Title III Securities-Based Crowdfunding: Ten Things You Should Know If You Are Considering Participating as an Issuer, Investor or Intermediary
Crowdfunding is a relatively new avenue for companies to raise capital from a large number of investors – the crowd. Until the Jumpstart Our Business Startup Act (JOBS Act) was enacted over three years ago, companies wishing to raise funds from a large number of investors with whom they had no prior relationship were limited to complying with costly rules necessary to engage in a registered public offering or fitting within certain narrow exemptions. Moreover, these narrow exemptions, in large part, limited the sale of securities primarily or solely to institutional and high net worth individual investors who qualify as accredited investors. Many companies turned to donation-based crowdfunding platforms established by companies such as Kickstarter and Indiegogo, but such platforms could not be utilized to sell securities, a term that is broadly defined by the Securities Act of 1933, as amended, to include, among other things, any investment contract, evidence of indebtedness or participation in any profit sharing agreement. As a result, companies utilizing these platforms were limited by the type of fundraising campaigns that could be employed (e.g. donations, advance product sales and giveaways) and by the number of people who were willing to participate in such types of offerings.
The JOBS Act established a regulatory framework for small businesses to raise capital from investors but actual implementation of that framework was dependent on the adoption of rules by the Securities and Exchange Commission (SEC). As noted in our earlier client alert, SEC Adopts Final Equity Crowdfunding Rules – Will They Be Worth the Wait?, the SEC adopted their long-awaited final rules on October 30, 2015 allowing “mom and pop” investors to participate in securities-based crowdfunding through online platforms. As a result of the new rules, which will largely become effective on May 16, 2016, securities-based crowdfunding extends to both accredited and non-accredited investors. The rules of the game have simply changed to accommodate the evolving dynamics of capital formation in the 21st century. The below summary highlights ten key items that all potential issuers, investors and intermediaries need to consider before deciding to participate in securities-based crowdfunding.
1. What are the basic parameters of crowdfunding under the SEC’s final rules?
The finals rules permit companies to raise a maximum aggregate amount of $1 million in a crowdfunding offering during a 12-month period. Given that crowdfunding is a novel method of capital formation for startup companies, Congress and the SEC were concerned about expanding the offering limit beyond $1 million. However, issuers can raise capital from an unlimited number of accredited and non-accredited investors. As discussed further below, individual investors are capped at certain investment amounts based upon their income and net worth.
Each issuer is required to provide basic information about the offering (e.g., the price of the security, target investment size, use of proceeds, etc.) that will permit the public to make an educated decision about whether to invest in such issuer. The final rules do not limit the type of securities that may be offered in reliance on Regulation Crowdfunding. Except in limited circumstances, investors who purchase securities in a crowdfunding offering will be restricted from transferring the purchased securities for one year from the date of purchase. Fundraising campaigns will be accomplished through web-based platforms set up by intermediaries that must be registered with the SEC. An intermediary entity will connect investors to issuers and facilitate the transaction on its portal website.
2. What type of ongoing compliance measures will companies be subject to after a crowdfunding offering?
Each company that participates in a crowdfunding offering is required to prepare an annual report and make such report available to the public through the company’s website. This is especially noteworthy to issuers who may wish to protect certain competitively sensitive information as they may be required to publicly disclose such information in both their initial filings for the offering and in annual reports. A crowdfunding issuer must file with the SEC (and post on their websites) an annual report with financial statements within 120 days after the end of the company’s fiscal year.
The annual report must include the name, legal status, physical address and website of the issuer; the names of the directors and officers; the names of the beneficial owners of 20% or more of the issuer; a description of the business and the anticipated business plan; the current number of employees; a discussion of the material factors that make an investment in the issuer speculative; a description of the capital structure; a description of the material terms of any indebtedness of the issuer; a description of exempt offerings within the past three years; a description of certain material transactions; and whether the issuer has failed to comply with any ongoing reporting requirements. In addition, issuers will be required to file financial statements certified by the principal executive officer of the issuer.
The ongoing reporting requirements are not indefinite. In fact, the final rules provide that the reporting requirements will terminate upon any of the following events: the issuer becoming a reporting company required to file reports under certain sections of the Exchange Act of 1934 (Exchange Act); the issuer filing at least one annual report and having fewer than 300 holders of record; the issuer filing at least three annual reports and having assets valued at less than $10 million; the issuer or another party purchasing or repurchasing all of the securities issued pursuant to the crowdfunding offering; or the issuer liquidating or dissolving in accordance with state law.
3. Will companies be forced to go public after a crowdfunding offering?
Regulation Crowdfunding is intended to help facilitate capital formation among small businesses without subjecting them to the morass of regulations imposed on public companies. However, if an issuer’s assets exceed $25 million and the issuer has 500 or more unaccredited shareholders (or 2,000 or more total shareholders), the issuer will be granted a two-year transition period before it will be required to register its class of securities pursuant to Section 12(g) under the Exchange Act. A crowdfunding issuer entering the more extensive reporting obligations under the Exchange Act will be considered an “emerging growth company” to the extent that the issuer otherwise qualifies for such status. It is likely that some issuers will be discouraged from pursuing a crowdfunding offering as a result of this potential trap.
4. What are the costs associated with crowdfunding?
The total costs that issuers will incur in a crowdfunding campaign will depend upon a variety of factors. The three most significant costs will be with respect to the intermediary, accounting and financial preparation and legal compliance. With respect to the intermediary fee, the final rules permit intermediaries to have a financial interest in the issuer. In order to comply with the final rules, the intermediary must receive the financial interest from the issuer as compensation for the intermediary’s services which must consist of securities of the same class (on the same terms) as those being offered through the intermediary’s platform. Although this may be an attractive option for some startup companies with no disposable cash, issuers should be wary of this option as it may require them to offer up to 10-15% (or more) of the fundraising round as an up-front fee. In addition, the issuer’s accounting costs will vary depending upon how much the issuer is seeking in the offering. As discussed in more detail in our previous alert, issuers are generally grouped into three categories based upon the total amount of the offering, which will dictate the type of financial disclosure required. In contrast to the draft rules, not all issuers are required to provide audited financial statements, which will dramatically reduce the cost for some issuers.
5. Who can invest in a crowdfunding offering?
Anyone can invest in a crowdfunding offering. Prior to Regulation Crowdfunding, securities-based crowdfunding was available only to accredited investors who satisfied certain income and net worth requirements. Under the final rules, however, investors big and small can participate in crowdfunding offerings in furtherance of the JOBS Act’s objective of helping startups and small businesses amass capital from a multitude of low-dollar investors. Nevertheless, this investment freedom is not without limits. Over a 12-month period, the aggregate investment by any individual investor across all crowdfunding offerings is capped at (1) the greater of $2,000 or 5% of the lesser of the investor’s annual income or net worth 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, not to exceed a total investment of $100,000, if both annual income and net worth equal $100,000 or more.
6. Does an investor have a right to revoke an investment?
Investors may freely cancel their investment commitments for any reason up until 48 hours prior to the deadline set forth in the issuer’s offering materials. Once this time period has passed, however, an investment commitment can only be canceled in the event of a material change to either the offering terms or the information provided by the issuer. In such cases, the intermediary must provide notice of the change to the investor, and, subsequently, the investor’s commitment will be canceled unless the investor reconfirms the investment within five business days of receipt of the notice. If the investor fails to reconfirm within this five-day period, the intermediary must, within five business days thereafter, give the investor notice of cancellation, the reason for cancellation and the anticipated refund amount and must also arrange for the refund of the investor’s funds. If the material change occurs within five business days of the offering deadline, the offering must be extended to allow for a period of five business days for the investor to reconfirm such investment.
If an issuer reaches the target offering amount prior to the deadline stated in the offering materials, the issuer may close the offering early as long as certain requirements are met. Although issuers may have different reasons for closing the round early, the final rules require the following: (1) the offering remains open for at least a total of 21 days; (2) the intermediary provides notice to potential and actual investors of (i) the new anticipated deadline, (ii) the investors’ right to cancel their investment commitments for any reason until 48 hours prior to the new deadline and (iii) whether the issuer will continue accepting investments during that 48-hour period; (3) the new offering deadline is scheduled for and occurs at least five business days after such notice is provided; and (4) the issuer continues to meet or exceed the target amount at the time of the new deadline.
7. Can an investor sell the shares of the issuer after the funding round closes?
Securities purchased in a crowdfunding offering are restricted for a period of one year under the final rules. Therefore, investors are generally prohibited from selling shares for at least one year following the crowdfunding offering. The SEC believes that by restricting the transfer of securities, investors will have a defined period of time during which they can observe the performance of the business and potentially obtain more information about the success or failure of the business before trading occurs. Notably, the SEC provided some exceptions to the restriction period. An investor may transfer the offered securities within the first year to the issuer, to an accredited investor, as part of an offering registered with the SEC, to a family member, to certain trusts or in connection with the death or divorce of the investor. Importantly, the restriction period applies to any purchaser during the one-year period beginning when the securities were first issued.
8. What are funding portals and how are they compensated?
Under Regulation Crowdfunding, all crowdfunding transactions must be conducted through intermediaries – either registered broker-dealers or registered funding portals. A funding portal is any person acting as an intermediary, generally through an internet-based program or application, in a crowdfunding offering or sale of securities. Funding portals can receive compensation from issuers in exchange for the crowdfunding services they provide to issuers. As discussed above, this compensation may take the form of a financial interest in the issuer. Significantly, funding portals may not receive special or additional compensation for highlighting issuers or offerings available on their platforms. Issuers are required to disclose any financial interest held by intermediaries in the issuer or its transactions, including the amount of compensation to be paid to the intermediary and any other potential or actual interest held by the intermediary.
9. What type of due diligence is required by intermediaries?
Regulation Crowdfunding imposes a number of due diligence requirements on all intermediaries, including funding portals, conducting crowdfunding offerings. Before accepting any investment commitments, an intermediary must first have a reasonable basis for believing the investor satisfies the investment limitations. In order to make this determination, the intermediary may rely on the investor’s representations concerning compliance unless the intermediary has reason to question the reliability of such representations. The intermediary must also obtain from the investor assurances that the investor has reviewed the educational materials, understands that the entire investment may be lost and is in a financial position to bear such a loss. In addition, the intermediary must collect a questionnaire from the investor demonstrating the investor’s understanding of the restrictions on his or her ability to cancel an investment commitment and resell the securities offered on the platform, as well as the risks involved in investing in equity crowdfunding offerings.
With respect to issuers, intermediaries must make publicly available to the SEC and investors all information that issuers are required to provide under Regulation Crowdfunding. Intermediaries must provide this information on their platforms in a manner that reasonably permits any person to freely access and save or store it. This information must be available for at least 21 days before any securities are sold in the offering and until the offering is completed or canceled. This is important for parties to note in terms of the time period for which a crowdfunding offering must remain open. In furtherance of their role as gatekeepers, intermediaries must also undertake certain measures to reduce the risk of fraud under the final rules.
10. Will there be multiple intermediaries to choose from to list an offering?
While there are currently several equity crowdfunding platforms available in the marketplace, with more likely to emerge in the near future in light of the recent release of Regulation Crowdfunding, the final rules make clear that an issuer may only utilize one intermediary at a time to conduct an offering or concurrent offerings. The rationale behind this requirement is to help foster a “crowd” to fulfill the purposes of the JOBS Act. Moreover, limiting issuers to one platform at a time promotes community among potential investors who can meet virtually on the platform and share information through its communication channels. Another benefit of this restriction is that it helps ensure compliance by issuers and intermediaries with Regulation Crowdfunding, particularly its investment limit provisions.
For more information, please contact Lori Smith (212.714.3075; firstname.lastname@example.org), Ryan Udell (215.864.7152; email@example.com) or Michael Psathas (212-868-4833; firstname.lastname@example.org).
 The term “security” is defined as “any note, stock, treasury stock, security future, security-based swap, bond, debenture, evidence of indebtedness, certificate of interest or participation in any profit-sharing agreement, collateral-trust certificate, preorganization certificate or subscription, transferable share, investment contract, voting-trust certificate, certificate of deposit for a security, fractional undivided interest in oil, gas, or other mineral rights, any put, call, straddle, option, or privilege on any security, certificate of deposit, or group or index of securities (including any interest therein or based on the value thereof), or any put, call, straddle, option, or privilege entered into on a national securities exchange relating to foreign currency, or, in general, any interest or instrument commonly known as a ‘security,’ or any certificate of interest or participation in, temporary or interim certificate for, receipt for, guarantee of, or warrant or right to subscribe to or purchase, any of the foregoing.” 15 U.S.C. 77b(a)(1).