Published in the November issue of Business NH Magazine.
If you have ever thought about selling stock to raise funds for your small or midsize business, then you know that the federal and state securities laws, and the costs of complying with them, can significantly reduce the utility of raising funds through an issuance of equity. The Jumpstart Our Business Startups Act (the “JOBS Act”) sought to change that by providing a number of modifications to the federal securities laws that were designed to liberalize the access of small and midsized businesses 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 became effective 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 general 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 investment dollars by allowing them to publically advertise their offerings to wealthy investors, a significant change from the current regime in which companies can advertise their offerings publically 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 4th, but instead issued a proposed rule for public comment on August 29th. The SEC will decide whether to adopt the proposed rule within 30 days of its issuance and a decision is expected this month.
The delay in 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 related to how crowdfunding will operate. That deadline expires on December 31, 2012.
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 on crowdfunding other than to remind businesses that the crowdfunding exemption is not yet effective. While the prospect of crowdfunding has captured the imagination of many, the implementing rules will largely control whether the crowdfunding exemption actually liberalizes access to capital markets for small businesses as it proponents touted.
Keeping in mind that the crowdfunding exemption is not yet effective, and that its effective date, and implementing rules are uncertain, it is nonetheless worthwhile to consider the context and contours of this significant legislation.
Tapping the Crowd
“Crowdfunding” is essentially the process of raising small amounts of money from a dispersed group of individuals (the “Crowd”) 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 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 midsized businesses.
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 that 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 and Crowd vetting occurs in open dialogues on internet platforms. These websites 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 seeking to raise funds, the Crowd identifies fraud more effectively than a regulator working in isolation.
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 $1,000,000 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 the greater of $2,000 or 5% 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 is 10% of the annual income or net worth of the investor, not to exceed a maximum investment of $100,000.
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 involving the offer or sale of securities for the account of others.
In addition to providing disclosure related to the investment, the portal must confirm the investor’s comprehension of the extent of the risk he 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.
The crowdfunding exemption preempts the authority of state securities regulators to require registration of securities offered pursuant to the exemption or to establish offering requirements (other than state notice filings). The exemption does not, however, 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 Required
As stated above, the exact mechanics of the crowdfunding exemption are still undefined. The SEC has the next 3 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.
Other Key JOBS Act Provisions
In addition to the crowdfunding exemption, the JOBS Act eases other impediments to capital formation, the highlights of which are as follows:
•Providing temporary regulatory relief to a new category of what are called “emerging growth companies” so that those small companies can go public more easily.
• Enabling private companies to use public solicitation of investors in connection with certain private securities offerings.
•Raising the limit from $5 million to $50 million of unrestricted debt, equity or convertible debt securities companies are permitted to publically offer and sell in any 12-month period without registration under Regulation A.
•Increasing the number of record shareholders that can invest in a private company before it must register under the Exchange Act from 500 to 2,000.
Once the SEC issues its implementing 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, licensed to practice in New Hampshire and Massachusetts. He can be reached at [email protected] or (603)628-1402. The McLane Law Firm is the largest full-service law firm in the state of New Hampshire, with offices in Concord, Manchester and Portsmouth as well as Woburn, Massachusetts.