On October 30, 2015, the Securities and Exchange Commission (“SEC”), by a 3-1 vote, adopted the long-anticipated final rules permitting federal crowdfunding (“Title III Crowdfunding”), providing a potentially attractive capital raising vehicle for small startup companies seeking investors via the Internet. Although the rules will not become effective until sometime later next year, the SEC press release, together with the enabling statutory provisions, § 4 (a)(6) and § 4A of the Securities Act of 1933 (“Securities Act”), provide a blueprint for the rules which will apply to this capital raising option. See Press Release, Securities and Exchange Commission, SEC Adopts Rules to Permit Crowdfunding, 2015-249 (Oct. 30, 2015).
As discussed more fully below, the success this capital raising option will have is uncertain. Title III Crowdfunding is only one option small startup companies with exciting ideas can avail themselves of in their search for capital. Private venture capital firms, state crowdfunding and even non-securities based crowdfunding platforms such as Kickstarter, offer potentially useful sources of capital. Certain exempt transactions under the federal securities laws are generally not feasible because of transaction costs and other restrictions. The general unavailability of bank lending essentially eliminates another potential source of capital, especially for small startups. Thus, Title III Crowdfunding has the advantage of allowing small startups access to the public to solicit investors. However, because the rules are somewhat cumbersome and complex and the penalties for non-compliance severe, many startups seeking to avail themselves of this capital raising option will need the assistance of competent legal counsel, among other disciplines. Other related considerations discussed below must also be taken into account, including the fact that once securities are issued, the federal general antifraud provision, Rule 10b-5 comes into play. See 17 C.F.R. § 240.10b-5.
With the final crowdfunding rules, the SEC completed the rule making process mandated by Title III of the Jumpstart Our Business Startups Act, 2012 (“JOBS Act”). Congress’ intent when it enacted the JOBS Act, which was echoed by President Obama when he signed the bill, was to facilitate capital formation by smaller companies to stimulate job growth. The overall means of achieving this objective was the relaxation and even elimination of certain costly and time consuming restrictions and requirements occasioned by the Securities Act, § 5 registration process. In addition to Title III, Title I of the JOBS Act established a significantly relaxed “IPO On Ramp” for emerging growth companies (those with less than $1B in revenues in the year of filing), which has turned out to be wildly successful. Title II eliminated the prohibition against general advertising and solicitation for Rule 506, Regulation D limited offerings, which resulted in the SEC adopting Rule 506(c). This option appears to be largely unused, at least by sophisticated issuers, likely because the verification requirements for accredited investors are fairly rigid and the penalties for non-compliance (e.g., loss of the exemption) severe. Title IV amended the Securities Act, § 3 (b)(2), to create the so-called Regulation A+ “mini-registration” offering which allows eligible (e.g., reporting companies excluded) U.S. and Canadian companies to issue certain securities up to $50M within a 12 month period with relaxed § 5 filing requirements, among other benefits. Because the SEC only recently adopted the regulations for this offering, it is too early to tell whether it will be widely used. In the grand scheme of things, unlike the above discussed offerings, Title III Crowdfunding is aimed at truly small startup companies seeking to raise a maximum of $1M in a 12 month period, primarily from small retail investors.
Unlike highly successful crowdfunding platforms such as Kickstarter, Title III Crowdfunding involves the issuance of equity securities to accredited and non-accredited investors. In other words, investors can acquire an equity or ownership stake in the ventures they invest in. Some of the relevant hurdles and limitations, in addition to the offering limitation discussed, include:
(1) The crowdfunding rules are limited to domestic non-reporting companies and other categories.
(2) Crowdfunding must be conducted through SEC approved Portals managed by SEC registered broker-dealers or other qualified persons (“Intermediaries”). In practice, this means crowdfunders may not blast their offering to the world on their website. Moreover, the Intermediaries face a laundry list of requirements, aimed at protecting investors. They also must join an industry self-regulated organization, which appears to be the Financial Industry Regulatory Authority (“FINRA”), which means they will be subject to the latter’s crowdfunding rules and other rules as well.
(3) The crowdfunding rules place fairly stringent limitations on the amount individual investors, especially small retail investors, can invest based on their income or net worth, and other factors. For example, the aggregate amount sold to all investors in a 12 month period may not exceed $100,000. Investors with incomes or net worth of less than $100,000 are allowed to invest only a small amount.
(4) Certain disclosure must be filed with the SEC and such information must be provided to investors and Intermediaries including the price of the security, the method for determining the price, discussion of the company’s financial condition, description of the business (“business plan”) and information on directors and officers who own more than 20% of the company.
(5) The new rules require audited financial statements depending on the size of the offering. In this respect, the SEC made a concession to facilitate crowdfunding. Specifically, the final rules permit a company offering up to $500,000 to submit “reviewed” financial statements as opposed to audited financial statements. Under § 4A (b)(1)(D)(iii), the SEC had leeway to impose the requirement of audited financial statements for lesser offerings.
(6) Under § 4A(e) of the Securities Act, with some exceptions, the resale of crowdfunding securities are restricted for one year from the date of purchase. Interestingly, if a market for crowdfunding securities develops, the one-year holding period may be academic. Liquidity is a real issue for investors. If crowdfunding is successful, the resourcefulness of the financial community will create a market for trading.
(7) There are certain post-offering “reporting” requirements.
(8) Companies who violate the crowdfunding rules face the risk of losing the § 4 transactional exemption, not to mention, depending on the circumstances, liability under § 12 (a)(2) of the Securities Act. However, there is some confusion how this will actually work based on the language in § 4A (e) of the Securities Act, and even Rule 10b-5’s antifraud provision, especially when material misstatements or omissions are involved.
In addition to complying with the rules, companies need to understand that under the relevant state corporation law, shareholders will have certain rights that need to be respected. This will lead to certain corporate governance requirements and formalities that the newly formed corporations will need to address in their incorporation documents and practices. In this situation, Title III Crowdfunding differs from many other private capital raising ventures that are not structured along traditional “public corporation” lines. See Reinventing the Deal, THE ECONOMIST, Oct. 24-30, 2014, at 21-24.
There is another important aspect of crowdfunding which companies need to be keenly aware of. The SEC and others are concerned that crowdfunding is a recipe for fraud on unwary unsophisticated investors who sink their money into highly risky ventures and can ill afford to prosecute recovery litigation when the ventures fail. Indeed, in this author’s experience, at least 50% of startup ventures fail within five years or less from their inception. This concern is reflected in Title III itself, where Congress included several mechanisms to reduce the risk of fraud and enhance financial disclosures. As such, crowdfunders can anticipate that the SEC will keep a close watch on their activities, which Commissioner Mary Jo White recently made clear when she stated that the Agency “will begin immediately to keep a watchful eye on how this market develops.” The Associated Press, SEC to Allow Securities Crowdfunding, PROVIDENCE J., Oct. 31, 2015. The SEC is a huge proponent of commencing enforcement proceedings for deterrence purposes. Companies can expect that the SEC will watch closely to see if they “jump the gun” before the regulations become law and then afterwards. Moreover, it is reasonable to expect that the SEC will keep a close eye on all disclosures for any violations under Rule 10b-5 as well as the disclosure requirements set forth in the rule.
Finally, many states (including Massachusetts) have enacted crowdfunding statutes or regulations which generally are based on the § 3 (a)(11) purely intrastate exemption under the Securities Act. Interesting, in the SEC Press Release, the agency announced that it was proposing an amendment to Rule 147, which governs § 3 (a)(11) offerings, to allow advertising outside of the state’s borders, retaining the limitation that sales may only be to residents of the issuer’s state or territory. While this is a subject best addressed in another article, the question becomes whether state crowdfunding will subsume Title III Crowdfunding, especially if many of the state regulatory regimes are less cumbersome than the Title III regime. The short answer is probably not because Title III Crowdfunding allows companies to offer their securities to the public and many of the restrictions on § 3 (a)(11) offerings under Rule 147 still remain.
While the details remain to be worked out, it is apparent that many companies will need at a minimum, the assistance of cost effective legal counsel to navigate successfully through the Title III Crowdfunding labyrinth and afterwards. Further, it is a simple fact of life that once a company enters the realm of federal securities law, life becomes a great deal more complicated and risky, especially for the unsophisticated. Given the size of many of the offerings, the costs associated with compliance could easily consume 10 to 20% of the offering and in some cases render the offering unfeasible. Lawyers who service this business will need to provide cost-effective solutions to their clients. With a little planning and foresight, this can be done.
So, what are the benefits of Title III Crowdfunding and why are many in the financial community excited about its prospects, some going so far as to suggest that it will become a multi-billion dollar business? From the startups perspective, crowdfunding offers an attractive fundraising vehicle given the general unavailability of bank loans and exhaustion of their families and friends’ financial resources. Being able to broadcast the offering through the Internet, albeit SEC approved and monitored Portals, allows crowdfunders to reach a potentially large number of investors, especially small investors who may be excited about getting in the ground floor of the next Facebook or similar venture. Also, Title III securities are “covered securities,” meaning that they are generally not subject to state regulation, which greatly reduces the costs of the offerings. While it is obvious, assuming the companies avoid § 12 (g)(1) “entry level” criteria for reporting company status, they will not be subject to the full sweep of the federal securities laws, especially the Securities Exchange Act of 1934. One also suspects that once the Portals are established, those run by broker-dealers will create a level of visibility for exciting startups, which could lead to substantial funding from institutional investors. Finally, there is talk about Congress raising the 12 month offering limit to $5M, which would go a long way to making such offerings more cost effective from a legal and auditing perspective and would attract more substantial startup companies who might otherwise pursue other offerings under the federal securities laws (e.g., § 3 (b)(1) small issue offering; Regulation D, Rule 505 limited offering).
Despite some of the disadvantages, Title III Crowdfunding offers young under-capitalized companies theability to reach a wide audience of potential investors. This option may not work for some startups, but if managed correctly, many will find it very attractive and rewarding. One hundred and eighty days after the SEC’s final crowdfunding rules are published in the Federal Register and the forms enabling the Portals to register with the SEC are effective, which the SEC expects to be in late January 2016, Title III Crowdfunding will be off and running. In the interim, companies interested in pursuing this option should start planning now. With the assistance of able counsel and other professionals, they will stand a better chance of conducting a successful offering and avoid legal complications afterwards.
Andrew C. Spacone, Esq. is Of Counsel, to Adler Pollock & Sheehan where he has a wide ranging corporate and litigation practice. Prior to Joining AP&S, Andrew was Deputy General Counsel & Assistant Secretary for Textron Inc., where he headed the litigation department. He retired from Textron in 2011 after thirty years with the company. Andrew also is an Adjunct Professor of Law at the Roger Williams University School of Law where he teaches Mergers & Acquisitions and Securities Regulation. The author would like to acknowledge the assistance of Nicole M. Verdi, Esq., a litigation associate with AP&S who assisted with this article.