As I discussed in a previous post last spring, startups and investors alike have been eagerly awaiting action by the U.S. Securities and Exchange Commission (“SEC”) to promulgate rules to facilitate equity-based crowdfunding. Well, alas, the SEC has proposed crowdfunding rules as mandated by the Jumpstart Our Business Startups Act (the “JOBS Act”). The JOBS Act, enacted back in April of 2012, is intended to enable startups and small businesses to raise capital through crowdfunding. The public comment period is set for 90 days, which means that equity-based crowdfunding could become a reality in early 2014.
The text of the SEC’s notice of proposed rulemaking is an ambitious 585 pages. Unlike the SEC, I value brevity. So, after providing a quick refresher on crowdfunding and the Securities Act, the remainder of this post will discuss the key provisions that potential crowdfunding issuers (i.e., the startups) and investors (i.e., the crowd) may find interesting. Specifically, I will point out a few key aspects of the long-awaited crowdsourcing rule’s requirements for exemption from the registration requirements of the Securities Act.
Background: Crowdfunding and the Securities Act
Currently, the only type of crowdfunding that is authorized in the US are those forms that do not involve the offer of a share in any financial returns or profits that the fundraiser may expect to generate from business activities financed through crowdfunding. Examples of crowdfunding websites that have become mainstream include the likes of indiegogo and Kickstarter. These platforms prohibit founders (the project starter) from offering to share profits with contributors (i.e., equity or security transactions) because such models would trigger the application of federal securities laws. And, under the Securities Act, an offer and sale of securities must be registered unless an exemption is available.
However, newly created Section 4(a)(6) of the Security Act, as promulgated under the JOBS Act, provides an exemption (the “crowdfunding exemption”) from the registration requirements of Securities Act Section 5 for certain crowdfunding transactions. With the introduction of this exemption, startups and small businesses will be able to raise capital by making relatively low dollar offerings of securities to “the crowd” without invoking the full regulatory burden that comes with issuing registered securities. Additionally, the crowdfunding provisions create a new entity, referred to as a “funding portal”, to allow Internet-based platforms to facilitate the offer and sale of securities without having to register with the SEC as brokers. Together these measures were intended to help small businesses raise capital while protecting investors from potential fraud.
Startups: Limits on Amount Raised
The exemption from registration provided by Section 4(a)(6) is available to a U.S. startup (the issuer) provided that “the aggregate amount sold to all investors by the issuer, including any amount sold in reliance on the exemption provided under Section 4(a)(6) during the 12-month period preceding the date of such transaction, is not more than $1,000,000.”
In the proposed rule, the SEC clarifies that only the capital raised in reliance on the crowdfunding exemption should be counted toward the limitation. In other words, all capital raised through other means will not be counted against the $1M sold in reliance on the crowdfunding exemption. As the SEC stated in its notice of proposed rule:
“If an issuer sold $800,000 pursuant to the exemption provided in Regulation D during the preceding 12 months, this amount would not be aggregated in an issuer’s calculation to determine whether it had reached the maximum amount for purposes of Section 4(a)(6).”
Startups: Limits on the Method of Crowdfunding
Under Section 4(a)(6)(C), an offering seeking the crowdfunding exemption must be “conducted through a broker or funding portal that complies with the requirements of Section 4A(a).” This means that crowdfunding can only occur through an intermediary, and that intermediary must meet the requirements of either (1) a broker, or (2) a funding portal. The SEC proposed two related limitations here:
1) Single intermediary – Prohibits an issuer from using more than one intermediary to conduct an offering or concurrent offerings made in reliance on the crowdfunding exemption. For example, you couldn’t use both FundMyStartUp.com and CrowdfundMyDreams.com for the same offering or even for different offerings when conducted concurrently.
2) Online-only requirement – Requires that an intermediary (i.e., the broker or funding portal) effect crowdfunding transactions exclusively through an intermediary’s platform. The term “platform” means “an Internet website or other similar electronic medium through which a registered broker or a registered funding portal acts as an intermediary in a transaction involving the offer or sale of securities in reliance on Section 4(a)(6).”
According to the SEC’s notice, with respect to the online-only requirement:
“We believe that an online-only requirement enables the public to access offering information and share information publicly in a way that will allow members of the crowd to decide whether or not to participate in the offering and fund the business or idea. The proposed rules would accommodate other electronic media that currently exist or may develop in the future. For instance, applications for mobile communication devices, such as cell phones or smart phones, could be used to display offerings and to permit investors to make investment commitments.”
A Quick Note about Funding Portals
As mentioned above, to fit within the crowdfunding exemption, the offering must be conducted through a broker or funding portal that complies with the requirements of Securities Act Section 4A(a).
Exchange Act Section 3(a)(80) (added by Section 304 of the JOBS Act), defines the term “funding portal” as any person acting as an intermediary in a transaction involving the offer or sale of securities for the account of others, solely pursuant to Securities Act Section 4(a)(6), that does not: (1) offer investment advice or recommendations; (2) solicit purchases, sales or offers to buy the securities offered or displayed on its platform or portal; (3) compensate employees, agents or other person for such solicitation or based on the sale of securities displayed or referenced on its platform or portal; (4) hold, manage, possess or otherwise handle investor funds or securities; or (5) engage in such other activities as the Commission, by rule, determines appropriate.”
Under the SEC’s proposed rules, the definition of “funding portal” is exactly the same as the statutory definition, except the word “broker” is substituted for the word “person”. The SEC is making clear that funding portals are brokers (albeit a subset of brokers) under the federal securities laws.
Investors: Limits on Amount Invested
Under Section 4(a)(6)(B), the aggregate amount sold to any investor by an issuer, including any amount sold in reliance on the exemption during the 12-month period preceding the date of such transaction, cannot exceed: “(i) the greater of $2,000 or 5 percent of the annual income or net worth of such investor, as applicable, if either the annual income or the net worth of the investor is less than $100,000; and (ii) 10 percent of the annual income or net worth of such investor, as applicable, not to exceed a maximum aggregate amount sold of $100,000, if either the annual income or net worth of the investor is equal to or more than $100,000.”
Because the statutory definition above creates some potential ambiguity, the SEC’s rule seeks to clarify the relationship between annual income and net worth for purposes of determining the applicable investor limitation. Essentially, the proposed rules take a “whichever is greater” method for measuring whether limitation (i) or (ii) applies. As the rule proposes,
- Where both annual income and net worth are less than $100,000, then the limitation will be set at the greater of (a) $2,000 or (b) the greater of (x) $5% of annual income or (y) 5% of net worth.
- Where either annual income or net worth exceeds $100,000, then the limitation will be set at the greater of (a) 10% of annual income or (b) net worth; provided, however, in either case (a) or (b) may not exceed $100,000.
Related to investor limits, but more important for startups to understand, the proposed rules alleviate burdens associated with vetting investor suitability. Specifically, the rule allows startups to reasonably rely on the efforts that the intermediary takes in order to determine that the amount purchased by an investor will not cause the investor to exceed investor limits.