Many startup founders are excited about the Securities and Exchange Commission’s (SEC’s) crowdfunding rules (adopted in 2015). The rules can help make new funding sources available to smaller companies that may lack access to traditional sources of capital. However, because the crowdfunding rules also seek to protect investors and minimize fraud, the rules can be difficult to navigate. The crowdfunding rules include certain limitations on who can engage in crowdfunding, how much individuals can invest, and what specific measures issuers and intermediaries must take before and during financings. Furthermore, as issuers and investors utilize the internet and social media to facilitate new investments, issuers and investors may become subject to other complicated US state and federal laws.
Those just beginning to consider the benefits and drawbacks of crowdfunding should take the following five important considerations into account:
Every crowdfunded equity or debt financing includes three principal players: the issuer, the intermediary and the investor. Under the crowdfunding rules, each of these players operates under a separate set of rules, regulations and obligations. The following summarizes the roles of each:
- Under the crowdfunding rules, the issuer refers to the company or entrepreneur that is crowdfunding debt or equity securities in an attempt to raise capital. Issuers are required to make certain disclosures to investors, intermediaries and the SEC and are limited in the amount of funds they may raise through crowdfunding in every 12-month period. Also, certain categories of issuers are ineligible to utilize crowdfunding, including: issuers located outside of the United States, public reporting companies and most hedge funds.
- The SEC crowdfunding rules require that crowdfunding be administered through an intermediary that is registered with the SEC and is a member of the Financial Industry Regulation Authority (FINRA). While many investors are familiar with traditional intermediaries such as broker-dealers, the SEC’s crowdfunding rules have created a new type of intermediary known as a Funding Portal, which, unlike a registered broker-dealer, is required to restrict its activity to online offerings made under the crowdfunding rules. According to these new crowdfunding rules, Funding Portals are subject to certain important restrictions that are not applicable to traditional registered broker-dealers. For instance, Funding Portals must conduct offerings exclusively over the internet and must meet extensive compliance obligations, including: providing investors with certain disclosures and educational materials, taking measures to reduce fraud, making specific information public on the platform and providing communication channels that issuers and investors can use and that the general public can view.
Finally, under the new crowdfunding rules, the investor is the individual or entity that invests capital in the issuer through the intermediary in exchange for debt or equity securities. Unlike traditional equity financings for non-public issuers, crowdfunding is not limited to certain exempt investors such as accredited investors (see What is an Accredited Investor for more). Instead, the SEC’s new crowdfunding rules allow almost anyone to invest in a company. However, these rules impose significant limitations on the amount an investor may invest over a certain period of time.
Most people are familiar with popular crowdfunding channels such as Kickstarter or GoFundMe, which allow ordinary consumers to pre-purchase products in order to “invest” in exciting new technologies, which are then developed and commercialized using the crowdsourced funds. Unlike these popular forms of crowdfunding, “equity crowdfunding,” also known as “investment crowdfunding” or “crowdinvesting,” is used to raise capital from investors who receive equity, shares or debt securities from the issuer in exchange for their investment. That investors receive equity, shares or debt securities for their investment brings equity crowdfunding under the complicated umbrella of financial and securities regulations.
An issuer is only permitted to raise a maximum aggregate of US$1 million through crowdfunding over any 12-month period and investors are only allowed to invest up to US$100,000 through crowdfunding in any given 12-month period. Moreover, if an investor’s annual income or net worth is less than US$100,000, the investor is limited to investing the greater of US$2,000 or 5% of the investor’s annual income or net worth (whichever is lesser). On the other hand, if an investor’s annual income and net worth is at least US$100,000, the investor is limited to investing 10% of the investor’s annual income or net worth (whichever is lesser), up to US$100,000. The aforementioned investment limits apply equally to all types of investors, including retail, institutional and accredited investors. When applying the investment limits to business entities, investment limitations are based on an entity’s revenue and net assets instead of an entity’s annual income and net worth.
In addition to the limits placed on how much money an investor can invest or how much money an issuer can raise, the new crowdfunding rules restrict the size of companies that may take advantage of all the benefits of these new rules. For example, an issuer’s total assets at the end of its fiscal year may not exceed US$25 million if an issuer wants to exclude the (often high) number of crowdfunding investors from an issuer’s calculation of total stockholders (which is significant because a company can be required to register as a public reporting company if they the company has too many stockholders).
After securities are purchased through a crowdfunded offering, there are certain limits on an investor’s ability to resell those securities. The limits include a wholesale restriction on the transfer of any securities for a year after purchase, except for transfers to: (1) family members, (2) accredited investors, (3) back to the issuer or (4) through a registered public offering.
While crowdfunding allows issuers to bypass traditional funding limitations through issuing securities directly to non-accredited investors, the SEC continues to impose certain stringent financial reporting obligations on issuers. For every 12-month rolling period, issuers must provide the following financial information:
- For offerings up to US$100,000 – Issuers must provide financial statements for the previous two fiscal years (the term may be shorter if issuer has existed less than two years). The required financial statements must comply with Generally Accepted Accounting Principles (GAAP) and a principal executive officer must certify the financial statements as true and complete. Issuers must also disclose total income, taxable income and sometimes a copy of the company’s income tax returns.
- For offerings greater than US$100,000 and less than US$500,000 – According to Regulation S-X, issuers must provide financial statements prepared under GAAP and an independent public accountant must review the financial statements.
- For offerings greater than US$500,000 – If the issuer is engaging in its first crowdfunding with an offering no greater than US$1 million, the reporting requirements are identical to offerings between US$100,000 and US$500,000. For repeat crowdfunding issuers, issuers must provide financial statements prepared under GAAP. An independent auditor must audit the financial statements and the financial statements must be disclosed with the audit report attached.
While crowdfunding generates the image of the mass advertising of company securities over social media, many are surprised to learn that advertising in connection with a crowdfunded offering is generally prohibited and that the SEC places significant restrictions on how issuers may reach-out to new investors.
The SEC strictly limits how issuers may advertise offerings to the public. Issuers may only advertise offerings using very specific and limited notices. The specific and limited notices may only include the following information: (1) the fact that the issuer is making an offering, (2) a web link connecting to the intermediary’s website, (3) the terms of the offering, including the nature, amount and price of the securities on offer as well as the offering’s closing date and (4) limited information about the issuer, including the issuer’s name, address, phone number, website and business.
Many of the SEC restrictions do not apply to issuer-to-investor communications made through an intermediary’s internet communication platform. So long as an issuer identifies as an issuer, it may utilize an intermediary’s communication platform to answer investor questions or clarify statements made about an issuance. However, intermediaries themselves may not communicate with investors through the internet communication channels and certain restrictions apply to other promoters.
Finally, funding portals are significantly limited in their ability to communicate with potential investors. According to the new rules, funding portals are prohibited from: (1) offering investment advice or recommendations, (2) soliciting purchases, sales or offers to buy securities, (3) compensating persons for solicitations or sales of securities (general business advertising for funding portal is permitted) or (4) other activities the SEC determines appropriate.
The SEC’s new crowdfunding rules offer companies different avenues to revenue that may not have been available previously. However, those companies that seek to crowdfund capital should seek out advice from legal counsel to navigate the complicated rules that govern crowdfunding securities.