Crowdfunding – a novel method of raising capital fueled by the power of social media – became a legal option for small businesses on April 5, 2012 when President Obama signed the Jumpstart Our Business Startups (“JOBS”) Act into law. Among other securities law changes, the JOBS Act allows issuers to raise up to $1 million from a large number of accredited and unaccredited investors by selling securities through a broker or SEC-approved funding portal. When sold through these qualified intermediaries, crowdfunded securities are exempt from the registration requirements of the Securities Act of 1933, as amended (the “Securities Act”), and state securities laws.
Crowdfunding will be available to issuers, investors and intermediaries only after a 270-day rule-making period, in which the Securities and Exchange Commission (“SEC”) and an applicable self-regulatory organization (“SRO”) will issue rules to carry out the crowdfunding measures of the JOBS Act. The specific requirements and procedures required for issuers to avail themselves of these permissions remain yet to be determined, and both supporters and critics await determination as to whether this exemption will be practically useful and/or commercially viable following the adoption and implementation of such rules and regulations.
JOBS Act RequirementsAnnual Investment Cap: For an investor with an annual income or net worth below $100,000, the investor’s annual investment in crowdfunded securities is capped at the greater of $2,000 or 5% of such investor’s annual income or net worth. For an investor with an annual income or net worth above $100,000, the aggregate annual crowdfunded investment is capped at 10% of such investor’s annual income or net worth. Securities sold to investors under the crowdfunding exemption are restricted securities with a one-year holding period, except under certain limited circumstances.
Information Requirements: Issuers offering crowdfunding securities are required to file a minimum threshold of information with the SEC regarding their businesses and provide that information to investors and potential investors through the crowdfunding intermediary they use to sell the securities.
- The initial filing includes: (i) the name, legal status and addresses of the business, (ii) the names of directors, officers and significant shareholders, (iii) a business plan and description of the business, (iv) financial information including, depending on the size of the business, income tax returns and officer-certified financial statements, unaudited financial statements or audited financial statements, (v) a description of the purpose and intended use of the funds, (vi) the target offering amount, (vii) the price of the securities, (viii) the ownership and capital structure of the business, including the terms of each class of the issuer’s securities, risks of minority ownership and methods of valuation for the securities, and (ix) any other information required by the SEC.
- Following the issue of crowdfunding securities, issuers are obligated to submit annual filings to the SEC and investors with reports on operations and financial statements for the prior year.
Restrictions on Issuers: Issuers are prohibited from advertising a crowdfunding offering except for notices directing potential investors to the applicable crowdfunding portal. Issuers cannot compensate any promoter without disclosing the compensation to investors.
Though not required to register the crowdfunded securities, an issuer, including the issuer’s officers, directors or partners, may still be held liable for any material misstatements or omissions under the Securities Act or any state securities laws prohibiting fraud, deceit or unlawful conduct in connection with a securities transaction.
Regulation of Intermediaries: The JOBS Act requires brokers and funding portals to register with the SEC and an applicable SRO as intermediaries between issuers and investors in crowdfunding offerings. Generally, intermediaries are prohibited from compensating promoters or finders and from allowing their officers or directors to take a financial interest in any issuer engaging their services. Funding portals, which are not subject to the extensive registration requirements applicable to a broker, are subject to additional restrictions including prohibitions from offering investment advice, soliciting transactions in securities offered on their portal, compensating any employees or agents for soliciting transactions, holding investor funds or securities, and engaging in any other activities prohibited by the SEC.
Duties of the Intermediaries: Crowdfunding intermediaries, which can be either brokers or SEC-approved funding portals, have substantial duties under the JOBS Act to provide information, reduce the risk of fraud and be responsible for investors’ and issuers’ compliance with the law.
Intermediaries must collect the information an issuer files with the SEC and make that information available to investors and potential investors. In addition to this reporting requirement, the intermediaries are required to obtain background checks on each of an issuer’s officers and directors, and anyone holding more than 20% of an issuer’s equity.
Under the JOBS Act, funding portals and brokers offering crowdfunded securities must:
- provide and require investors to review risk-related disclosures and other education materials;
- require investors to positively affirm they understand the risks of crowdfunding securities by answering questions pertaining to the risks generally applicable investments in start-ups, emerging businesses and small issuers and the risk of illiquidity in crowdfunded securities;
- ensure that investors are limited to the caps on annual investments; and
- protect investor privacy.
The Crowdfunding Basics chart attached here sets forth further descriptions of the applicable provisions of the crowdfunding terms.
Issues to ConsiderCrowdfunding In Practice: For years, founders of small businesses have sought to raise the capital they need to start and grow their businesses from their own networks of family, friends and business associates. The JOBS Act changes the landscape these enterprises must navigate by creating an alternative pathway for small companies to raise a limited amount of capital from a much wider and deeper pool of potential investors. Following the rule-making period, small businesses will be able to plan for their financial future by choosing crowdfunding from among more traditional options such as angel investors, bank loans, government grants and venture capital.
Choosing Crowdfunding: The business decision to crowdfund, however, comes with a new set of legal risks and factors potential issuers must consider.
- Businesses must weigh the benefits of crowdfunding against traditional financing options that may bring more intangible resources and access to future financing.
- The expenses of crowdfunding are still uncertain. Businesses will need to plan for the expense of compliance with the JOBS Act, including the cost of (i) producing the initial filing information and providing annual reports, (ii) creating equity documents and (iii) engaging an intermediary. The magnitude of many of these expenses will remain uncertain until the SEC produces the reporting rules and intermediaries can calculate the costs of compliance, which will be passed on to issuers.
- The disclosures required of issuers in a crowdfunding offering may create risk for competition at a very early stage of product development because of the amount of information that will be publicly available, such as the business plan and financial statements of the business.
- Issuing crowdfunded securities could potentially provide a good way to market a company’s product or service and increase exposure to a wide range of investors and end-users. Conversely, products for which a market does not exist may be weeded out at an earlier stage by public disinterest in funding the business.
- Proper planning of the equity issue will include considering the voting, participation, anti-dilution and repurchase rights of the securities. Issuers will also need to consider restrictions on the use of proceeds from the offering.
Intermediary Concerns: Business entities seeking to become a market participant as a crowdfunding intermediary will have a related set of legal considerations. The major concerns for intermediaries will be the expense of developing the funding portal platform in compliance with the requirements of the JOBS Act, the expense of conducting the required background checks on issuers and their officers, directors and significant shareholders, and the liability of the intermediary for ensuring compliance with applicable rules and regulations for the crowdfunding.
* * * * *The crowdfunding provisions of the JOBS Act are intended to significantly enhance small businesses’ ability to raise capital. As with other recent initiatives to stimulate small business growth through regulatory reform, the impact of such efforts may ultimately look different from what the drafters originally intended. We expect the SEC to respond with additional rulemaking as well as clarifications and guidance and will be tracking those developments as well as the reactions of companies and market participants to this new fundraising model. Please contact your Goodwin Procter LLP attorney or any of the attorney contacts listed here with questions or concerns.