Crowdfunding. Crowdfunding is a financing method used primarily by startups and small businesses to raise small amounts of capital from a large number of people over the internet. Crowdfunding websites currently avoid the securities laws since they do not sell stock or other securities.
SEC Action. The SEC proposed crowdfunding regulations in a 585 page release in October 2013. The SEC adopted final rules in October 2015. The final rules substantially follow the proposed rules. The retail crowdfunding rules apply to all 300 million potential investors in the United States. Separate SEC rules apply to sales to the approximately 8.7 million accredited investors in the United States; accredited investors are persons who generally have $300,000 of annual joint income or a $1 million net worth.
Crowdfunding Through Retail Sales
The detailed requirements for retail crowdfunding sales are summarized below.
Offering Cap. The total amount sold to all investors, including amounts sold in reliance on the crowdfunding provisions, during a 12-month period may not exceed $1million.
Investor Eligibility. The total amount sold to any single investor in any 12-month period is limited; a $100,000 limit applies to all crowdfunding investments by the investor in all companies. If the annual income or net worth of the investor is below $100,000, the limit is 5% of the annual income or net worth. If the annual income or net worth of the investor is $100,000 or more, the limit is 10% of the lesser of annual income or net worth. The funding portal, described below, has certain obligations to verify the qualification of the investors.
Business Disclosures. Disclosure must be made to potential investors of various business factors, similar to what is generally found in an offering prospectus. These include a description of the business, the use of proceeds, risk factors, related party transactions, balance sheet descriptions and business plan information.
Financial Disclosures. Financial statements for the most recently-completed fiscal year must be provided. For offerings between $100,000 and $1,000,000, the financial statements must be reviewed by an independent public accountant. For offerings of more than $500,000, second and subsequent crowdfunding offerings must include financial statements audited by an independent public accountant.
SEC Filings. The information provided to investors must be filed with the SEC on a Form C. An annual update of the information must be filed with the SEC on Form C.
Required Funding Portal. A company raising capital pursuant to the crowdfunding regulations must use a registered funding portal as an intermediary. The funding portal can be a registered broker or a new registered funding portal entity. The broker or funding portal must be registered with the SEC pursuant to relaxed registration requirements and has certain obligations to verify the issuer’s compliance with the crowdfunding regulations.
Resale Restrictions. Resale of crowdfunding securities would be restricted for one year following the initial sale. During the one-year period, resales could only be made to the issuer, to an accredited investor, or to a family member of the purchaser.
Marketing Restrictions. The funding portal website would contain the general solicitation and advertising information. Issuers are prohibited from any advertising other than notices which direct investors to the funding portal.
Liability Exposure. Crowdfunding sellers have securities law liability for material misstatements or material omissions in the documents provided to investors. Under the proposed SEC regulations, these liabilities are based on negligence, as opposed to the general antifraud securities liabilities which require scienter.
Costs. Compliance with the crowdfunding regulations will require the use of lawyers, accountants and experts at the funding portal level. The SEC, in its proposing release, estimated the costs for a $1 million crowdfunding offering at $152,000.
Effect of Rules
The proposed rules drew substantial flak from the investment community as not accomplishing congressional mandate to make retail crowdfunding sales easier and less costly. Companies and their advisors will need to make a determination of whether the benefits of being able to raise up to $1 million in a 12-month period outweigh the potentially significant burdens and expenses of complying with the SEC’s eligibility, disclosure and related costs under the new rules. The final rules will become effective in May 2016 and may not be utilized by companies prior to that time.