On October 30, 2015, the Securities and Exchange Commission (SEC) adopted long-awaited final rules that will allow for the offer and sale of securities through online crowdfunding (known as "Regulation Crowdfunding"). The adoption of crowdfunding rules completes the last major rulemaking mandate for the SEC under the JOBS Act. When the rules become effective, companies will be able to raise up to $1 million in any 12-month period through online crowdfunding portals. The new crowdfunding rules will be effective 180 days after they are published in the Federal Register, which has not occurred as of the publication of this alert.
Non-securities-based forms of crowdfunding have been around for a while. Many start-up companies have used donation-based crowdfunding to raise capital for a variety of business ideas. However, people giving money in these crowdfunding events have been unable to reap a return on the money invested and usually just donate their money to support a product, cause, or entrepreneur. These crowdfunding donors often receive products or promotional items, but companies have been unable to offer or sell securities in these crowdfunding campaigns.
Some companies have taken advantage of the exemption from registration found in Rule 506(c) of Regulation D, which was adopted by the SEC in 2013, to broadly advertise sales of securities. Some have referred to these offerings as crowdfunding. However, unlike the crowdfunding rules adopted by the SEC on October 30, Rule 506(c) only allows for sales of securities to accredited investors, among other differences.
Once Regulation Crowdfunding becomes effective, companies will be able to engage in crowdfunding to offer and sell securities through online funding portals. These rules contain a number of restrictions and obligations, as outlined in the SEC's final rule release on Regulation Crowdfunding.
The following is a brief overview of some of the key provisions of Regulation Crowdfunding. Further details can be found in the SEC's final rule release.
Companies may raise no more than $1 million under Regulation Crowdfunding in a 12-month period.
Certain companies are ineligible to conduct crowdfunding offerings through Regulation Crowdfunding. Ineligible companies include:
- Non-U.S. companies,
- Exchange Act reporting companies,
- Certain investment companies,
- Companies that are disqualified under Regulation Crowdfunding's disqualification rules (e.g., companies with "covered persons" who have been convicted of certain securities-related violations),
- Companies that have failed to comply with the annual reporting requirements under Regulation Crowdfunding during the two years immediately preceding the filing of the offering statement, and
- Companies that have no specific business plan or have indicated that their business plan is to engage in a merger with an unidentified company or companies.
During any 12-month period, individual investors may invest no more than:
- If either their annual income or net worth is less than $100,000, then the greater of:
- $2,000 or
- 5 percent of the lesser of their annual income or net worth;
- If both their annual income and net worth are equal to or more than $100,000, 10 percent of the lesser of their annual income or net worth; and
- During the 12-month period, the aggregate amount of securities sold to an investor through all crowdfunding offerings may not exceed $100,000.
Securities purchased in a crowdfunding transaction generally cannot be resold for a period of one year.
An advertising notice, similar to "tombstone ads" under Securities Act Rule 134, that includes the terms of the offering can include no more than:
- A statement that the issuer is conducting an offering, the name of the intermediary through which the offering is being conducted, and a link directing the investor to the intermediary's platform;
- The terms of the offering, which include:
- The amount of securities offered;
- The nature of the securities;
- The price of the securities; and
- The closing date of the offering period; and
- Factual information about the legal identity and business location of the issuer, limited to the name of the issuer; the address, phone number and website of the issuer; the e-mail address of a representative of the issuer; and a brief description of the business of the issuer.
Form C and Offering Statement
Issuers engaged in a crowdfunding offering must file a Form C with the SEC and provide it to investors and the relevant broker or funding portal. Form C must contain the following disclosures:
- The name, legal status, physical address, and website address of the issuer;
- The names of the directors and officers (and any persons occupying a similar status or performing a similar function), and each person holding more than 20 percent of the shares of the issuer;
- A description of the business of the issuer and the anticipated business plan of the issuer;
- A description of the financial condition of the issuer;
- A description of the stated purpose and intended use of the proceeds of the offering sought by the issuer with respect to the target offering amount;
- The target offering amount, the deadline to reach the target offering amount, and regular updates about the progress of the issuer in meeting the target offering amount;
- The price to the public of the securities or the method for determining the price; and
- A description of the ownership and capital structure of the issuer.
Additional disclosure requirements include:
- The compensation to be paid to the intermediary;
- Website where investors will be able to find the issuer's annual report and the date by which it will be available on the website;
- Whether the issuer previously has failed to comply with the ongoing reporting requirements of Regulation Crowdfunding;
- The current number of employees;
- Risk factor disclosure tailored to the issuer's business and the offering;
- Description of the material terms of any indebtedness;
- Information about each exempt offering within the past three years; and
- Certain related party transactions since the beginning of the issuer's last fiscal year (related parties include any person who is the beneficial owner of 20 percent or more of the issuer's outstanding voting equity securities).
In addition, the rules include a catch-all provision that requires issuers to disclose any material information necessary to make the statements made, in light of the circumstances under which they were made, not misleading.
Issuers must also include in the offering statement specified legends about the risks of investing in a crowdfunding transaction.
In connection with its financial statements, an issuer must provide a discussion of its financial condition. This discussion should address, to the extent material, the issuer's historical results of operations, in addition to its liquidity and capital resources. No particular format is required, but this discussion should also take into account the proceeds of the offering and any other known or pending sources of capital.
Financial statements must be prepared in accordance with U.S. generally accepted accounting principles (GAAP), and all financial disclosures must cover the shorter of the two most recently completed fiscal years or the period since inception of the business.
The minimum financial disclosure requirements are based on the amount offered and sold through crowdfunding within the preceding 12-month period, as follows:
- Issuers offering $100,000 or less:
- Disclosure of the amount of total income, taxable income, and total tax as reflected in the issuer's federal income tax returns certified by the principal executive officer (tax returns need not be provided), and financial statements certified by the principal executive officer. If financial statements are available that have been reviewed or audited by an independent public accountant, the financial statements must be provided instead.
- Issuers offering more than $100,000 but not more than $500,000:
- Financial statements reviewed by an independent public accountant. If financial statements are available that have been audited by an independent public accountant, the financial statements must be provided instead.
- Issuers offering more than $500,000:
- First-time issuers must provide financial statements either reviewed or audited by an independent public accountant.
- Issuers that have previously sold securities in reliance on Regulation Crowdfunding must provide financial statements audited by an independent public accountant.
Interim financial statements are not required. However, any material changes since the period for which financial statements are provided must be included in the required discussion of financial condition and results of operations.
Ongoing Reporting Requirements
Issuers that have sold securities in a crowdfunding transaction will be required to file an annual report with the SEC, and post it on the issuer's website, no later than 120 days after the end of the fiscal year covered by the report. The financial statements included in the annual report are only required to be certified by the principal executive officer as true and complete in all material respects. However, if financial statements that have been reviewed or audited by an independent certified public accountant are available, they must be provided instead.
The issuer will be required to disclose in its annual report information about the company and its financial condition, as required in Form C in connection with the offer and sale of the securities.
Issuers will be required to file annual reports until the earliest of the following events occurs:
- The issuer is required to file reports under Exchange Act Section 13(a) or 15(d);
- The issuer has filed at least one annual report and has fewer than 300 holders of record;
- The issuer has filed at least three annual reports and has total assets that do not exceed $10 million;
- The issuer or another party purchases or repurchases all of the securities issued through crowdfunding transactions, including any payment in full of debt securities or any complete redemption of redeemable securities; or
- The issuer liquidates or dissolves in accordance with state law.
Certain accommodations were made for crowdfunding offering reports that differ from traditional filings made on EDGAR, the SEC's reporting system for public companies.
All crowdfunding transactions must take place through an SEC-registered intermediary, either a broker-dealer or a new type of SEC registrant called a "funding portal." The intermediary must also be a member of a national securities association registered under Exchange Act Section 15A (FINRA is currently the only one). Also, the intermediary's directors, officers, or partners (or similar persons) may not have any financial interest in an issuer using its services in connection with a crowdfunding transaction.
Crowdfunding intermediaries are required to do the following:
- Provide investors with educational materials;
- Take measures to reduce the risk of fraud (e.g., perform background checks on issuers and issuers' officers and directors);
- Provide communication channels to permit discussions about offerings on the platform; and
- Facilitate the offer and sale of crowdfunded securities.
Regulation Crowdfunding prohibits funding portals from:
- Offering investment advice or making recommendations;
- Soliciting purchases, sales, or offers to buy securities offered or displayed on its platform;
- Compensating promoters and others for solicitations or based on the sale of securities; and
- Holding, possessing, or handling investor funds or securities.
Certain safe harbors are available for funding portals to help in their compliance efforts. Intermediaries must also take measures, as outlined in Regulation Crowdfunding and the final rule release, to reduce the risk of fraud with respect to crowdfunding transactions.
Lastly, security holders who acquired their securities through crowdfunding do not count toward the threshold that requires an issuer to register its securities with the SEC under Section 12(g) of the Exchange Act if the issuer (1) is current in its annual reporting obligation, (2) retains the services of a registered transfer agent, and (3) has less than $25 million in assets.
Many entrepreneurs have shown significant interest in this method of capital raising for some time, and it is likely that many will now look to raise money through crowdfunding. If you have any questions, please contact the Venable attorney with whom you work, one of the authors, or a member of Venable's Corporate Finance and Securities Team.