United States: SEC's Crowdfunding Regulations Take Effect

About two and a half years after the first proposed crowdfunding rules were published, the Securities and Exchange Commission's long-anticipated regulations recently became effective. Regulation Crowdfunding is the SEC's implementation of Title III of the Jumpstart Our Business Startups Act of 2012 (the JOBS Act), adding a new Section 4(a)(6) to the Securities Act of 1933 to provide an exemption from Securities Act registration requirements for certain "crowdfunding" transactions and establish a separate regulatory regime for those offerings. Crowdfunding allows companies, including start-ups, to raise capital by offering and selling securities through crowdfunding offerings generally using the internet and enables the public to purchase securities in these limited offerings.

Investor Eligibility; Limitations on Offering

There are significant risks involved with crowdfunding investments so the rules also limit the amount of capital that any one investor can contribute to all crowdfunding offerings in any rolling 12-month period based on the investor's net worth and annual income:

  • For individuals with either an annual income or net worth that is less than $100,000, the limit is the greater of (a) $2,000 and (b) 5% of the lesser of the investor's annual income and net worth; and
  • For individuals with both an annual income and net worth of at least $100,000, the limit is 10% of the lesser of: (x) the investor's annual income or (y) the investor's net worth. It is important to note, however, that even for the wealthiest of investors in this category; there is a cap of $100,000 in any rolling 12-month period and "net worth" excludes the value of an investor's primary residence. 

Disclosure Requirements; Ineligible Issuers

The issuer must file certain information with the SEC to conduct a crowdfunding offer disclosing:

  • Crowdfunding transactions under the new rules must be conducted online through a registered broker-dealer or a new non-broker type of intermediary called a "funding portal." Under the new rules, the total amount of securities sold by an issuer is limited to $1 million during any 12-month period. Only securities sold under the Section 4(a)(6) exemption, and no other registration exemptions, count towards the $1 million limit.
  • The price to the public of the securities or the method for determining the price, the target offering amount, the deadline to reach the target offering amount, and whether the company will accept investments in excess of the target offering amount;
  • Financial statements of the company that, depending on the amount offered and sold during a 12-month period, are accompanied by information from the company's tax returns, reviewed by an independent public accountant, or audited by an independent auditor. A company offering more than $500,000 but not more than $1 million of securities relying on these rules for the first time would be permitted to provide reviewed rather than audited financial statements, unless financial statements of the company are available that have been audited by an independent auditor;
  • A discussion of the company's financial condition;
  • A description of the business and the use of proceeds from the offering;
  • Information about officers and directors as well as owners of 20 percent or more of the company; and
  • Certain related-party transactions.

In addition, the issuer would be required to file an annual report with the Commission and provide it to investors. However, holders of securities purchased in crowdfunding offerings would not count toward the threshold that requires a company to register its securities under Exchange Act Section 12(g) if the company is current in its annual reporting obligations, retains the services of a registered transfer agent and has less than $25 million in total assets as of the end of its most recently completed fiscal year.Certain types of entities are not eligible to use the crowdfunding exemption, specifically:

  • Reporting companies under the Exchange Act;
  • Non-U.S. companies;
  • Certain investment companies (including most hedge funds);
  • Companies that are disqualified under provisions similar to the "bad actor" criteria under Rule 262 of Regulation A and Rule 506 of Regulation D and companies that have failed to comply with the annual reporting requirements under Regulation Crowdfunding during the two years immediately preceding the filing of the offering statement; and
  • Companies that have no specific business plan or have indicated that their business plan is to engage in a merger or acquisition with an unidentified company or companies.

Resale Restrictions Securities sold under this exemption have certain resale restrictions, notably that they cannot be resold for one year unless transferred back to the issuer, an accredited investor, as part of a registered offering, or to the purchaser's family members or a family trust in connection with the death or divorce of the purchaser. Even after the one-year period, the liquidity and ease of transferring such securities is far from guaranteed.

Crowdfunding Portals

A small number of crowdfunding portals under Title III have already registered and are in the process of beginning operations. Some are starting with debt only issuances, and others are facilitating debt and equity issuances. Fees usually involve an upfront listing fee ($500 is fairly typical), along with a percentage of the capital raised, usually from 7-10%. While the profitability of this type of venture remains to be seen, those interested can, likely with some guidance, register with both FINRA and the SEC and try to grab a piece of the action that way.

Practical Effect

While Regulation Crowdfunding is a significant step by the SEC in acknowledging the growing importance of internet and social media-based capital raising for small businesses and start-ups, companies utilizing the new exemption need to be aware of its limitations. Importantly, the $1 million per issuer in any rolling 12-month period may not be enough to meet the capital needs of many businesses, especially those that have large up-front capital costs or those that ultimately need significant infusions of additional capital in the first year of operation. Due to the low dollar contribution limits, lack of liquidity of the securities, and advertising/marketing hurdles associated with targeting the unsophisticated investor, it may be difficult to find enough investors willing to purchase securities in a crowdfunding offering. There are administrative costs and burdens to consider as well, including costs of the broker-dealer or funding portal and providing reviewed or audited financial statements and a disclosure document that complies with SEC rules (all of which costs generally must be incurred prior to any crowdfunding), as well as ongoing compliance costs, including progress updates and an annual reporting requirement.Even with these burdens and the $1 million limitation, many companies would not be able to obtain a business loan (and certainly not equity funding) for anywhere close to that amount and might benefit from the capital infusion crowdfunding portals can provide. If the initial round of crowdfunding is successful, the company may then have a sufficient balance sheet and credibility to qualify for bank financing, or may even go on to issue additional debt or equity in a larger private offering using Regulation D or another applicable exemption.

Finally, Texas-based companies that think their capital needs can be met by other Texans and don't need to rely on a nationwide funding portal may be able to utilize the Texas Crowdfunding Exemption which has been in effect since 2014. This too has a $1 million cap on fundraising per 12-month period and a low $5,000 contribution limit per offering for non-accredited investors. While compliance might be less burdensome than the SEC requirements under Regulation Crowdfunding, Texas startups might have a harder time raising the capital they need if they are limited to Texas-based investors at $5,000 per offering. Whether the Texas regime remains a viable option in light of the new Jobs Act rules remains to be seen.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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