On October 30, 2015, the SEC adopted the much-anticipated final rules governing equity crowdfunding. These rules allow companies to raise capital in securities offerings over the internet from a broader range of individual investors than ever before. The rules are expected to become effective in May 2016.
Equity crowdfunding has been heralded as a boon to both startups and individual investors. It is expected to be especially attractive to smaller startups that do not require large amounts of capital to reach the next stage of development, as it will allow such companies to attract capital from larger audiences. It is also expected to be popular with smaller investors who to date have had very little access to opportunities to invest in startups and have less capital to deploy than the typical startup investor. Moreover, entrepreneurs who cannot (yet) garner, or do not want, investment from traditional VCs or angel investors will be able to raise funds more easily from friends, family, fans, the local community and other interested individuals without the management and exit implications and the legal and other costs that come with traditional angel or venture capital investment. Finally, it is expected that entrepreneurs may turn to equity crowdfunding as a first step in demonstrating market interest before trying to access more typical sources of startup capital.
Crowdfunding Regulation Essentials.
The new rules permit startups to raise $1 million of equity in crowdfunding in any 12-month period and allow any individual to invest in securities of a crowdfunding company, subject to certain limits. Until the effective date, only “accredited investors”, those either earning $200,000 in annual income (or $300,00 if married) or having $1 million in net worth (exclusive of the value of their home), are permitted to invest. Under the new rules, however, any investor may equity crowdfund, subject to the following:
|If the crowdfunding investor has:||His/her maximum crowdfunding investment in any 12 months is:|
|either annual income or net worth less than $100,000||greater of|
|both annual income and net worth equal or greater than $100,000,||10% of lesser of lesser of annual income or net worth|
No investor, no matter his or her net worth, is allowed to invest more than $100,000 through equity crowdfunding in any 12-month period.
Securities issued in a crowdfunding must be issued through an SEC-registered internet portal, and are subject to a one-year restriction on resale with certain limited exceptions.
Considerations for Startups
While equity crowdfunding under the new rules has yet to be tested, there are some key considerations startups should take into account in deciding whether to raise capital via crowdfunding.
Crowdfunding Disclosure Requirements.
One paramount consideration is that the rules require significant disclosures by the issuer to provide greater transparency to small investors. Issuers must prepare and submit to the SEC frequent and comprehensive filings, including the following:
- Initial filing (Form C) containing significant disclosures about the business as well as the offering itself. Financial statements must be included and, depending on the size of the company, must be either reviewed or audited by an independent certified public account
- Amendment filings (Form C/A) if there are material changes in previous disclosures
- Periodic update filings (Form C/U) when certain milestones are met (such as receiving commitments for 50% of the target offering amount)
- Annual reports (Form C-AR) including financial statements reviewed by an independent CPA
- Termination filings (Form C-TR) when the company’s reporting obligations may be terminated upon certain milestones (such as having already filed at least none annual report and having less than 300 stockholders).
These documents also require disclosure of information concerning the price to the public of the securities being offered, the method for determining the price, the target offering amount and the deadline to reach that offering amount, a discussion of the company’s financial condition, a description of the company’s business and the use of proceeds from the offering, and details regarding the officers, directors and any 20% shareholders of the company and any related party transactions.
Much of this information and these documents must be provided to investors and/or the intermediary, or posted on the issuer’s own website. Compliance with these ongoing and detailed disclosure requirements will be costly (from both legal and accounting perspectives) and time-consuming for smaller companies. It should be noted that issuers who fail to comply with these rules risk losing their exemption from securities registration and being held in violation of federal securities laws (especially if material misstatements or omissions are made). The SEC has indicated that because the rules are new, it will be keeping a watchful eye on how the crowdfunding process develops.
In addition, crowdfunded companies may be subject to even more burdensome disclosure requirements if they acquire in excess of 500 non-accredited shareholders and have total assets over $25 million. Once these thresholds are crossed, issuers will have a two-year grace period before being required to formally register their securities under Section 12(g) with the SEC and file public reports with the SEC like a public company that has undergone an IPO.
Companies issuing shares via crowdfunding are permitted under the new rule to concurrently raise capital using certain traditional private fundraising methods often used by startups (such as under Regulation D of the Securities Act, Regulation A, Rule 701 (covering employee benefit plans) and Regulation S (dealing with offshore offerings)). If an issuer intends to pursue concurrent offerings or subsequent offerings in close proximity to a crowdfunding issuance, it needs to pay close attention to the complex rules governing each type of offering (like rules prohibiting general solicitation and advertising) so as not to trip up the other offering(s).
Impact on Shareholder Base.
Startups also should consider the consequences of having a large and disparate group of potentially unsophisticated investors as shareholders, and the impact that may have on corporate governance and the company’s ability to raise significant capital in the future from traditional angel and VC investors. Having such a shareholder base may make it more difficult to obtain shareholder approval of those types of corporate transactions requiring shareholder consent given that the shareholders may be numerous, will not be personally known to the company and may be quite unsophisticated. Even if desired approvals can be obtained, they may not be able to be obtained in a timely fashion without undue effort and expense. Furthermore, crowdfunded companies that acquire a significant number of small individual investors may find themselves precluded from raising capital at a later date from more traditional funding sources, which tend to value companies with fewer shareholders all of whom are personally known to management.
Thus, understanding the SEC’s regulatory framework for both crowdfunding and other securities offerings, as well as taking into account the corporate governance, legal, financial, practical and operational impact of equity crowdfunding, will be essential to any startup’s decision to pursue equity crowdfunding. While crowdfunding can provide access to a larger pool of investors, there may be significant and ongoing burdens for companies that engage in equity crowdfunding that startups must carefully consider, in light of their capital needs before joining the crowd.
Christine B. Padlan,
with Karen Masterson Dienst