Crowdfunding under the JOBS Act
In 2012, Congress passed the JOBS Act to make it easier for start-up companies and small businesses to raise capital and to provide additional investment opportunities for a wide-range of investors.
Please note that, while this article accurately describes applicable law on the subject covered at the time of its writing, the law continues to develop with the passage of time. Accordingly, before relying upon this article, care should be taken to verify that the law described herein has not changed.
One of the main purposes of the JOBS Act was to alleviate the funding gap and accompanying regulatory concerns faced by start-ups and small businesses when raising equity capital for small dollar thresholds. See JOBS Act, Pub. L. No. 112-106, 126 Stat. 306, 306 (2012).
As is common with new laws, commentators, politicians, and business leaders are split as to whether the JOBS Act will be successful. Most agree crowdfunding under Titles II and IV of the JOBS Act will flourish but are more reserved about Title III. Regardless of one’s confidence in the legislation, it has arrived: the SEC proposed its rules for Title III and Title VI in late 2013, while Title II came into effect on September 23, 2013.
An understanding of crowdfunding’s basic concepts is important for investors and small business owners who want to take advantage of the new exemptions. This article provides a general synopsis of the rules, proposed or final, for each type of crowdfunding under the JOBS Act.
Background of Crowdfunding
“Crowdfunding” describes an emerging method of raising capital that has been used outside of the securities arena to raise funds, usually through Internet websites such as Kickstarter, Kiva, or IndieGoGo, for a variety of projects. There are several flavors of crowdfunding, such as “rewards crowdfunding,” wherein individuals who fund a project usually receive some sort of “reward,” i.e., a t-shirt or prototype. Others styles include “donation crowdfunding,” “lending crowdfunding,” and “pre-purchase crowdfunding.”
Crowdfunding allows entrepreneurs and small business to finance their companies with small contributions of capital from large numbers of individuals instead of using traditional financing methods, i.e., private equity funds, banks, or angel investors.
Historically, crowdfunding has not been used as a means to offer and sell securities because offering a share of a company’s financial returns could trigger the application of the labyrinth of federal securities laws. In response, the JOBS Act created exemptions from the registration requirement and state Blue-Sky laws so this funding method could easily be used to offer and sell securities too. Specifically, Title III was designed to help provide startups and small businesses with capital by making relatively low dollar offerings of securities less costly, while Titles II and IV modified existing rules to effectively allow crowdfunding activities.
Background to the Securities Act of 1933: Registration Requirement
Under Section 5 of the Securities Act of 1933 (“33 Act”), an offer or sale of “securities,” i.e., ownership shares of a business, must be registered with the SEC. Recognizing that full registration is not necessary for all securities issuances, the ’33 Act also offers several exemptions from the registration requirement, usually based on the type of security or the nature and size of the transaction.
Section 4(a) (2) of the ’33 Act provides that an issuer of securities does not have to go through the time and expense of a registered public offering in a transaction “not involving any public offering.” Realizing this abstract language needed clarification, the SEC issued Regulation A and Regulation D, a series of rules guiding issuers through the complexities of private offerings.
As will be discussed in this article, the JOBS Act created or expanded three different kinds of “crowdfunding.” First, Title III created the most high-profile provision of the JOBS Act: the new “crowdfunding” exemption, enacted as Section 4(a)(6) of the ’33 Act. See JOBS Act § 302. Second, Title II of the JOBS Act eliminated the ban on “general solicitation and advertising” in connection with offerings made pursuant to Rule 506 of Regulation D under the ’33 Act. See JOBS Act § 201(a)(1). Finally, Title IV of the JOBS Act expanded Section 3(b) of the ’33 Act by requiring the Securities and Exchange Commission (“SEC”) to increase the maximum offering limit under the Regulation A exemption. See JOBS Act § 401(a). These sections can be summarized as follows:
Title III Crowdfunding has received the most attention and specifically allows for “crowdfunding” activities. This provision allows companies to:
- raise up to $1 million per year,
- using an SEC–registered portal,
- fom an unlimited number of investors who do not have to be accredited,
- wth strict limits on the amount each investor can invest.
Title II Crowdfunding allows companies to raise an unlimited amount of money from an unlimited number of accredited investors using general solicitation and advertising.
Title VI Crowdfunding required the SEC to expand existing Regulation A to permit companies to raise $50 million per year using general solicitation and advertising.
Requirements of Title III Crowdfunding
Title III Crowdfunding is what most people think of when they hear “crowdfunding” in the same sentence as “JOBS Act.” And indeed, Section 302 of the JOBS Act expressly required the SEC to permit “crowdfunding” activities.
As it must when offering other securities, a company relying on Title III’s Crowdfunding exemption must comply with numerous requirements, disclosures, and monetary thresholds. Indeed, there are dozens, if not hundreds, of requirements, as evidenced by the nearly 600 pages of the SEC’s proposed rules. The following are some of the most significant:
- An issuer is permitted to raise a maximum aggregate of $1 million through Title III Crowdfunding offerings in any 12-month period.
- An investor who has an annual income or net worth of less than $100,000 can invest (in a 12-month period) no more than the greater of (a) $2,000 or (b) 5% of his or her annual income or net worth.
- An investor who has an annual income or net worth of $100,000 or more can invest (in a 12-month period) up to 10% of his or her annual income or net worth, with a cap of $100,000.
- The issuer may not use general solicitation and advertising, as it can in Title II or Title IV offerings, but it may advertise to direct potential investors to the portal’s website.
- Securities sold under Title III may not be resold within one year.
Title III Crowdfunding transactions must take place through an SEC-registered intermediary, either a broker-dealer or a “funding portal.” A funding portal is an independent online platform for launching crowdfunding offerings, such as ifunding, Patch of Land, or Poliwogg.
- Intermediaries are required to provide investors with educational materials, take affirmative measures to reduce fraud, provide channels for communication about offerings on the platform, and make information available about the issuer and offering.
- Intermediaries may not solicit investments, offer investment advice, handle investor funds, or compensate employees based on sales.
- Issuers can use only one funding portal at a time.
Non-U.S. companies, certain investment companies, public-reporting companies, companies that failed to comply with the annual reporting requirements, and other companies disqualified by the rules are not eligible to use Title III Crowdfunding.
Issuers must file a disclosure statement with the SEC at least 21 days prior to its first sale in addition to other financial disclosures, such as audited financial statements for sales over $500,000. Among other things, the offering documents must include:
- Information about officers and directors as well as owners of 20 percent or more of the company.
- The price to the public of the securities being offered, the target offering amount, the deadline to reach the target offering amount, and whether the company will accept investments in excess of the target offering amount.
- Certain related-party transactions.
- A description of the financial condition of the company.
- Financial statements and possibly a copy of the company’s tax returns.
- The issuer’s prior offerings, in addition to the prior offerings in which its directors and other principals were involved.
Issuers are required to file an annual report via EDGAR, the SEC’s electronic database, and provide it to investors.
Legal prospectus liability applies to disclosures, with a “knowledge” exception for misstatements and omissions.
An investor harmed by a material misrepresentation or omission in any of the issuer’s required filing materials is accorded a private right of action.
Due diligence is required of the issuer, including background checks on management and large stockholders.
Investors can change their minds up to two days before the investment deadline and must be given the right to terminate the investment in the event of a material change in the investment opportunity.
The issuer must use new Form C to report its Title III offering.
“Bad actors” are excluded from Title III Crowdfunding.
Likely the most notorious condition of Title III Crowdfunding is the $1 million capital ceiling. While Congress believed $1 million was a substantial amount for small businesses, many commentators and small business owners fervently disagree. Nevertheless, the SEC opted not to recommend an increase and the threshold remains at $1 million.
Significantly, the SEC confirmed that capital procured through other offerings, such as Regulation D or Title II, will not be counted towards the $1 million. Thus, an issuer can complete an offering made in reliance on Title III that occurs simultaneously with, or is preceded or followed by, another exempt offering, such as a Title II offering. Of course, an issuer conducting a concurrent exempt offering for which general solicitation is not allowed must be satisfied that purchasers in that offering were not solicited by means of the Title III offering.
For example, if a prospective investor in a concurrent private placement for which general solicitation is not permitted became interested in that private placement through some means other than the Title III offerings, such as through a substantive, pre-existing relationship with the issuer, then the fact that the Title III offering was posted publicly on the intermediary’s platform would not affect the availability of the other private placement exemption. On the other hand, if an investor first discovered the issuer through a solicitation in a Title III offering, that investor would likely not be eligible to participate in a concurrent private placement in which general solicitation is not permitted. See Crowdfunding, 78 Fed. Reg. 66428 (proposed Nov. 5, 2013) (to be codified at 17 CFR 200, 227, 232, 239, 240, 249).
The second major concern for small businesses is the requirement to provide audited financial statements when raising over $500,000. Before proposing the rules, SEC Chairman Mary Jo White emphasized the SEC wanted the “market to thrive, in a safe manner for investors.” Mary Jo White, Chairman, SEC, Remarks at Open Meeting (Oct. 23, 2013) (transcript available at http://www.sec.gov/News/Speech/Detail/Speech/1370540003082#.U6xlOZRdVyI). Of course, “safe” generally means higher costs for the issuer. As the comment period has ended and the SEC is reviewing the comments, it will be interesting to see if this provision remains unchanged in the final rules.
Outlook. Title III tries to balance two competing interests. On one hand, it gives ordinary people the ability to invest in private deals; while on the other hand, it must protect people from the risks inherent in these types of deals. Title III attempts to create a balance by using the tools of traditional securities laws—disclosure, transparency, reporting, and regulation. Unfortunately, the numerous legal caveats, regulatory boundaries, and procedural hurdles in the SEC’s proposed rules simply might be too much for many small companies to afford.
Most commentators believe the SEC will finalize its rules by late 2014, and hopefully, the SEC complies, as small businesses, start-ups, and politicians, eagerly await. Arizona officials believe the State’s business-friendly atmosphere will allow Title III Crowdfunding to make a substantial impact on the economy. In fact, Fast Company magazine published a national ranking of “startup cultures” in 2013, listing Arizona as the fourth best state for innovation, ahead of Massachusetts (i.e., Boston) and even California (i.e., Silicon Valley). "The United States of Innovation: Ranking the States (and a District) For Innovation
," Fast Company (April 15, 2013).
Only after Title III Crowdfunding becomes effective will the marketplace fully understand the usefulness of the exemption. Other blends of crowdfunding have clearly made an impact on the marketplace, but only time will tell whether the JOBS Act created a practical exemption for small-dollar crowdfunding in the cautious securities world.
Title II Crowdfunding: New Rule 506(c)
Many people are confused as to whether raising equity capital through Title III Crowdfunding is the same as crowdfunding under new Rule 506(c). In short, it is not. While Title II of the JOBS Act does not expressly use the term “crowdfunding,” it inevitably permits crowdfunding activities—but to a restricted crowd.
Background. Rule 506(b) of Regulation D describes a type of private offering that has been the preferred method of issuers for many years due to its flexibility and unlimited monetary standards. The rule permits an issuer to raise an unlimited amount of capital through an unlimited number of accredited investors plus 35 non-accredited investors, while exempting the offering from state Blue Sky registration.
However, because it is a “private placement,” Rule 506(b) prohibits “general solicitation and advertising” to find investors. “General solicitation” is a very broad concept that essentially includes any attempt to create a market for the securities being offered. Thus, an issuer could promote an issuance to an existing customer but could not use the Internet to find more.
JOBS Act. Section 201(a) of the JOBS Act required the SEC to eliminate the prohibition on general solicitation under Rule 506 where all purchasers of the securities are “accredited investors” and the issuer takes “reasonable steps” to verify that the purchasers are accredited investors.
To implement Section 201(a), the SEC adopted paragraph (c) of Rule 506. A Rule 506(c) offering, i.e., a Title II Crowdfunding offering, is also exempt from state Blue-Sky registration, but permits an issuer to use “general solicitation and advertising” to raise an unlimited amount of money from an unlimited number of accredited investors, but no unaccredited investors. Like Title III Crowdfunding, “bad actors” are prohibited from using Rule 506(c).
Generally, an “accredited investor” is a natural person who: 1) earned income that exceeded $200,000 (or $300,000 together with a spouse) in each of the prior two years, and reasonably expects the same for the current year; or 2) has a net worth over $1 million, either alone or together with a spouse (excluding the value of the person’s primary residence). An “accredited investor” may also be an entity such as a bank, partnership, corporation, nonprofit or trust, when certain criteria are satisfied.
The JOBS Act requires that issuers wishing to engage in general solicitation take “reasonable steps” to verify the accredited status of purchasers. Rule 506(c) includes a verification method requiring an objective determination by the issuer as to whether the steps taken are “reasonable” in the context of the particular facts and circumstances of each purchaser and transaction. Among the factors that an issuer should consider under this method are:
- the nature of the purchaser and the type of accredited investor that the purchaser claims to be;
- the amount and type of information that the issuer has about the purchaser; and
- the nature of the offering, such as the manner in which the purchaser was solicited to participate in the offering, and the terms of the offering, such as a minimum investment amount.
- In addition, Rule 506(c) includes a non-exclusive list of verification methods that issuers may use, but are not required to use, when seeking greater certainty that they satisfy the verification requirement with respect to natural person purchasers. These methods include:
- verification based on income, by reviewing copies of any Internal Revenue Service form that reports income, such as Form W-2, Form 1099, Schedule K-1 of Form 1065, and a filed Form 1040;
- verification on net worth, by reviewing specific types of documentation dated within the prior three months, such as bank statements, brokerage statements, certificates of deposit, tax assessments and a credit report from at least one of the nationwide consumer reporting agencies, and obtaining a written representation from the investor;
- a written confirmation from a registered broker-dealer, an SEC-registered investment adviser, a licensed attorney or a certified public accountant stating that such person or entity has taken reasonable steps to verify that the purchaser is an accredited investor within the last three months and has determined that such purchaser is an accredited investor; and
- a method for verifying the accredited investor status of persons who had invested in the issuer’s Rule 506(b) offering as an accredited investor before September 23, 2013 and remain investors of the issuer.
Rule 506(b) remains unchanged following the adoption of Rule 506(c) and continues to be available for issuers that wish to conduct a Rule 506 offering without the use of general solicitation or that do not wish to limit sales of securities in the offering to accredited investors. Accordingly, there are now two types of offerings available under Rule 506:
- Traditional Rule 506(b) offerings, in which 35 non-accredited investors can participate, but cannot use general solicitation; and
- New Rule 506(c) offerings, which can use general solicitation, but must be sold to accredited investors only.
Outlook. Rule 506(c) offerings are viewed as an excellent way for companies to raise an unlimited amount of money through crowdfunding activities. Specifically, companies may solicit and advertise to the crowd using resources such as the Internet, television, newspapers, radio, and social media. Of course, companies must take “reasonable steps” to verify the purchasers are accredited investors. However, because the JOBS Act provides several methods to carry out this task, it may not be too big of a hindrance.
Another intriguing issue concerns misstatements and omissions in a company’s advertising materials. Under the ’33 Act, any general solicitation or advertising must not misstate or omit any material information. Thus, companies must make sure its marketing is accurate and truthful, as liability for misstatements still lingers. Now that general solicitation and advertising are permitted, it will be interesting to see how companies overcome the limitations of new technology, e.g., the maximum of 140 characters on Twitter, while satisfying the meticulous securities laws.
Title IV Crowdfunding: Regulation A+
Regulation A has always permitted companies to use general solicitation to find investors, but the drawbacks of Regulation A were detrimental to its utility: a company could raise only $5 million; a “mini-registration” statement must be filed by the issuer with the SEC (very expensive); and offerings were subject to state securities laws in every state where the securities were offered. As a result, Regulation A was not used very often.
In response, Section 401(a) of the JOBS Act directed the SEC to relax Regulation A’s requirements. In December of 2013, the SEC proposed its rules which created what is now referred to as “Regulation A+.” Under the rules, Section 3(b)(2) of the ’33 Act will permit:
- an issuer to raise up to $50 million during any 12 month period
- an issuer to use general solicitation and advertising to find investors.
- an issuer to sell to non-accredited investors, subject to a maximum investment of 10% of the investor’s income or net worth in Regulation A+ offerings.
Regulation A+ offerings are exempt from registration under state Blue-Sky laws.
Of course, Regulation A+ still requires companies to file a “mini-registration” statement with the SEC before any sales are made, including audited financial statements. Moreover, Regulation A+ offerings require significant ongoing reporting to the SEC. Neither Title II Crowdfunding nor Title III Crowdfunding requires a registration statement, mini or otherwise, and Title II is free of most reporting requirements. Nevertheless, the advantages of Regulation A+ could make it appealing for many issuers, particularly with the ability to sell to non-accredited investors.
The Comment Period for the SEC’s Regulation A+ rules closed in March of 2014. The final rules are not expected until early 2015.
In summary, the JOBS Act constructed several new avenues for raising money via the “crowd.” The new legislation lead to substantial changes in the federal securities laws with the goal of providing investors with greater access to the nation’s capital markets. Each method has its benefits and drawbacks, and an issuer should understand the obligations and limitations for whichever approach it selects. One thing is certain, however: Crowdfunding in the securities world has arrived.
If you have questions regarding a possible securities law matter, or to arrange for a consultation concerning your legal matter, please contact Robert Mitchell at firstname.lastname@example.org
or at (602) 452-2730.