This post will be the first post on the new concept of crowdfunding. Crowdfunding is billed as being a savior of small business and a boost to the power of the everyman entrepreneur by tapping into the power of the internet and the masses to provide funding for their businesses. This first post will give you the basics of what crowdfunding is and what restrictions the JOBS Act (the law which created it) places on it.
What is crowdfunding? Crowdfunding is essentially a pooling of capital from a group of people to an enterprise in order to support the actions of that enterprise. Colloquially it could be described as building a wall with a lot of tiny bricks. This will be done over the Internet. With this in mind, the type of crowdfunding that is permitted under the JOBS Act must be distinguished from the type of crowdfunding that has been going on for a few years now.
Before the JOBS Act, there were places, mainly websites, that people could go to and provide funding to an entrepreneur for their particular project. Kickstarter is one of the crowdfunding websites that has been around since 2008. Kickstarter focuses on providing funds for creative projects such as video games, comics, gadgets and films. How it works is the investor pledges an amount of money to the project during a funding time window. When this window is closed the amounted pledged is tallied and then measured against the funding goal that was set as an estimate of the funds that would be required to do the particular project. Stu’s Kitchen, for example, has a goal of moving into open space that will allow them to produce more Bloody Mary mix and not have to rely on the charity of community kitchens and friends. They have a goal of $20,000 and, as of 18 days from the end of the funding period, they have received pledges of $3,511. If they don’t meet their funding goal then they don’t receive any funding from their offer on Kickstarter. If, however, they do meet their funding goal then they will receive the funds that are pledged to them by the donors.
A question naturally arises as to what the pay off is for investing in a project on Kickstarter. The answer is that it varies. If you help fund “Stu’s Bloody Mary Mix!” by pledging $25 then you will receive 2 bottles of the mix, shipped for free to your house. If you pledge $500 and you live in their locale, they will do a Bloody Mary bar for you and 20 of your friends, providing all of the alcohol and glassware.
What if, for instance, you wanted actual stock in the company that was making Stu’s Bloody Mary Mix!? Could Stu’s Kitchen give you stock in their company for a pledge of cash? This would constitute the sale of a security. As a general rule, all public securities offerings must be registered with the SEC in accordance with The Securities Act of 1933 and The Securities Exchange Act of 1934. This registration is extremely time-consuming and costly, likely not within the budget of Stu’s Kitchen.
Even in pre-JOBS Act securities law; there was still a way to become exempt from the registration requirements, however. The way to become exempt was to have a Section 4(2) (of The Securities Act of 1933) offering. This exempts a transaction from the registration requirements of Section 5 of the act to “transactions by an issuer not involving any public offering.” To be a public offering, it does not have to be offered to everyone in the world, it just has to be offered in such a way that a lot of people who don’t know what they are doing are at risk of losing their savings. To avoid being a public offering, one would need an exemption to make a private offering. A private offering exemption is available only where protection of the Act is not needed, for example, making an offer solely to institutional investors. This still leaves a lot to be clarified as to what constitutes a private offering (or private placement). To clarify, the SEC provided Rules 504, 505 and 506 of Regulation D under the Securities Act of 1933.
Rule 504 allows exemption to Section 5 if “the aggregate offering price for an offering of securities… shall not exceed $1,000,000, less the aggregate offering price for all securities sold within the twelve months before the start of and during the offering of securities under this Rule…” Rule 504 does not allow companies to solicit or advertise to the public with regards to their offerings. Generally, the securities received in the transaction would also be considered to be “restricted” securities meaning that the purchaser may not resell them to the public unless the sale is exempt from SEC registration requirements. A company could offer unrestricted securities if either the company’s offer is registered in at least one state that requires a registration statement that is publically filed as well as requires a substantial disclosure document to investors, the company’s offer is registered in a state that that requires the registration and the disclosure document and sells in a state that does not have those requirements so long as the disclosure documents are given to all purchasers, or the company only sells according to state law exemptions that allow solicitation and advertising so long as all of the purchasers are “accredited investors”. Accredited investors are described in Rule 501 of Regulation D. The requirement for a person to be considered to be an accredited investor is that the person must have a personal or joint (with spouse) net worth of over $1 million or they must have an individual income over $200,000 or joint income (with spouse) of over $300,000 in each of the two most recent years and expect that same level of income in the year of the sale. Accredited investors also include directors, executives or general partners of the issuer. Other elements of Rule 504 include no limit to the number of purchasers and there is integration with other offerings within 6 months prior and after the offering and certain types of companies are excluded. Rule 504 does not preempt the state “blue sky” laws however, so the requirements under states where the offering is registered must still be met.
Rule 505 has a higher offering ceiling than Rule 504, with the maximum sales able to reach $5 million. There is a limit on the number of non-accredited purchasers, however, and that limit is 35. There is no limitation on the number of accredited investors that may purchase the securities. Rule 505 has a resale limitation that prohibits the resale of the securities for two years without registering them. The purchasers must also be informed that they are purchasing restricted stock. General solicitation as well as advertising is prohibited under all circumstances. Companies can give accredited investors as much or as little information as they would like but they must provide non-accredited investors with disclosure documents that are akin to those that would be produced had the offering been registered. Any information that is given to accredited investors must also be given to non-accredited investors. Financial statement information that is required under Rule 505 varies dependent on offering size. Rule 505 transactions are also subject to any relevant state “blue sky” laws.
Rule 506 has been the favored exemption status for securities offerings for companies recently. Under Rule 506 there is no limit on the amount that can be offered, so companies can well exceed the $5 million offering limit of Rule 505. The companies are still prohibited from general solicitation and advertising, however. A company may sell to 35 non-accredited investors and an unlimited amount of accredited investors. Unlike Rule 505, the non-accredited investors must be sophisticated. Rule 506 exempted offerings are exempt from state “blue sky” registration unlike Rules 505 and 504. This lack of required reporting to the states makes Rule 506 transactions attractive. Like Rule 505, companies must provide non-accredited investors with disclosure documents that are akin to those that would be produced had the offering been registered and any information that is given to accredited investors must also be given to non-accredited investors and they have the same requirements with regard to financial statements. Rule 506 has the same resale limitation as Rule 505.
Title III of the JOBS Act or the CROWDFUND Act sets out the parameters for the new crowdfunding exemption. The first requirements that are set out are those with regards to how much can be sold in aggregate and how much can be sold to each person. In a crowdfunding offering, the total offering cannot exceed $1 million just as in Rule 504. Also, for investors with annual incomes or a net worth of less than $100,000, they may not purchase more than the greater of $2,000 or 5% of their annual income or net worth, whichever is greater. If the investor has an annual income or a net worth of more than $100,000 then the limit of investment is 10% of their annual income or net worth. Crowdfunding will also exempt companies from the individual state “blue sky” laws. This will prevent the states from imposing their own additional regulations on the crowdfunding offerings.
All of these transactions must go through an intermediary that has registered with the SEC as either a broker or a funding portal. There is a good deal of responsibility that is placed on these intermediaries for transactions such as these. They must ensure that investors review education material and generally understand the risks that are associated with their investment. The SEC has set out measures that these intermediaries must follow in order to reduce the risk of fraud and worked with FINRA to develop the rules and register the funding portals. (As of this post, the rules have been proposed, the comments have been taken and the SEC is finalizing them.)
Brokers are a familiar term in the current environment of securities transactions, however funding portals are a little different. Funding portals won’t have to register as a broker or dealer under Section 15(a)(1) of the 1934 Act. Funding portals must remain subject to the authority of the SEC, however. This means that they must still commit to following the rules set out by the SEC and be subject to any examination that the SEC requires. Funding portals must also be a member of one of the national securities associations that are registered under section 15A.
Just like the scheme that is provided under Kickstarter, the CROWDFUND Act requires that the company meet their funding goal in order for any of the related transactions to go through. This is to be ensured by the intermediary. In addition, there are also advertisement restrictions. Issuers can’t advertise the terms of the offering. All that they may do is to direct potential investors to the funding portal or the broker. Issuers also cannot compensate anyone to promote the offerings through the broker or funding portal without complying with a yet to be determined procedure to be laid out by the SEC in order “to ensure that such person clearly discloses the receipt, past or prospective, of such compensation, upon each instance of such promotional communication…” Issuers must also make at least annual filings with the SEC and provide investors reports of the results of operations and financial statements of the issuer. On top of all of these requirements, the SEC provided further restrictions and regulations regarding these offers.
That is all for the basics of crowdfunding but there are still other questions. Why would companies use this method of funding over the normal method of angel investing or venture capital? Is there a risk of fraud? Should you invest in a company through crowdfunding? How will the SEC rules modify the parameters set out in the JOBS Act? What impact will this have on the small business funding landscape? These questions will all be answered in later posts.