On October 30, 2015, the Securities and Exchange Commission (SEC) adopted the final rules implementing Title III of the Jumpstart Our Business Startups Act (JOBS Act), known as “crowdfunding.” These rules take effect on May 16, 2016. As that deadline approaches, companies, investors and intermediaries seeking to take advantage of these rules must prepare themselves to assure full compliance.
The new rules are designed to help small companies raise capital and allow non-accredited investors to participate in venture capitalism—something historically left only to accredited investors. Because investors participating in crowdfunding are expected to have a lower level of financial sophistication, the rules provide safeguards through certain limitations on companies, investors and intermediaries. In short, the rules broadly do the following:
- Cap the amount of money an issuer can raise through crowdfunding in a year
- Limit the amount investors can contribute to crowdfunding in a year
- Impose specific and general disclosure requirements on issuers
- Create a regulatory framework for the broker-dealers and funding portals that facilitate crowdfunding
The final crowdfunding rules are mostly in-line with the rules proposed by the SEC last year. However, below are some notable differences between the proposed and final rules.
- Exception for Audited Statements. First-time issuers may elect a one-time exception to the requirement that they provide audited financial statements for an offering greater than $500,000. Instead, the rules allow the issuer to submit statements reviewed by an independent public accountant. Presumably, this exception will help small companies seeking only an initial investment of capital by reducing up-front transaction costs.
- Exception to Annual Reporting Obligation. An issuer need not comply with the annual reporting requirements if either (1) the issuer has filed at least one annual report and it has fewer than 300 holders of record, or (2) the issuer has filed annual reports for at least the three most recent years and it has total assets of $10 million or less. Again, these exceptions help reduce some of the administrative costs of crowdfunding.
- Intermediary Compensation. Issuers may pay intermediaries in stock, instead of cash. They may report compensation paid as either a dollar value or percentage of the offering amount and may use a good faith estimate if the parties are unable to identify an exact amount at the time of filing the offering statement on Form C.
- Intermediary Selectivity. Intermediaries may use their discretion in determining whether to let an issuer use their platforms. This should allow intermediaries to better screen issuers and create more targeted crowdfunding platforms.
- Disclosure Obligations. Issuers must disclose any material information necessary in order to make the statements made not misleading. This modification places an affirmative obligation on issuers to correct any statements that were or became misleading after they were made.
- Tax Return Disclosure. Issuers need not provide copies of their federal income tax returns when conducting offerings of $100,000 or less. Instead, they need only provide the issuer’s amount of total income, taxable income and total tax as set forth in its filed tax returns with the principal executive officer’s certification.
The remainder of this post summarizes the crowdfunding framework, including the relevant changes to the final rules, so that investors, intermediaries and start-up companies can prepare for the new crowdfunding rules to take effect in May.
I. RULES PERTAINING TO ISSUERS
All companies other than those listed below are eligible to use Regulation Crowdfunding.
- Non-U.S. companies
- Publicly traded companies
- Blank check companies and special purchase acquisition companies
- Certain investment companies
- Companies disqualified by the Regulation Crowdfunding provisions (e.g. bad actors)
- Companies that have failed to file their annual report required by Regulation Crowdfunding for the past two years
Annual Limit on Capital Raised
One of the biggest limitations imposed by the rules on crowdfunding is the limit on capital raised each year. Specifically, issuers may raise a maximum aggregate amount of $1 million through crowdfunding offerings on a 12-month rolling basis. Other non-crowdfunding capital raising options do not count toward this limit. The offering cap includes offering expenses and intermediary fees. Some critics argue that this limit is too low for the cost and time companies will have to spend working out the limitations.
Issuer Disclosure Statements
- Initial Offering Statement. Issuers must comply with various disclosure requirements and file certain information with the SEC in connection with a crowdfunding offering, including an offering statement on Form C. Generally, an issuer must disclose information about company management, financial structure and condition, an assessment of the specific and general risks of the investment, and a reasonably detailed description of the offering including (1) the purpose and intended use of the proceeds of the offering, (2) the price of the securities to the public or the method for determining the price, (3) the target offering amount, (4) whether the target amount may grow, (5) the deadline to reach the target amount, and (6) updates on efforts to reach the target amount at specified benchmarks.
Issuers must also provide financial statements prepared in accordance with U.S. GAAP for the issuer’s two most recent fiscal years. Based on the proposed amount of the offering, issuers may elect varying levels of review. If the issuer seeks to raise $100,000 or less, the issuer’s principal executive officer may certify the statements to be true and complete in all material respects. If the issuer seeks to raise more than $100,000 but not in excess of $500,000, an independent public accountant must review the statements. If the issuer seeks to raise more than $500,000, an independent public accountant must audit the statements, except that first-time issuers may instead provide reviewed financial statements.
- Annual Reporting Requirements. Issuers must provide an annual report containing financial statements certified true and complete in all material respects by the issuer’s principal executive officer and any other information similar to what the issuer included in its offering statement on Form C.
Companies must continue to issue annual statements until the company (1) liquidates or dissolves, (2) goes public, (3) no longer has any shareholders who originally purchased securities in their crowdfunding offering, (4) files at least three annual reports and has total assets that do not exceed $10 million, or (5) files at least one annual report and has fewer than 300 holders of record.
- Material Information Requirement. In addition to the specifically enumerated disclosure requirements, the rules require disclosure of any material information necessary to make any statements made, in light of the circumstances under which they were made, not misleading. In other words, companies must correct any statements that become misleading due to a later development in the business.
II. RULES PERTAINING TO INVESTORS
Limitations on Amount Contributed by Investors
The SEC distinguishes between accredited and non-accredited investors, defining the former as one whose net worth is greater than $1 million (excluding a primary residence) or whose annual income in each of the two most recent years is greater than $200,000 ($300,000 for married couples). Accredited investors are not restricted as to how much they can invest in start-ups. In contrast, Regulation Crowdfunding allows non-accredited investors to contribute lesser amounts to crowdfunded start-ups based on their income and net worth. The rules subdivide non-accredited investors into two categories: (1) investors with a net worth or annual income less than $100,000, and (2) investors with a net worth and annual income greater than $100,000.
- Investors with Annual Income or Net Worth Below $100,000. Investors who fall into the first non-accredited category are limited in the amount they can invest annually through crowdfunding by the greater of $2,000 or 5% of the lesser of their annual income or net worth.
- Investors with Annual Income and Net Worth Above $100,000. Investors who fall into the second non-accredited category are limited in the amount they can invest annually through crowdfunding only to the extent that the investment does not exceed 10% of the lesser of their annual income or net worth up to $100,000.
Investors who purchase securities in a crowdfunding offering may not resell those securities within one year of their initial issuance other than to (1) an accredited investor, (2) third parties in a registered offering, (3) an investor’s family member, or (4) the issuer.
III. RULES PERTAINING TO INTERMEDIARIES
Issuers must conduct every crowdfunding offering through an intermediary, also known as a “platform.” These platforms must register as either broker-dealers or funding portals. Companies must conduct each crowdfunding offering through a single intermediary. While platforms may accept issuers’ securities as compensation for services, the directors and officers of an intermediary may not hold any securities of an issuer on their portal.
Due Diligence Requirements
Intermediaries are responsible for a certain amount of due diligence on their part. First, they must run background checks on an issuer’s officers, directors and 20% beneficial holders. They must deny access to their platform for any issuer they reasonably believe is subject to any of the bad actor disqualification provisions of Regulation Crowdfunding. Second, they need a reasonable basis for believing that issuers complied with all requirements of Regulation Crowdfunding and employ accurate methods for record keeping. Finally, they must have a reasonable basis for believing investors on their portals satisfy the investment limits established by Regulation Crowdfunding. Intermediaries may reasonably rely on the representations of issuers and investors, unless they have any reason to question the reliability of those representations.
IV. LIABILITY CONSIDERATIONS
Both issuers and intermediaries will likely have liability for materially misleading statements and omissions in an issuer’s offering statement. Not surprisingly, an issuer of crowdfunded securities is liable to a purchaser if the issuer makes an untrue statement of a material fact or omits to state a material fact. The SEC specifically declined to exempt intermediaries from liability, noting that it will likely consider intermediaries an “issuer” in this context. Intermediaries will likely bake this cost of liability uncertainty into the transaction fee, which may further negate some of the monetary benefits of crowdfunding.
 A company cannot crowdfund a fund to invest in other crowdfunded opportunities. Each offering must include a business plan for which the underlying purpose must be a bonafide business and not an investment vehicle.