When we last wrote on the new rules permitting equity crowdfunding, the comment period had recently closed. To date, however, there is no sign of when the final rules will be issued or what changes (if any) will be made from the proposed rules. Additionally, a recent event has made investors even more eager for the final crowdfunding rules to be implemented. On March 25, 2014, Facebook Inc. agreed to acquire Oculus VR Inc., the maker of a virtual-reality headset, for $2 billion in cash and stock.[1] Oculus was founded in 2012 and used Kickstarter to fund its first round of investment, raising over $2.4 million. Because Kickstarter is not an “equity crowdfunding” platform, those first “investors” in Oculus did not receive a single cent of the $2 billion purchase price paid by Facebook.[2]
This is the type of situation the crowdfunding rules were designed to address. As will be described, though, the proposed rules would not have allowed Oculus to raise the amount it did, and likely would be deficient for the fundraising needs of many other companies. Because of this problem, among other shortcomings, members of Congress have proposed legislation to remedy the situation.
One of the biggest criticisms of the proposed crowdfunding rules has been the high cost of completing an issuance. The SEC performed a cost/benefit analysis detailing the estimated costs of raising money via crowdfunding under the proposed rules. The SEC considered three cost elements involved with crowdfunding issuances: (1) the success fee (the amount paid to intermediaries for facilitating the transaction); (2) the compliance costs (related to the preparation and filing of forms both before and after the fundraising transaction); and (3) the cost of a Certified Public Accountant review or audit.
According to a summary of the SEC’s cost/benefit analysis, it is estimated that issuances under $100,000.00 will consume on the low-end 12.9% of the money raised; for issuances over $100,000.00 but less than $500,000.00, the low-end cost could drop to 7.96%; and for issuances from $500,000.00 to $1 million, the low-end cost could drop to 7.66%.[3] (For reference, the SEC estimated the average sales commission for Regulation D offerings of up to $1 million to be 6.5%.)[4]
Because of the high potential cost of crowdfunding issuances and the relatively low $1 million cap, among other issues, members of Congress have proposed legislation to address the proposed regulations’ shortcomings. The bill, entitled the Equity Crowdfunding Improvement Act of 2014 (H.R. 4564), was proposed on May 6, 2014.[5] The bill repeals and replaces the problematic provisions of Title III of the JOBS Act as currently enacted. There are five significant changes proposed by the bill:
First, corporations would be allowed to raise significantly more capital under the crowdfunding exemption. (Note: the bill expressly limits its availability to entities organized as corporations at the time the securities are issued.)
- Under the proposed rules, there are three issuance tiers under the crowdfunding exemption with corresponding issuer obligations: first, for issuances of up to $100,000.00, tax returns and unaudited financial statements of the issuer must be filed with the SEC; second, for issuances of $100,000.00 to $500,000.00, an independent accountant must review the issuer’s financial statements; and third, for issuances of $500,000.00 to $1 million, the issuer’s financial statements must be audited.
- The bill expands the first tier to cover issuances up to $500,000.00; the second tier would cover issuances of $500,000.00 to $3 million; while the third tier would cover issuances of $3 million to $5 million.
This change would allow corporations to raise more capital while spreading the costs of an issuance over a larger amount of capital. Under the proposed rules, Oculus would not have been able to raise the full $2.4 million it received on Kickstarter, whereas the bill would have both allowed Oculus to raise that amount and do so without requiring audited financial statements.
Second, the bill eliminates a number of the filing burdens placed on issuers both before and after an offering. In particular, issuers will no longer be required to describe their current financial condition and the intended use of the offering proceeds before the offering, or be required to issue ongoing annual reports on the results of the issuer’s operations after the offering.
Third, individuals would be allowed to invest more money in corporations through the crowdfunding exemption.
- Under the proposed rules, the maximum amount individuals can invest through the crowdfunding exemption is the greater of $2,000 or 5% of such individual’s annual income in one year, if both annual income and net worth are below $100,000.00; or if either annual income or net worth are above $100,000.00, then the maximum becomes the greater of 10% of net worth or annual income, with a cap of $100,000.00.
- The bill raises the maximum amount individuals can invest is raised to the simple formula of the greater of $5,000 (adjusted for inflation annually), or 10% of the investor’s annual income or net worth.
Fourth, the bill eliminates a number of burdens placed on the intermediaries between issuers and investors. (As an initial matter all references to “funding portals” have been removed and replaced with simply “intermediary,” yet most of the requirements remain the same with a few exceptions detailed here.) Intermediaries would no longer be required to provide Investor Education Materials, or require investors to positively affirm that they understand they can lose their entire investment. Additionally, intermediaries would be allowed to “curate” issuer offerings. Under the proposed regulations, any attempt by a Funding Portal to be selective as to which issuers can use its services (even attempts to screen out questionable issuers) is considered by the regulations as offering “investment advice” and, as a consequence, is prohibited. The proposed bill would allow curation of offerings by excluding an intermediary’s curation of issuer offerings from the definition of “investment advice.”
Fifth, the bill would exclude crowdfunding investors from being counted as shareholders of record for the purposes of the shareholder cap under the Securities Exchange Act of 1934. This change prevents crowdfunding issuers from triggering some of the reporting obligations imposed on companies if they have more than a certain number of investors.
While the bill addresses many of the criticisms leveled at the proposed rules, it is unclear what chance of success it has of being enacted. As for the proposed rules, while it is unknown when they will become finalized or what changes (if any) will be made to them, it is expected that the final rules will be similar to the proposed rules—with all of its shortcomings. Until the rules are finalized, issuers can continue to use the traditional methods of fundraising as well as other recently altered exemptions (specifically Regulation D and Regulation A+ offerings, respectively).
[1] http://online.wsj.com/news/articles/SB10001424052702303949704579461812019189626
[2] http://blogs.wsj.com/digits/2014/03/25/aug-1-2012-when-oculus-asked-for-donations/
[3] http://venturebeat.com/2014/01/02/it-might-cost-you-39k-to-crowdfund-100k-under-the-secs-new-rules/
[4] http://www.sec.gov/rules/proposed/2013/33-9470.pdf FN 828
[5] https://www.govtrack.us/congress/bills/113/hr4564/text
