stock to raise funds. The Jumpstart Our Business Startups Act (the JOBS Act) sought to change that by modifying the federal securities laws designed to increase access to capital.
The most controversial measure of the JOBS Act, the crowdfunding exemption, allows private companies to raise limited amounts of capital from an unlimited pool of small investors by selling unregistered shares in their ventures.
Some provisions of the JOBS Act took effect immediately, while the crowdfunding exemption and others require SEC rulemaking before they become effective. Title II of the JOBS Act, for example, which lifts the ban on public solicitation for investment from accredited investors under Rule 506, is another that requires SEC rulemaking.
This rule change will greatly expand companies' ability to solicit investments by allowing them to publicly advertise their offerings to wealthy investors, a significant change from the current regime in which companies can advertise their offerings only if shares are sold exclusively to wealthy investors from within their private networks. The SEC was supposed to issue a final rule related to public advertising of Rule 506 offerings on July 4, but instead issued a proposed rule for public comment on Aug. 29. The SEC requested that all formal comments on the proposed rule be submitted by Oct. 5, 2012, which creates the possibility that final amendments could be adopted by years end. The delay in the enactment of rules relating to the public advertising of Rule 506 offerings has prompted some to question whether the SEC will delay its adoption of rules pertaining to the crowdfunding exemption or whether it will adopt a set of rules that limits the usefulness of the exemption.
The SEC was given 270 days to draft the rules on how crowdfunding will operate. That deadline expires on Dec. 31. Since President Obama signed the JOBS Act in April, the SEC has held meetings and solicited public comment relative to crowdfunding, but it has not given any specific guidance other than to remind businesses that the crowdfunding exemption is not yet effective.
Tapping the Crowd
Crowdfunding is essentially the process of raising small amounts of money from a dispersed group of individuals, often via the internet.
Crowdfunding relies on the collective action of a group of investors who network and pool their money to support startup companies and small businesses.
Until the passage of the crowdfunding exemption, federal securities laws have prevented would-be crowdfunders from selling equity in their ventures. This is because, by definition, an offering of securities to the crowd would constitute a public offering.
The Securities Act of 1933 prohibits issuers of unregistered securities from making public offerings without registration, a process that is prohibitively expensive for small- and mid-sized businesses.
Crowd Vetting
Proponents of equity-based crowdfunding argue that registration of company shares under federal or state securities laws is not necessary because the crowd is capable of policing itself. The idea is the crowd is constantly vetting the ideas presented by entrepreneurs, and supporting only those businesses they and their peers deem worthy.
Discussions among prospective backers occurs on websites that strive to provide transparency, open communication, accountability and information exchange among the entrepreneurs and the crowd of prospective investors.
Proponents theorize that when the crowd shares its analysis of the business model, prospective products, and background of the entrepreneur, those would-be investors are able to identify fraud more effectively than a regulator working in isolation.
Crowdfunding Exemption
Title III of the JOBS Act allows entrepreneurs to use crowdfunding intermediaries to sell equity in their companies by introducing a new private placement exemption called the crowdfunding exemption.
Once effective, the crowdfunding exemption will allow private companies to raise limited amounts of capital from an unlimited pool of small investors by selling unregistered shares in their ventures.
Under the exemption, a private company can raise up to $1 million in any 12-month period by issuing securities to individual investors subject to the following investor caps:
1. The aggregate investment that a company can sell to an investor with an annual income or net worth of less than $100,000 during a 12-month period cannot exceed $2,000 or 5 percent of the annual income or net worth of the investor.
2. The aggregate investment that a company can sell to an investor with an annual income or net worth greater than $100,000 during a 12-month period is 10 percent of the annual income or net worth of the investor, not to exceed a maximum investment of $100,000.
Funding Portal
Companies seeking crowdfunding cannot sell directly to investors. They must use an SEC-registered broker or a newly created class of SEC-registered funding portals. A funding portal is any person acting as an intermediary in a crowdfunding transaction.
In addition to providing disclosure related to the investment, the portal must confirm the investor's comprehension of the risk he or she is undertaking, require compliance with the terms of the crowdfunding exemption, and ensure that all offering proceeds are only distributed to the issuer when the aggregate capital raised from all investors meets or exceeds the target offering amount. An entity ceases to be a funding portal if it exceeds its limited role of intermediary, such as by offering investment advice or recommendations, managing investor funds, or soliciting purchases, sales, or offers to buy the securities offered on its website or portal.
Fraudsters Beware
While the crowdfunding exemption preempts the authority of state securities regulators it does not restrict the states' ability to discover, stop, and prosecute fraudulent offerings. In addition, issuers, executives, and directors will be liable to purchasers of these securities under state and federal securities laws for material misstatements or omissions contained in disclosure documents.
SEC Implementation
The exact mechanics of the crowdfunding exemption are still undefined. The SEC has the next two months to create additional rules to implement the exemption, which will resolve certain issues, but uncertainty surrounds how crowdfunding will work in practice. Drawing from a wide base of initial investors may give a startup the capital it needs for its initial launch, but a large group of initial investors will complicate the process of getting shareholder approval for subsequent rounds of financing. Furthermore, the startup's acceptance of crowdfunding could discourage venture capitalists that might otherwise be willing to invest greater dollars in a later round of financing.
Once the SEC issues its rules, the crowdfunding exemption will offer an interesting avenue for participation by small investors in early-stage startups. Its usefulness in practice, however, remains to be seen.
Daniel Sieck is a member of the Corporate Department at the law firm of McLane, Graf, Raulerson & Middleton, Professional Association, with offices in Concord, Manchester and Portsmouth as well as Woburn, Massachusetts. He can be reached at daniel.sieck@mclane.com or 603-628-1402.
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