When President Obama signed the bipartisan Jumpstart Our Business Startups Act (the “JOBS Act”) on April 5th 2012, it generated a great deal of excitement in the entrepreneurial community and seemed to acknowledge that viable capital formation can emerge from the bottom up. For example, the proposed “Crowdfunding” regulations, implemented by the Securities and Exchange Commission (the “SEC”) on October 23, 2013, mirror the provisions of Title III of the JOBS Act, and establish guide lines for companies to raise limited investment seeking capital from “non-accredited” investors—everyday people earning less than $200,000 per year or with net worth less than one million dollars. These people represent approximately ninety-nine percent of the country.
Broadly speaking, “crowdfunding” is defined as the collective effort of individuals who network and pool their money together, usually via the internet and social media to support efforts initiated by other people or organizations. Because crowdfunding efforts require an outreach to the public—the “crowd”— who then have discretion regarding which efforts to support, it can be seen as a sort of “meritocracy” of financing.
Crowdfuding, in the larger sense, has been around for a long time. As is often referenced, the pedestal of the Statue of Liberty was financing by a Crowdfunding effort engineering by Joseph Pulitzer, through his newpaper, the New York World. Over 125,000 people contributed a total of over $100,000, primarily through numerous, small donations. Recently, Crowdfunding has been deployed largely to raise funds for relatively small artistic and technological ventures like music, films, gadgets and internet games. Notably, a group of young innovators raised over $10 million in just over a month to finance production of their “Pebble Watch.” To give you an idea of how vibrant this marketplace is, Kickstarter, the platform over which the Pebble Watch was promoted, raised an estimated $319million in 2012 and has now raised nearly $900million in its short existence.
What is new with the JOBS Act, is that the same process that has worked to sell smart watches and other gadgets on Kickstarter may now be deployed for equity. Let’s take a closer look at the Title III rules recently implemented by the SEC.
The SEC’s Proposed Title III Crowdfunding Rules
Generally speaking, investors will receive securities in exchange for their capital contributions. Title III, along with Regulation A of the 1933 Securities Act, is one of the few ways that non-accredited investors may participate in private securities offerings. However, due to governmental concern about the potential for abuse and economic misfortune, there are several major limitations to Title III.
First, Title III enables only relatively modest capital raises. Offering companies can raise only a maximum of $1 million in a 12 month period. However, it does not appear that an integration rule applies to Title III, which means that a company may utilize other exemptions to raise additional, subsequent or even concurrent capital through non-solicitation provisions, most likely pursuant to Regulation D.
Companies raising money through Title III Crowdfunding will also have to incur accounting costs, depending on the size of their respective offerings:
- Companies offering $100,000 or less need only provide tax returns for the most recently completed year and a financial statement certification by an executive officer suffice.
- Companies offering more than $100,000 but less than $500,000 must provide financial statements reviewed by independent accountant.
- Any offering above $500,000 requires audited financials.
Such audit requirements may be an impediment on small companies as associated costs could easily exceed $50,000 and can be arduous and time consuming.
Further dampening the desirability of Title III offerings is the fact that securities issued pursuant to Title III are subject to a 1-year restriction period.
Only U.S. private companies that are not subject to filing periodic reports with the SEC are allowed to rely on the Title III Crowdfunding regulations. As a result, foreign issuers, Investment Companies, including hedge funds, and issuers without a bona fide business plan are excluded from eligibililty.
Eligible companies must disclose certain key information with the SEC as follows:
- The legal name of the Business, address telephones, a website, a business summary and the contact information of the officer representative of the company;
- A statement that the company is conducting a Crowdfunding offering;
- The name of the broker-dealer or portal through which the offering will be made [note: Title III offering must be listed through a registered broker-deal or registered portal] and a link to such broker-dealer or portal where the company is permitted to conduct the offering;
- Terms of the offering including the name and nature of the securities, the price of the securities, the amount of the securities, and the closing date of the offering.
Title III Crowdfunding requires the filing of an offering statement on Form C and can only be furnished to the investor through a registered broker-dealer or an authorized Portal. Moreover, the issuers will have to disclose a broad scope of information to the SEC, such as all shareholders holding more than 20 percent of all shares outstanding in the company, the business plan, the financial conditions of the company, the use of proceeds, and all applicable risk factors.
In an effort to protect non-accredited investors from fraud and from themselves, the SEC proposes to implement the following investment limitations:
- Investors may not invest more than $2,000 or 5% of the investor’s annual income or net worth, whichever is greater, if both annual income and net-worth are less than $100,000; or
- 10% of the investor’s annual income or net worth, whichever is greater, if either the investor’s annual income or net worth is equal to or more than $100,000.
- During any 12-month period, no investor would be allowed to purchase more than $100,000 of securities through Title III Crowdfunding.
These provisions are supposed to limit the exposure of ostensibly vulnerable and relatively unsophisticated non-accredited investors. As a limited counterbalance, the SEC allows an unlimited number of non-accredited investors to partake in any Title III offering without requiring the offering company to become publicly reporting.
A key investor protection under Title III of the JOBS Act requires Crowdfunding transactions under its provisions to take place through a SEC-registered intermediary, either a broker-dealer or a funding portal. In addition, the proposed rules prohibit the use of multiple intermediaries to conduct the offering.
These new “Portals” must register with the SEC and must also become a member of a national securities association, such as FINRA. A non-broker portal will be also subject to registration with the SEC and will have specific compliance requirements. A funding portal will not be allowed to (i) provide investment advice, (ii) compensate employees or agent or anyone for solicitation or purchase of securities on its site, (iii) will not be allowed to solicit offers of securities on its site, (iv) may not manage or hold investment funds or securities for issuers and must use a third party to conduct such task.
The proposed rules specifically prohibit secondary market activity in the Title III securities sold through broker-dealers or Portals.
The practicability of Title III remains to be seen, especially because its rules and limitations seem to defeat the essence of “Crowd” initiated endeavors. If the spirit of the law was to allow non-accredited investors to participate in the investment marketplace, capitalism, and, in a larger sense, freedom, the rules, as written, impose substantial burdens on both investors and the small companies seeking them as investors. On one hand, the $1milllion ceiling is likely too low for all but the smallest start-ups and family businesses. On the other hand, the process, with the mandatory registered broker/portal and audit requirements is likely too cumbersome for those same companies to utilize effectively. Without further flexibility, Title III’s potential for “bottom-up” capital formation is limited. It may be that some other structure, perhaps Regulation A, will emerge as the best vehicle for companies to earn investment from the bulk of the American population. But that will be a story for another day.Companies seeking legal advice with regard to raising capital using crowdfunding under the provisions of Regulation D and Regulation A should contact the law firm of JSBarkats PLLC at firstname.lastname@example.org, (646) 502-7001 www.jsbarkats.com