This is part 1 of a 2 part post on the five myths of investment crowdfunding. Part 2 is here.
What is “crowdfunding”?
Crowdfunding is a method of raising money to fund a project or venture using the Internet. An entity or individual raising funds through crowdfunding typically seeks small individual contributions from a large number of people. A crowdfunding campaign generally has a specified target amount of funds to be raised and an identified use of those funds.
Rewards/Donation vs. Investment Crowdfunding.
With donation-based crowdfunding, a venture accepts monetary “donations” with no consideration returned (other than recognition). Similarly, in a rewards-based crowdfunding campaign, a venture accepts monetary “contributions” in exchange for some kind of incentive, recognition or promotional gift. These types of campaigns have become popular through the use of Kickstarter, Indiegogo, GoFundMe and other platforms.
Investment crowdfunding, however, is when a company offers investors a share of financial returns or profits generated from business activities being financed. Sometimes this is also referred to as “equity” crowdfunding, but that concept is too narrow. These types of offerings aren’t limited to stock or ownership interests in a company. They can also cover debt and royalty streams as well as other kinds of securities and investment contracts.
Does the campaign involve the offer and sale of a “security”?
The key distinction is whether the campaign involves the offer and sale of a “security,” which triggers regulation under federal and state law. An investment crowdfunding campaign is much more challenging from a regulatory perspective because it triggers a complex web of federal and state securities regulation. The Securities and Exchange Commission (the SEC) identifies eight separate federal statutes (plus related rules and regulations) that govern the securities industry. Each state (including jurisdictions like Washington, D.C. and Puerto Rico) also regulates the offer and sale of securities through local “blue sky” laws. On the federal level, the two primary regulatory schemes are established by the Securities Act of 1933, as amended, and the Securities Exchange Act of 1934, as amended. Section 5 of the Securities Act makes it unlawful to offer and sell securities without first registering them with the SEC, unless the offering falls within an exemption from those registration requirements. The Exchange Act (which is the principal source of reporting obligations for public companies and regulates the secondary trading of securities in the United States) also includes broad anti-fraud provisions, imposing liability for material misstatements and omissions made in connection with the offer or sale of securities. Generally, each state also requires registration, unless an exemption is available. The states also impose anti-fraud liability. More recent legislation like the Jumpstart Our Business Startups Act of 2012 (the JOBS Act) and certain provisions of the Fixing America’s Surface Transportation Act of 2015 have created new pathways for conducting exempt offerings outside of the traditional private placement exemption. Federal and state laws also regulate broker-dealer activities, investment companies and investment advisors, all of which can be implicated by investment crowdfunding.
This article will not discuss all of the technical requirements imposed by these regulations. Of course, these details are of critical importance, and anyone who intends to advise clients on investment crowdfunding will need to carefully read and study the related statutes and regulations. But it would be too hard to cover everything in this article. Instead, in an effort to shine some light on some common misconceptions and “myths” about investment crowdfunding, this article will focus on the big picture and practical realities involved here.
MYTH #1: All crowdfunding is the same.
Beyond the distinction between Rewards/Donation campaign and Investment Crowdfunding, it is important to understand that there are different ways to conduct an investment crowdfunding offering. Companies must strictly adhere to a particular set of rules in order to claim an exemption and to avoid registration requirements. In many instances, the availability of a particular exemption turns, in large part, upon:
• the amount of money an issuer wants to raise,
• the nature of the investor (i.e., whether or not they satisfy certain residency, sophistication or wealth standards),
• the manner by which the offering is conducted (i.e., many exemptions prohibit the use of general solicitation and general advertising to market the securities) and
• the types of disclosures that may be required.
In addition, in some instances, certain types of issuers are prohibited from relying on an exemption. For instance, companies that that file reports under the Exchange Act and certain investment companies cannot use Regulation A or Regulation Crowdfunding.
However, when considering how an investment crowdfunding offering might fit within a particular exemption, the most critical factors will be the amount of money to be raised, the degree to which all of the members of the “crowd” (not just the super-wealthy) can participate, and whether, and how, companies can communicate with potential investors. Many exemptions prohibit the use of general solicitation to market an offering and/or restrict investments to only accredited investors (entities and individuals who meet certain financial standards), both of which are incompatible with the idea of sourcing capital from the “crowd.”
Fundamentally there are four different paths to Investment Crowdfunding:
• Accredited Investor Crowdfunding – These types of offerings rely primarily on the “private placement” exemption found in Rule 506(c) and, in specific situations, Rule 506(b) of Regulation D. There is no limit on the amount of money a company can raise but only “accredited investors” can participate. Typically, there are no mandated disclosures although issuers usually provide investors some information about the issuer, its operations and the offering.
• New Regulation A (as amended by Title IV of the JOBS Act and commonly known as “Regulation A+”) – While there are limits on the amount a company can raise in a 12-month period under new Regulation A ($20 million under tier 1 and $50 million under tier 2), generally anyone can invest (sometimes subject to caps). Issuers submit a detailed disclosure document (including audited financial statements for tier 2 offerings) to the SEC (and, with tier 2 offerings, applicable state regulatory agencies) for review and comment, and issuers engaged in tier 2 offerings typically will be required to comply with on going reporting requirements. But companies can advertise the offerings and, in some instances, will be able to “test the waters” before making any formal filings with the SEC.
• Regulation Crowdfunding – Under the new Section 4(a)(6) exemption established by Title III of the JOBS Act, companies can utilize the Internet to conduct investment crowdfunding campaigns to raise up to $1 million in a 12-month period. Generally, anyone can invest, irrespective of their sophistication or net worth (subject to caps); however, issuers are extremely limited in the manner in which this offering can be conducted. Issuers must use either a SEC registered “funding portal” or registered broker-dealer to conduct the offering and must prepare (and file with the SEC) specific disclosure materials (including audited financial statements, in some circumstances) and must comply with on going reporting requirements once the offering is complete. Funding portals and broker-dealers operating under Regulation Crowdfunding are subject to numerous regulations dictating activities they are required to undertake, as well as those that they are prohibited from undertaking, in connection with an investment crowdfunding offering.
• Local Crowdfunding Exemptions – Many states have established procedures where local companies can conduct exempt investment crowdfunding offerings. These exemptions are established by statute or rule on a state by state basis and are typically structured to rely on the intrastate offering exemption (Section 3(a)(11) and/or Rule 147 of the Securities Act) or the limited offering exemption under Rule 504 of Regulation D. North Carolina has yet to pass such legislation, although a bill structured in reliance upon the intrastate offering exemption may be taken up in the short session this spring . Typically, there are limits on the amounts an issuer can raise. It varies between $1 million and $2 million, and there is a push to raise these thresholds to $5 million.
Typically, anyone can participate, subject to investment caps. Issuers prepare specific disclosure documents (including audited financials in certain circumstances) to be filed with local regulators and may be subject to on going reporting requirements once the offering is concluded.
But wait . . .
Can’t companies use Kickstarter or Indiegogo to sell securities?
At last check, no. Neither of these platforms have adopted programs to enable investment crowdfunding campaigns on their platforms . . . but they might do so in the future.
What if what this issuer is offering isn’t a “security”?
Don’t be fooled. The Securities Act has a broad definition of what it deems to be a security: stock, ownership interests, units, partnership interests, promissory notes, bonds, options, warrants, royalty streams, investment contracts . . . if it involves giving money to someone else to manage with the expectation of profits, you’ve usually got a security.
Aren't some companies are too small to be regulated?
This is just plain not true. Every issuer – irrespective of its size, age or value – must comply with federal and state securities laws.
Aren't some offerings are too small to be regulated?
Again, not true. An offering of any amount is subject to regulation.
There are no de-minimis exceptions.
MYTH #2: Now that we have the JOBS Act, . . . anyone can invest in offerings (not just the “super wealthy”).
Conceptually yes, this is true. But, in practice, it depends on how the offering is structured and which exemption a company wants to use. The JOBS Act aims to reduce capital raising restrictions currently faced by many companies, both by loosening regulations governing private securities offerings and by easing the road to public securities offerings for so-called “emerging growth companies.” However, it achieved these goals in highly complicated regulatory fashion. Some parts of the JOBS Act make it easier for people who are not “accredited investors” to invest in offerings; for instance, Title IV created new Regulation A, which increased the amount of money an issuer can raise in a “mini-public offering” (which can include “retail” investors, sometimes subject to a cap) to up to $50 million. Title III of the JOBS Act created “Regulation Crowdfunding,” which established the structure for true “investment crowdfunding” offerings similar to campaigns we see on Kickstarter and Indiegogo where anyone in the “crowd” can participate (subject to caps). But Title II of the JOBS Act, which eliminated the ban on general solicitation in Rule 506 and Rule 144 offerings, only permits accredited investors to participate.
And . . . companies can freely advertise offerings??
No. They cannot. Just because aspects of the JOBS Act permit the use of general solicitation and advertising, or the use of the Internet, to reach investors does not mean there are no rules to follow. And the rules surrounding what issuers can say, and when, are complex. For instance, under new Regulation Crowdfunding an issuer cannot advertise its offering over the Internet or really make any other kind of public announcement about its offering (other than through a very short press release). The issuer must use a registered funding portal or registered broker-dealer to conduct the offering. Although an issuer can advertise much more freely under the Rule 506(c) exemption, it must be prepared to verify that all of the purchasers are accredited investors. In any event, an issuer should not just go off and advertise an offering without careful planning. It needs to determine which rules apply and then follow them – or the company risks busting its exemption and having to scrap or delay an offering (or even worse, needing to conduct a recession offering to try to “clean up” the problem).
. . . they can even “test the waters” without risk?
Testing the waters is the idea that, before making a lot of costly and time-consuming regulatory filings, an issuer can preview the terms of a specific offer to assess market reaction. If there is positive reaction, then the issuer moves forward with the more complicated aspects of the offering, but, if there isn’t market acceptance, the issuer can stop and reassess its options. In the investment crowdfunding world, the test the waters concept can clearly be used in new Regulation A offerings and, conceptually, in Rule 506(c) offerings. But it is not risk free and it is definitely complicated. There are two primary things to keep in mind. First, there is no clear path to testing the waters under state regulations. Some states do not permit a company to test the waters at all while others require companies to file the materials before first use. So, if state regulation isn’t preempted, it can be hard to navigate the process in an offering that might be conducted in multiple states (which seems hard to avoid when utilizing the “world wide web” to test the waters). Next, companies will have anti-fraud liability on the materials used to test the waters and typically would need to file the materials used to test the waters with regulators. This can impact the content of the materials used to test the waters and requires careful planning and control of the process.
And, with the JOBS Act, we can ignore state “Blue Sky” regulation?
Again – absolutely not. The degree to which the states can regulate an offering depends upon what path a company is pursuing. Some exemptions (like intrastate offerings or Rule 504 offerings) depend on local rules and regulations. In addition, not all federal exemptions preempt blue sky regulation. Preemption generally applies to (1) Rule 506 offerings, (2) Regulation Crowdfunding offerings and (3) tier 2 Regulation A offerings (although there is an ongoing lawsuit that challenges federal preemption of tier 2 offerings). Even with preemption, the states typically can require notice filings and the payment of fees. They also impose anti-fraud liability on offerings. Companies will also need to be cognizant of any state broker-dealer and sales person regulation that may apply to preempted offerings.
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