On October 23, 2013, the SEC proposed rules governing the offer and sale of securities through "crowdfunding." If adopted, these rules would allow issuers to raise capital by selling small amounts of equity to a large number of investors via regulated Internet crowdfunding platforms.
This is the first of a two-part client update series discussing the proposed crowdfunding rules. Part I will focus on the application of the proposed rules to companies contemplating a capital raise, and Part II will address the proposed rules governing regulated crowdfunding platforms.
- Most private U.S. companies will be permitted to raise up to $1,000,000 in a 12-month period from a large number of small investors through a crowdfunding platform.
- Issuers will have substantial disclosure obligations, and must make several filings with the SEC during and after the raise.I
- nvestors will be limited in the amounts they can invest each year through crowdfunding, depending on the investor's income and net worth.
- Final rules are not expected to be adopted until sometime in 2014.
New type of offering exempt from registration
As proposed, the new "crowdfunding exemption" would allow companies to sell securities without needing to register formally with either the SEC or state securities regulators. Companies could raise up to $1,000,000 during any 12-month period in reliance on this particular exemption. If a company conducts a separate capital raise relying on a different exemption, such as through a traditional private placement, the rules do not require the company to aggregate the amounts raised. This means that there are ways for companies to potentially raise more than $1,000,000, although not through crowdfunding alone.
Who can crowdfund?
In order to take advantage of the new rules, the company proposing to issue securities cannot be:
- An investment company
- A blank check company
- A "bad actor" that is disqualified from participating in the crowdfunding offering due to certain securities law or fraud-related violations.
The bad actor disqualification rules are similar to those barring participation in certain private placements. For more information about bad actors, read our discussion of the bad actor rules in Rule 506 private placements here.
What will entrepreneurs need to do?
Provide basic information to investors. In the interest of protecting investors, the SEC has proposed extensive issuer disclosure requirements, to be provided to investors through an online crowdfunding platform at least 21 days before the offering starts. Among other disclosures, companies must provide prospective investors with an offering statement that contains information about the following:
- Officers, directors and shareholders. A company must disclose the identity and business experience of its directors and officers, as well as the identity of its 20% or greater shareholders.
- Business information. Companies need to describe their business, which may involve providing investors with a copy of the company's business plan. Also, companies need to provide investors with information about the risk factors that make the investment speculative; related-party transactions between the company and directors, officers, family members, or others; and information about any other exempt offerings that the issuer conducted within the past three years.
- Use of funds. Issuers must provide detail about their intended use of proceeds from the raise.
- Financial information. Issuers must provide certain financial information to investors, based on the size of the proposed offering:
$100,000 or less: Companies must provide income tax returns for the most recently completed fiscal year (if any), and financial statements certified by the issuer's principal executive officer.
More than $100,000, up to $500,000: Companies must provide financial statements reviewed by an independent public accountant, as well as the accountant's review report.
More than $500,000: Companies must provide independently audited financial statements.
Companies must also disclose any outstanding debt and all material terms of the debt, including the amount, the maturity and the interest rate, and discuss their financial condition of proposed financial milestones.
- Offering information. Information about the number, type and price of securities offered, the target rasie and the deadline for reaching the target, as well as a maximum amount, if any, that companies will accept if the offering is oversubscribed. Companies must also inform investors how to cancel commitments, and that commitments may be cancelled until 48 hours before the company's deadline.
Limit advertising. The crowdfunding rules are completely separate from the rules that allow general solicitation or advertising for certain types of private placements. For information about general solicitation, click here. Although many commenters have encouraged the SEC to allow crowdfunding issuers to advertise, the SEC has explicitly refused to do so. Instead, issuers seeking to crowdfund can engage in "tombstone" advertising and tell potential investors that they are conducting an offering; provide information about the identity of the issuer, the amount of the raise, and the type of securities offered; and direct investors to the crowdfunding platform where the issuer's securities are listed.
File with the SEC. Even though crowdfunding offerings are exempt from registration with the SEC, there is still a disclosure filing requirement. Companies would be required to file a "Form C," a new type of form specifically for crowdfunded offerings, at the following times:
- Before the offering starts.
- During an offering, when anything material about the offering or the company changes.
- When they are required to update the SEC about progress toward a funding goal.
- Annually, within 120 days of the end of a fiscal year, with the company's annual report attached.
- After the company no longer has Form C filing obligations (an exit filing), which will usually occur either when the company is acquired, becomes public, or dissolves.
File annually. Companies would need to file an annual report on EDGAR, the SEC's filing system, within 120 days of the end of the most recent fiscal year covered by the report, and would also need to post the annual report on the company's website. The annual report would contain essentially the same information as a company's first offering statement to investors, which is described above.
File with states? Because crowdfunding is a new type of offering, it is not yet clear whether, and in what circumstances, companies will need to make notice filings at the state level.
Be prepared for cancellations. If the minimum target amount is not met, the company will not be able to keep any investor funds. If there is a material change to the offering, investors will have to reconfirm their investments, or the proposed investment will be cancelled and the funds returned. These requirements could create uncertainty for companies, especially considering that there may be expenses incurred preparing the disclosures, paying crowdfunding platform fees, and possibly paying accounting and legal fees.
Don't jump the gun. Keep in mind that these rules are only proposed. No one can crowdfund in reliance on the proposed rules until they are finalized sometime in 2014.
How much will investors be able to invest?
Anyone will be permitted to invest in a crowdfunding offering regardless of whether they satisfy accredited investor standards. However, in any 12-month period an investor may invest in the aggregate in all crowdfunding offerings in which the investor is interested only up to a certain maximum amount, depending on that investor's income and net worth, counted together with a spouse. If an investor's annual income or net worth is:
- Less than $100,000, the investor can invest a maximum of:
- $2,000, or
- 5% of the investor's annual income or net worth, whichever is greater.
- $100,000 or more, the investor can invest:
- up to 10% of the investor's annual income or net worth, but
- with a maximum investment ceiling of $100,000, regardless of income and net worth.
Note that an investor cannot transfer securities purchased through crowdfunding for one year, with some limited exceptions, making the investment relatively illiquid.
Implications and Interpretations
- We anticipate that most, if not all, issuers will need professional help navigating the proposed crowdfunding requirements. Because of this, and because of all of the disclosure, accounting and filing requirements applicable to a company wishing to engage in crowdfunding, companies will need to manage costs carefully. As a result, issuers should carefully consider whether there are other, more cost-effective options, such as traditional private placements, angel funding, accredited investor platforms or, for some companies, pre-selling products or services through rewards-based platforms.
- For some companies, the exposure, publicity and excitement generated by a crowdfunding raise may provide more benefit than the money from the raise. These advantages to crowdfunding, although difficult to quantify, may be significant in some instances, especially for companies with a simple story or attractive consumer products.
- By accepting a large number of small investors, even a successful company financed through crowdfunding may find it difficult to attract second round venture or other institutional investors, which have traditionally resisted dealing with hundreds of small shareholders.
- All crowdfunding offerings must take place through a registered crowdfunding platform. The SEC has also proposed rules regulating these platforms. As proposed, those rules may discourage potential platforms from registering. For a discussion of the proposed rules related to crowdfunding platforms, please see Part II of this Client Update on the proposed crowdfunding rules.
- Issuers should be wary of potential liability for rescission – where an investor has the right to return the securities, demand a refund of the purchase price – if there were material misstatements or omissions in connection with the offering.
- Investors who successfully invest in small companies often rely on diversification, and invest in many companies simultaneously to minimize the risk associated with any single company. Because of the limitations on the amounts that individuals can contribute to crowdfunding, it seems as though most investors will not be able to achieve this sort of portfolio diversification.
The full text of the SEC release proposing the new crowdfunding rules is available here. We expect that the SEC will receive many comments on the proposed rules. Comments are due on or before February 3, 2014, and can be submitted to the SEC here.