New Crowdfunding Rules Present Challenges and Opportunity
May 16, 2016
On May 16th, the U. S. Securities and Exchange Commission’s long-awaited rules known as “Regulation Crowdfunding” take effect, providing a revolutionary method for emerging companies to raise capital. The SEC’s adopting release and accompanying new rules span 685 pages and are intended to implement the final major piece of the Jumpstart Our Business Startups Act, commonly referred to as the “JOBS Act”, passed in 2012. These new rules allow almost anyone, regardless of financial means, for the first time ever, to invest through an internet funding portal in securities (primarily capital stock or debt) of privately held companies. This method of fundraising, which involves the sale of securities through the solicitation of a large number of people via the internet, has the makings of a watershed event, in light of federal and state securities laws which historically have made this level of investor participation nearly impossible.
Crowdfunding, itself, is not entirely new. Other forms of crowdfunding have been available to companies for several years now. However, those earlier forms have been limited to fundraising in which (i) no securities or ownership interests are issued (instead, funders would typically receive promotional items or special product deals in exchange for their “investments”), or (ii) securities or ownership interests are sold to so-called “accredited” investors, who satisfy significant income or net worth requirements. These traditional forms of crowdfunding can be expected to continue, unabated as a result of these new rules.
The excitement surrounding the new crowdfunding rules has centered around making fundraising of small amounts easier for start-up companies, and “democratizing” investing by permitting the common man/woman to participate in investment in private companies. Unfortunately, the new rules, which contain a myriad of limitations, requirements and traps for the unwary, provide such a narrow window of opportunity for companies and investors that most companies can be expected to bypass this form of fundraising in favor of other less tedious, expensive and time consuming means of raising capital. For those with limited alternatives, however, this new option is at least worth a look.
To be expected, there are dollar limits on this type of crowdfunded offering. Companies are limited to raising a maximum of $1.0 million in any 12 month period by this method. Individual investors are also limited in the annual investments they can make among all crowdfunded offerings in which they participate. For individual investors the annual aggregate limit is formulaic and results in a maximum investment of between $2,000.00 and $5,000.00 per year for an individual with net worth or income below $100,000.00. Those with higher incomes or net worth can spend up to 10% of it so long as they invest no more than $100,000.00 per year, in the aggregate, among all crowdfunded investments. This means, for example, that a person with a net worth of $1.0 million can invest the exact same amount as Warren Buffet can invest in crowdfunded offerings over the course of a year. Namely, no more than $100,000.00 in the aggregate. This anomalous result went largely unexplained by the SEC in its adopting release covering these new rules.
In our view, these dollar limitations in and of themselves (together with the ever present anti-fraud requirements of federal and state securities laws) provide protection against significant financial harm for investors, while still freeing up meaningful capital for emerging cash-strapped companies. But, sadly, the SEC could not help but layer on additional protections and safeguards, which weigh down the very companies and investors the JOBS Act was purported to liberate.
Additional regulation imposed by the Regulation Crowdfunding include a host of disclosure requirements that few private companies have ever experienced. These include, for example, publicly disclosing information regarding officers, directors and 20% owners, related party transactions, business descriptions, financial condition discussions, financial statements (that must be audited in most cases), and the requirement to file recurring periodic reports after completing an offering.
It should also be noted that these new crowdfunded offerings will not be conducted by the companies who are seeking the capital. Instead, they will be offered via internet funding portals by third-party intermediary firms who will be registered with and closely monitored by the SEC. These intermediaries are required to work hard to control and complete such offerings by taking a number of steps, including those designed to reduce fraud, educate investors, set up communication channels to disseminate information and facilitate securities sales. At the same time, they will be prohibited from making recommendations, offering any advice, soliciting anyone to purchase securities or compensating promoters and others to solicit such purchases, or holding any investor funds. To say that their job will be difficult is an understatement. How their fees will be structured and whether such fees will be affordable to start-up companies remains to be seen.
In light of the cumulative restrictions and requirements imposed by the rules, it is our expectation that companies will bypass this method of fundraising if at all possible and, as such, it is likely to become a fundraising method of last resort. In our view, the SEC missed an important opportunity to truly “jump start” emerging businesses with the Crowdfunding Regulation. Capital raising for young companies through the sale of securities has always been challenging. Recent financing trends indicate that we may be in our most challenging market environment within the last ten years or so. Thus, it is inevitable that some companies will at least consider using this new method. For those willing to do so, extreme care will be necessary. Skilled professional advisors should be retained to determine whether this type of crowdfunding is a viable option. In particular, only experienced securities and transactional lawyers will know how to structure such offerings in a manner that avoids terms and conditions that would hamper or prohibit subsequent rounds of capital, since subsequent rounds will surely be conducted using traditional methods of fundraising and finance. We anticipate that many, and perhaps most, companies will opt not to pursue this new type of crowdfunded capital raising in favor of other, more traditional methods of capital raising which they will likely find more suitable for their needs.
Eventually, the SEC will likely reconsider the burden of these rules and adjust them in order to make crowdfunding viable for more than a few young companies, as was clearly envisioned by Congress in passing the JOBS Act. In time, if this model proves to be successful and is relatively free of the fraud and mischief that the SEC appears to expect, then crowdfunding among the masses, as a means of selling securities, could become a useful tool for emerging companies to raise much needed capital and, in turn, serve to significantly boost our nation’s economy.