On October 23, 2013, the U.S. Securities and Exchange Commission (SEC) issued proposed rules to allow securities crowdfunding pursuant to the Jumpstart Our Business Startups Act of 2012 (JOBS Act). The proposed rules are subject to public comment and modification before implementation. Comments are due on or before February 3, 2014. Until final rules become effective (expected in mid-2014), no securities crowdfunding is permitted. The final rules may differ significantly from the proposed rules.
A note regarding different types of crowdfunding. Securities generally consist of equity or debt of a company, including rights to acquire equity in the future. Equity typically consists of common stock or preferred stock. Debt typically consists of debentures or promissory notes, which may be convertible into equity. Do not confuse equity or other securities crowdfunding with non-securities (contribution, donation or reward) crowdfunding through Kickstarter, Indiegogo, RocketHub and other sites which does not currently involve the issuance of equity or debt by your company.
Overview of Proposed Securities Crowdfunding Rules
Here is a brief overview of some of the many provisions in the proposed crowdfunding rules that may be of interest to companies and their founders contemplating raising capital through crowdfunding. The complete version of the proposed rules may be found at http://www.sec.gov/rules/proposed/2013/33-9470.pdf.
Required Use of Registered Intermediary.
One of the principal features of the proposed rules is that securities crowdfunding may be conducted only through an intermediary registered with both the SEC and the Financial Industry Regulatory Authority (FINRA). The intermediary must be either a registered “funding portal” or a registered “broker-dealer”.
You and your company cannot act as your own intermediary or offer securities directly to investors. No equity crowdfunding or solicitation is allowed through your own website! You and your company are not allowed to communicate directly with potential investors. Communication is permitted only through a single, registered crowdfunding intermediary, chosen by you, that complies with applicable regulations (and only after your company has filed required information with the SEC as noted below). Your company will have the ability to choose an intermediary from all registered funding portals and all registered broker-dealers that offer crowdfunding services.
Limitations on Investments.
The proposed rules contain extensive limitations and requirements applicable to a crowdfunding offering by your company, including the following:
Your company may not raise more than $1,000,000 during any 12-month period using crowdfunding.
Limitations also apply to the total dollar amount invested by each investor in crowdfunding transactions during any 12-month period, depending on the investor’s annual income or net worth (excluding the value of the investor’s principal residence). The limitations are:
- Maximum of $2,000 or 5 percent of the investor’s annual income or net worth, whichever is greater, if both the annual income and the net worth of the investor are less than $100,000.
- Maximum of 10 percent of the investor’s annual income or net worth, whichever is greater, if either the annual income or the net worth of the investor is equal to or more than $100,000. During the 12-month period, these investors would not be able to purchase more than $100,000 of securities through crowdfunding.
SEC Form C Filing.
Your company must file relatively detailed information with SEC on new Form C, including:
- Description of the business and business plan of the company
- Description of the purpose and intended use of the offering proceeds
- Description of the offering, including target dollar amount, deadline and progress updates
- Description of the terms of the securities, including the number of securities being offered, any limitations on voting rights, and how the terms of the securities may be modified
- Description of how the securities are being valued (valuation method) and examples of how such securities may be valued by the company in the future
- Price of the securities or the method for determining the price
- Disclosure of financial condition of company, including results of operations, liquidity and capital resources
- Disclosure of ownership and capital structure of company
- Disclosure of information regarding officers, directors and 20% owners, including business experience during the last 3 years, and transactions between the company and related parties
- Disclosure of the amount of compensation paid to the intermediary for conducting the offering
- Risk factors relating to investment in the company, including factors that make an investment in the company speculative or risky, plus factors relating to lack of control by the investor and the potential impact of corporate actions such as additional issuances of securities and dilution
- Financial disclosure based on the size of the offering and any other crowdfunding offering by the company in the last 12 months, as follows:
- a company offering $100,000 or less is required to file income tax returns for the most recently completed year (if any) and financial statements that are certified by the principal executive officer to be true and complete in all material respects;
- a company offering more than $100,000, but not more than $500,000, is required to file financial statements reviewed by an independent public accountant; and
- a company offering more than $500,000 is required to file financial statements audited by an independent public accountant.
All of this information will be filed and made publicly available (indefinitely) through the SEC’s electronic reporting system known as EDGAR.
Financial statements must include a balance sheet, income statement, statement of cash flows and statement of changes in owners’ equity, must be prepared in accordance with U.S. generally accepted accounting principles (U.S. GAAP), and must cover at least the shorter of the two most recently completed fiscal years or the period since inception of the business.
Eligibility and disqualification.
In order to be eligible to file SEC Form C, your company must be organized under the laws of a state or territory of the United States or the District of Columbia. Foreign companies are not allowed to conduct a crowdfunded offering in the U.S. In addition, you will not be permitted to file Form C if your company has no specific business plan or has indicated that its business plan is to engage in a merger or acquisition with an unidentified company. Also excluded are companies that are subject to public securities reporting requirements under the Securities Exchange Act of 1934, investment companies as defined in the Investment Company Act of 1940 and certain other companies. Finally, your company may be disqualified from crowdfunding offerings if the company or any of its officers, directors, 20% owners or promoters is the subject of certain criminal convictions, securities injunctions or regulatory orders.
State Securities Filings.
Your company may be required to file a separate notice with the securities regulatory agency in the state where company is based and any state where 50% or more of securities are sold. For instance, if your company is based in California or sells a majority of the securities in California, you are required to file a notice with the Securities Regulation Division of the California Division of Corporations (formerly the Department of Corporations) and pay the applicable filing fee.
After conducting a crowdfunding offering, your company is required annually to file with the SEC and post on your company’s website a report including results of operations and financial statements. This information will be publicly available through the SEC’s EDGAR electronic reporting system.
Your company is generally NOT permitted to advertise the crowdfunding offering of securities, except publication of a relatively limited notice that refers interested persons to the registered intermediary for the offering (with a link to the website of the intermediary).
Your company is generally not permitted to compensate any person to promote the securities offering outside of the communication channels provided by the registered intermediary for the offering. Your company is permitted to compensate persons to promote the securities offering using the communication channels provided by the registered intermediary for the offering, such as the website of the intermediary, if (1) the promoter clearly discloses the receipt of compensation (both past and prospective) each time the person makes a promotional communication, and (2) compensation is not based on the amount of securities purchased by investors (no sales commissions) unless the promoter is a registered broker-dealer.
Restrictions on Resales.
Securities issued in a crowdfunding offering may not be transferred by the investor for one year after the date of purchase, except when transferred: (1) to the company that issued the securities; (2) to an accredited investor (as defined in applicable regulations); (3) as part of an offering registered with the SEC; or (4) to a family member of the investor or the equivalent, or in connection with certain events, including death or divorce of the investor, or other similar circumstances.
Your company and its officers and directors are liable to investors for material misstatements or omissions in connection with offering. To help protect against personal liability of officers and directors, your company should strongly consider obtaining director and officer liability insurance before starting the crowdfunding offering process. All of your Company’s proposed crowdfunding activities and proposed disclosures should be reviewed in advance by qualified securities counsel. All tax returns and financial statements should be prepared with the assistance of qualified accounting professionals.
Proposed Rules Applicable to Funding Portals
In order to act as a funding portal under the proposed rules, a funding platform operator:
- Must register with the Securities and Exchange Commission (SEC) and comply with SEC and applicable state rules
- Must register with the Financial Industry Regulatory Authority (FINRA) and comply with FINRA and applicable state rules
- May be registered broker-dealers but broker-dealer status is not required
- Must conduct background checks and securities regulatory history checks on the company and the company’s officers, directors and 20% owners
- Must take various measures to reduce risk of fraud and maintain certain detailed records, including information regarding companies, investors and all communications that occur on or through the platform of the funding portal
- Must have an objective, reasonable basis to believe that the investor satisfies the applicable investment limitations
- Must deliver certain disclosures to investors, including disclosures related to investment risks and other investor education materials
- Must disclose to investors the manner in which the funding portal operator is compensated
- Cannot own stock or have any other financial interest in your company
- Must post and maintain the required company information for at least 21 days before the first sale of securities
- Must provide communication channels by which investors can communicate with one another and with representatives of the company about offerings of the company’s securities
- Cannot provide investment advice or recommendations to investors
- Cannot solicit purchases, sales or offers to buy securities (or compensate others for solicitation)
- May advertise the funding portal itself
- May compensate others for referring companies and investors to the portal but generally may not base the compensation on the purchase or sale of securities (no sales commissions allowed)
- May pay sales commissions or other transaction-based compensation to a registered broker-dealer and may provide services to a registered broker-dealer
- Cannot handle securities or investor funds but may accept investor commitments
- May be liable to investors for material misstatements or omissions in connection with offerings conducted on the platform of the funding portal, including misstatements and omissions contained in materials furnished by a company issuing securities
Final rules from the SEC are not expected until mid-2014, and the SEC is likely to make some changes to the rules based on public comment. If you would like to comment on the rules, go to the SEC’s website at http://www.sec.gov/rules/proposed.shtml. After final rules are issued, much will depend on early experience in the crowdfunding marketplace, including the success of companies in raising capital through funding portals and the adequacy of investor protections. If you believe that crowdfunding is right for your company, you should select your company’s crowdfunding intermediary and any promoters with care and after appropriate research. Companies face a high risk of legal action from unhappy investors if business performance does not meet investor expectations. Good disclosure by companies before accepting investment, including thoughtful identification of company-specific risks, will provide a first line of defense against a securities fraud claim. Companies that provide minimal disclosure or create unrealistic expectations or that rely on boilerplate risk factors will be disadvantaged if faced with an investor lawsuit. Your company should not take a “fill in the blank” approach to disclosure requirements or rely on your funding portal to identify issues in your company’s disclosure materials, especially where investors may have no prior experience with you or your company or with the risks associated with investing in a company such as yours. Also keep in mind that the SEC does not review or approve your company’s crowdfunding disclosure or offering. You and your company are responsible for ensuring compliance with the crowdfunding rules and other securities regulations. Thorough disclosure, good legal counsel and good accounting advice can greatly reduce the risk of successful investor claims. In addition, director and officer liability insurance may help protect against personal liability of individual directors and officers in the event of an investor claim.
Copyright © 2013 David P. Horne. All rights reserved. All trademarks are property of their respective owners.
Below is the SEC press release regarding the proposed crowdfunding rules from the SEC website www.sec.gov.
SEC Issues Proposal on Crowdfunding
FOR IMMEDIATE RELEASE
Washington D.C., Oct. 23, 2013 —
The Securities and Exchange Commission today voted unanimously to propose rules under the JOBS Act to permit companies to offer and sell securities through crowdfunding.
Crowdfunding describes an evolving method of raising capital that has been used outside of the securities arena to raise funds through the Internet for a variety of projects ranging from innovative product ideas to artistic endeavors like movies or music. Title III of the JOBS Act created an exemption under the securities laws so that this type of funding method can be easily used to offer and sell securities as well. The JOBS Act also established the foundation for a regulatory structure for this funding method.
SEC Chair Mary Jo White noted that the intent of the JOBS Act is to make it easier for startups and small businesses to raise capital from a wide range of potential investors and provide additional investment opportunities for investors.
“There is a great deal of excitement in the marketplace about the crowdfunding exemption, and I’m pleased that we’re in a position to seek public comment on a proposal to permit crowdfunding,” said Chair White. “We want this market to thrive in a safe manner for investors.”
The SEC is seeking public comment on the proposed rules for a 90-day period following their publication in the Federal Register.
# # #
SEC Open Meeting
Oct. 23, 2013
Crowdfunding is a term used to describe an evolving method of raising money through the Internet. For several years, this funding method has been used to generate financial support for such things as artistic endeavors like films and music recordings, typically through small individual contributions from a large number of people.
While crowdfunding can be used to raise funds for many things, it generally has not been used as a means to offer and sell securities. That is because offering a share of the financial returns or profits from business activities could trigger the application of the federal securities laws, and an offer or sale of securities must be registered with the SEC unless an exemption is available.
Congress created an exemption to permit securities-based crowdfunding when it passed the JOBS Act last year. Among other things, the JOBS Act was intended to help alleviate the funding gap and accompanying regulatory concerns faced by startups and small businesses in connection with raising capital in relatively low dollar amounts.
Title III of the JOBS Act established the foundation for a regulatory structure that would permit these entities to use crowdfunding, and directed the SEC to write rules implementing the exemption. It also created a new entity – a funding portal – to allow Internet-based platforms or intermediaries to facilitate the offer and sale of securities without having to register with the SEC as brokers. Together these measures were intended to facilitate capital raising by small businesses while providing significant investor protections.
Consistent with the JOBS Act, the proposed rules would among other things permit individuals to invest subject to certain thresholds, limit the amount of money a company can raise, require companies to disclose certain information about their offers, and create a regulatory framework for the intermediaries that would facilitate the crowdfunding transactions.
Under the proposed rules:
- A company would be able to raise a maximum aggregate amount of $1 million through crowdfunding offerings in a 12-month period.
- Investors, over the course of a 12-month period, would be permitted to invest up to:
- $2,000 or 5 percent of their annual income or net worth, whichever is greater, if both their annual income and net worth are less than $100,000.
- 10 percent of their annual income or net worth, whichever is greater, if either their annual income or net worth is equal to or more than $100,000. During the 12-month period, these investors would not be able to purchase more than $100,000 of securities through crowdfunding.
Certain companies would not be eligible to use the crowdfunding exemption. Ineligible companies include non-U.S. companies, companies that already are SEC reporting companies, certain investment companies, companies that are disqualified under the proposed disqualification rules, companies that have failed to comply with the annual reporting requirements in the proposed rules, and companies that have no specific business plan or have indicated their business plan is to engage in a merger or acquisition with an unidentified company or companies.
As mandated by Title III of the JOBS Act, securities purchased in a crowdfunding transaction could not be resold for a period of one year. Holders of these securities would not count toward the threshold that requires a company to register with the SEC under Section 12(g) of the Exchange Act.
Disclosure by Companies
Consistent with Title III of the JOBS Act, the proposed rules would require companies conducting a crowdfunding offering to file certain information with the SEC, provide it to investors and the relevant intermediary facilitating the crowdfunding offering, and make it available to potential investors.
In its offering documents, among the things the company would be required to disclose:
- Information about officers and directors as well as owners of 20 percent or more of the company.
- A description of the company’s business and the use of proceeds from the offering.
- 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 of the company that, depending on the amount offered and sold during a 12-month period, would have to be accompanied by a copy of the company’s tax returns or reviewed or audited by an independent public accountant or auditor.
Companies would be required to amend the offering document to reflect material changes and provide updates on the company’s progress toward reaching the target offering amount.
Companies relying on the crowdfunding exemption to offer and sell securities would be required to file an annual report with the SEC and provide it to investors.
One of the key investor protections Title III of the JOBS Act provides for crowdfunding is the requirement that crowdfunding transactions take place through an SEC-registered intermediary, either a broker-dealer or a funding portal. Under the proposed rules, the offerings would be conducted exclusively online through a platform operated by a registered broker or a funding portal, which is a new type of SEC registrant.
The proposed rules would require these intermediaries to:
- Provide investors with educational materials.
- Take measures to reduce the risk of fraud.
- Make available information about the issuer and the offering.
- Provide communication channels to permit discussions about offerings on the platform.
- Facilitate the offer and sale of crowdfunded securities.
The proposed rules would prohibit funding portals from:
- Offering investment advice or making recommendations.
- Soliciting purchases, sales or offers to buy securities offered or displayed on its website.
- Imposing certain restrictions on compensating people for solicitations.
- Holding, possessing, or handling investor funds or securities.
The proposed rules would provide a safe harbor under which funding portals can engage in certain activities consistent with these restrictions.
The Commission will seek public comment on the proposed rules for 90 days. The Commission will then review the comments and determine whether to adopt the proposed rules.
Here is a link to the complete set of rules proposed by the SEC:
Note that the proposed rules are subject to modification by the SEC before implementation.