Raising money from a large number of people to finance an entrepreneur's business, now popularly known as crowdfunding, has been around for centuries. Markets and regulators fluctuate between helping to facilitate crowdfunding when capital markets are tight and regulating it after bubbles and frauds. The Securities Act of 1933 and the Securities Exchange Act of 1934 were a response to the capital markets excesses of the 1920s.
On April 5, 2012, the JOBS Act was signed into law to amend the current regulatory scheme to make it easier for early stage companies to raise capital from the public. Title III of the JOBS Act is known as the CROWDFUND Act and is intended to enable entrepreneurs to raise money by selling securities to non-accredited, non-sophisticated investors through funding portals on the internet.
Modern crowdfunding can be traced from Jonathan Swift's Irish Loan Fund of the 1700s, through micro financing in the mid-1970s, to Kiva, the first micro lending website that begat the proliferation of crowdfunding websites in the last few years.
The more popular crowdfunding websites have been used to fund films, music, fashion, journalism, charity, gaming and some small businesses. Generally, the current U.S. securities regulatory framework does not allow crowdfunding companies to sell securities to nonaccredited investors as consideration for their "contribution," and prior to full implementation of the JOBS Act, companies cannot sell securities to accredited investors through a general solicitation to the public. Consequently, entrepreneurs raising money through crowdfunding have been giving contributors items or experiences as consideration for their "contribution."
Prior to the JOBS Act becoming effective, U.S. securities laws generally require that an offering of securities to investors must either be registered with the SEC or qualify for an exemption from registration under those laws and/or their rules. Start-up companies are not suitable for a registered, public offering since they do not have the financial record of accomplishment or sufficiently matured technology or products that can generate revenues that the capital markets require. Furthermore, they generally do not have the resources necessary to comply with the regulatory requirements to register their securities with the SEC. Therefore, early stage companies typically try to raise money through private transactions that qualify for an exemption from registration with the SEC.
The most popular of those exempt transactions is a sale of securities to accredited investors under the safe harbour of Rule 506 of Regulation D. An issuer selling securities under Rule 506 is prohibited from advertising or generally soliciting the offer. Issuers under Rule 506 can raise an unlimited amount of money from investors, however, there can be no more than 35 non accredited investors, and all non-accredited investors must either be sophisticated investors capable of evaluating the merits and risks of the proposed investment or have a representative who is sophisticated. Aside from certain types of entities, an accredited investor is an individual that has income in excess of $200,000 in each of the two most recent years or joint income with a spouse in excess of $300,000 in each of those years and has a reasonable expectation of reaching the same income level in the current year or has individual or a joint net worth with a spouse in excess of $1 million excluding a primary residence. Issuers can decide what information to disclose to accredited investors but all non-accredited investors must receive information that is very similar in style and substance to the information that must be provided in a registered public offering. Preparing this type of disclosure documentation is costly and takes a significant amount of management attention away from running the issuer's business.
The CROWDFUND Act changes part of the current regulatory scheme by creating an exemption from registration that allows issuers to sell securities to non-accredited investors through an intermediary that is either a broker or a funding portal registered with the SEC. Furthermore, as long as the issuer and the funding portal comply with the requirements of the CROWDFUND Act, issuers can sell to non-accredited and non-sophisticated investors without going through the costly process of registering the offering with the SEC or complying with Rule 506.
The CROWDFUND Act requires crowdfunding sales to take place through a registered broker or funding portal that is registered with the SEC and applicable self-regulatory associations. The exemption from registration under the CROWDFUND Act depends on compliance with three main categories of statutory requirements: 1) limits on the aggregate amount issuers can sell and on the amount individual investors can invest; 2) regulation of funding portals; and 3) mandatory disclosure by the issuer.
Once the CROWDFUND Act becomes effective, issuers will be able to reach a broader class of investor, in what is intended to be a less costly and less time-consuming transaction. The CROWDFUND Act required the SEC to promulgate implementing regulations before the end of 2012. The SEC missed that deadline, and it is unclear when those regulations will be proposed and finalized. However, at some point the SEC will promulgate those regulations and the CROWDFUND Act will take effect.
The CROWDFUND Act Creates New Disclosures for Issuers and Intermediaries
The new regulatory framework established by the CROWDFUND Act has created a lot of excitement in the entrepreneurial and technology communities. Although many details depend upon the yet non-existent implementing regulations, the CROWDFUND Act is clearly intended to open up a new paradigm in start-up financing.
The CROWDFUND Act regulates the sale of securities through crowdfunding websites by restricting the aggregate amount of securities a company can sell in a 12-month period, the amounts individual investors may purchase in a 12-month period, imposing certain requirements on the intermediaries raising the funds and requiring significant disclosure of information by the issuer.
The CROWDFUND Act restricts the amount of securities a company can sell to crowdfunding investors during any 12-month period to $1 million. The amount sold to any single investor during a 12-month period cannot exceed the greater of $2,000 or 5 percent of the investor's annual income or net worth if either the investor's annual income or net worth is less than $100,000 or 10 percent of the investor's annual income or net worth, not to exceed a maximum aggregate amount sold or $100,000, if the investor has annual income or net worth of $100,000 or more.
The CROWDFUND Act regulates crowdfunding intermediaries in six main areas: 1) conflicts of interest; 2) disclosure and investor education; 3) anti-fraud protection; 4) the manner of sale; 5) availability of issuer information for the SEC and investors; and 6) registration with the SEC and applicable self-regulatory organizations.
In order to avoid conflicts of interest, among things, intermediaries are prohibited from: 1) giving advice, soliciting or advertising about securities available for investment on their website; 2) having officers, directors or partners that have a financial interest in an issuer; and 3) compensating any finder or lead generator for providing the intermediary with information about potential investors.
Intermediaries have an affirmative obligation to make certain disclosures and SEC mandated investor education materials available to investors. Included in the disclosures is information about risks and specifically about the risk of loss of the entire investment. However, under the CROWDFUND Act, intermediaries have more than a disclosure obligation with respect to risks and issuer information; intermediaries have an affirmative obligation to confirm that the investors have read and understand those risks and can bear the risk of loss of their investment. The manner in which intermediaries will be Alrequired to make this confirmation is not yet clear; hopefully the SEC will address this issue when it promulgates the rules required by the CROWDFUND Act.
In addition to disclosure and investor education about risks, the intermediary must also implement SEC mandated anti-fraud mechanisms. Those mechanisms will include obtaining background and securities enforcement regulatory history checks on each officer, director and more than 20 percent stockholder of the issuer.
In executing the transactions, the intermediary must make the issuer's disclosure material available to the SEC and potential investors and ensure that all offering proceeds are provided to the issuer when the aggregate capital raised equals or exceeds the target offering amount. The intermediary must provide all investors with the opportunity to cancel their investment commitments. The intermediary also has an affirmative obligation to ensure that no investor has exceeded the 12-month aggregate purchase limitations and must ensure investor privacy. The manner in which the intermediary must do so is not yet clear and will hopefully be addressed by the SEC when it issues its crowdfunding rules. Furthermore, the intermediary is prohibited from advertising the terms of the offering except for notices that direct investors to the funding portal or broker.
The intermediary must at least annually file with the SEC and provide to investors reports of the results of operations and financial statements of issuers and must comply with other SEC mandated mechanisms for the protection of investors and the public interest.
Finally, the intermediary must be registered with the SEC and any applicable self-regulatory agency, such as FINRA.
The CROWDFUND Act also imposes significant disclosure requirements on issuers. Issuers must file with the SEC, provide to the intermediary and make available to investors, disclosures having to do with the issuer's management, board of directors and controlling stockholders, financial situation, business and business plan, the offering and the issuer's capital structure.
The nature and extent of the financial information that must be disclosed depends upon the size of the offering and ranges from income tax returns and financial statements certified by the issuer's principal officer for offerings of $100,000 or less, to financial statements reviewed by an independent public accountant for offerings of more than $100,000 and less than $500,000 to audited financial statements for offerings of more than $500,000 or such other amount to be established by the SEC.
The disclosures must also include a description of the stated purpose and intended use of the proceeds of the offering, the target offering amount, the deadline to reach the target offering amount, and regular updates regarding the progress in meeting the target offering amount. Those disclosures must also include the share price to the public or the method for determining the price. Prior to the actual sale, each investor must receive in writing the final price and all required disclosures with a reasonable opportunity to rescind the commitment to purchase the securities.
In disclosing the terms of the securities being offered, the issuer must disclose how such terms may be modified, a summary of the differences between different classes of securities, including how the rights of the securities being offered may be materially limited, diluted, or qualified by the rights of any other class of securities and also provide a description of how the exercise of the rights held by the principal stockholders could negatively impact the purchasers of the securities.
Beyond those disclosures, the issuer must also explain how the offered securities are being valued and examples of methods for how such securities may be valued in the future, including during subsequent corporate actions. Finally, the disclosures must include a discussion of the risks to purchasers relating to minority ownership and associated with corporate actions, such as additional issuances of securities, a sale of the issuer or its assets or transactions with related parties.
Investors Likely Will Not See Significant ROI
Will the CROWDFUND Act actually allow small investors to share in the "bonanza" of successful start-up companies or provide start-up companies with access to readily available piles of cash in the long term? Although the crowdfunding and entrepreneurial communities are excited about the potential of raising capital through crowdfunding, the typical investment cycle for successful start up companies will likely make crowdfunding less attractive for both investors and entrepreneurs in the end.
Inexperienced investors may not realize that the annual limitations on the amount start-ups can raise through crowdfunding make it likely that the successful start-ups will need to raise significant additional funding in the future; $1 million just does not go as far as it used to for a technology start-up. Founders and early investors in start-ups typically are diluted by subsequent investors; however, they protect themselves by starting with large holdings of equity and negotiating some special rights for themselves.
The per investor limitations of the CROWDFUND Act prevent individual crowdfunding investors from obtaining large holdings and therefore, once subsequent venture capital has been invested in an issuer the crowdfunding investors' holdings will be diluted substantially and their right to receive a share of the proceeds of a successful exit likely will be preempted by the special rights of other classes of preferred stock that are issued to later investors. The likely result is that crowdfunding investors will receive little if any return on their investment in a venture backed start-up company even if the issuer ultimately is sold in a successful liquidity event.
Even if a start-up goes public, the crowdfunding investors' stock will not be registered in the IPO, will be subject to a customary lock up and those investors will not have the right to register their stock with the SEC, keeping their stock illiquid. It is not very likely that an individual crowdfunding investor will ever see a significant return on a crowdfunding investment even if the issuer goes public.
Of course, crowdfunding is not limited to start-up technology companies and investors can invest in companies that may be smaller scale successes. In fact, very few start-up companies are ever funded by angel investors and/or venture capital funds. Most start-ups that are not funded will eventually fail. On the other hand, some startup companies are not funded by angels or venture capital investors and may go on to be nice businesses that generate a living income for their founders. However, such businesses rarely generate dividends, have a liquidity event that would provide a return on investment to investors or go public. Crowdfunding investors in those types of companies will be holding illiquid securities that are also unlikely to generate a return on investment.
Returning to a crowdfunded company that goes on to receive venture capital investment, indeed, investors will receive a lot of information in the mandatory disclosures and will somehow be required to acknowledge that they understand the risks of investment. Will this acknowledgment be done through on-line click through questions? If so, the effectiveness of on-line disclosures and click through confirmation of the understanding of those disclosures is questionable at best. On-line purchasers of products and services have become conditioned to generally accept the terms and conditions of purchase and click through the explanations without even reading them. Click through disclosures and confirmations on crowdfunding portal would not likely be any different.
From the issuer perspective, entrepreneurs should be aware that the disclosure requirements of he CROWDFUND Act will require them to expose a significant amount of sensitive business and financial information to the investing public. While issuers make significant disclosure to investors in non-crowdfunding private transactions, that disclosure typically remains confidential. Under the CROWDFUND Act, the disclosures essentially become public through filing with the SEC and being posted on the crowdfunding website, resulting in financial information, competition sensitive information and confidential business plans being exposed to the public to the potential detriment of the issuer and its current stockholders. It is unclear whether this issue will be addressed in the SEC's rules.
The CROWDFUND Act exempts issuers that have a large number of crowdfunding stockholders from being treated as a public company for securities laws purposes. However, state corporate laws may make it difficult for private companies that have large numbers of crowdfunding stockholders to take corporate action. For example, in many privately held venture backed companies, stockholder actions are often taken by unanimous or majority written consent and board and stockholder meetings are often held by conference call; but in a company with a few hundred common stockholders, this is no longer feasible at the stockholder level.
The issuer will have to spend time and resources to prepare and deliver legally compliant meeting notices and materials to hundreds of stockholders and will have to comply with all corporate formalities with respect to those stockholders. While non-voting stock can be issued to crowdfunding investors, doing so can have the effect of creating a separate class of stock with class voting rights by operation of law in certain situations resulting in those investors having a potential veto on major corporate actions. It is unlikely that the founders of a crowdfunded company want to give that type of control to their crowdfunding investors.
Will entrepreneurs risk the potential damage that disclosure to the world of their most sensitive information, plans and technology before a product has even been completed in order to crowdfund? Furthermore, will it damage start-ups and their other investors to have entrepreneurs spending time, energy, most importantly, management focus, on corporate governance and shareholder issues when they should be focusing on creating a product and building a business?
Will small, unaccredited investors really understand that their investments will be too small to enjoy any significant return on investment given the way successful start-ups are financed? Will they really review the required investor education materials and truly digest the fact that most start-ups fail, some become profitable businesses with no liquidity for investors, and a very select few actually become home runs? Will they be prepared to continue to invest when they see that even home runs make very little money for crowdfunding investors?
When crowdfunding investors become frustrated with minimal or no returns, when entrepreneurs make mistakes in corporate governance, and crowdfunding supported companies do not achieve their business goals, will the technology investment world be ready for the time, expense and distraction that will be created by the shareholder lawsuits that are sure to come?
At least initially, crowdfunding will likely provide entrepreneurs with easier access to a broader range of capital. Nevertheless, before the tech and tech investing community jump on the bandwagon, everyone had better think through the unintended consequences for both investors and entrepreneurs. Every new regulatory scheme has unintended consequences that cost more than anyone anticipates and crowdfunding is no exception.
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