Trending publication

09.08.2014 | Article

Early-stage companies need tremendous amounts of cash to grow rapidly. Yet, angel groups and venture-capital firms are not usually a realistic option for early stage startups. Additionally, entrepreneurs often find that financing options such as savings, friends, family, and bank loans, even if available, cannot cover the high startup costs attendant to growing a business. Recently, the media has anointed “crowdfunding” as the solution to this startup capital gap. But what exactly is crowdfunding?

Basics: Equity or Reward Crowdfunding

The concept behind crowdfunding is straightforward: an entrepreneur solicits the public (i.e., the “crowd”) for many small contributions to grow his or her business. The benefits from this type of fundraising are clear — an entrepreneur avoids awkward appeals to friends and family for money, sidesteps the challenges of obtaining and repaying a commercial loan, and postpones fundraising pitches to angel groups and venture capitalists until the company is more viable. Things get murky, however, when we look to what a company may offer in exchange for the crowd’s money.

Companies may issue debt or equity securities in regulated transactions or offer various rewards in an unregulated transaction. Such rewards may include pre-purchases, other products, services, digital downloads, name recognition or anything else of value to the donor (including, in one well publicized case, saying the donors’ names while making potato salad on webcam).

Reward based crowdfunding-transactions, popularized by web intermediaries like Kickstarter, are free of securities regulations, but companies may have to consume precious cash to fund the production and distribution of rewards.

Equity crowdfunding has the promise of helping companies raise large amounts of money from investors without the attendant costs of delivering a reward. In order to engage in equity crowdfunding, however, companies must be careful to comply with applicable securities laws.

So how burdensome are the securities laws, and what did the JOBS Act actually do?

Federal and state laws prohibit companies from offering “securities” to the public unless the securities are registered with applicable regulators (an expensive process typically available to only well-established companies) or exempt from registration. “Securities” include any interest in a company’s profits, such as stock, LLC membership and convertible debt. Penalties for violating securities laws include repayment of funds raised, fines, and bars from future securities offerings, all of which can halt a company’s growth.

On April 5, 2012, Congress passed the Jumpstart Our Business Startups (“JOBS”) Act of 2012. The JOBS Act authorized the creation of two distinct equity crowdfunding options that are exempt from securities registration requirements: (1) Rule 506(c) crowdfunding, which permits sales to only “accredited investors” and (2) portal crowdfunding, which permits sales to the general public.

Rule 506(c) Crowdfunding – Sales to High Net-Worth Individuals

Effective since September 23, 2013, Rule 506(c) under the Securities Act of 1933 (the “Securities Act”), permits companies to offer securities to the general public through general solicitations, including via social media, television, magazines, and websites, without registering such transaction with federal or state regulators. In order to rely on Rule 506(c), however, companies must:

1. Sell their securities only to “accredited investors,” such as private funds and individuals with at least $1 million in net worth (excluding primary residence) or $200,000 in annual income ($300,000 with spouse) in each of the past two years; and

2. Take “reasonable” steps to verify each purchaser’s accredited investor status.

The Securities and Exchange Commission (the “SEC”) — the federal regulator responsible for adopting Rule 506(c) and monitoring its compliance — has confirmed that companies may not rely on purchaser self-certifications to satisfy their accredited investor verification obligations. The SEC has also declined to adopt a comprehensive list of verification methods, leading to some uncertainty. Specific methods that the SEC has so far endorsed include (a) reviewing purchaser financial disclosures (e.g., W-2’s, brokerage statements, credit reports) and representations to confirm that they meet accredited investor income or net worth minimums and (b) obtaining a certification from a registered broker, adviser, CPA, or lawyer as to a purchaser’s accredited investor status.

Entrepreneurs should carefully consider their target investors before engaging in a Rule 506(c) offering. Once a startup begins advertising its offering under Rule 506(c), it may be temporarily prohibited from relying on other exemptions that do bar general solicitations. Also, while industry groups like the Angel Capital Association and Securities Industry and Financial Markets Association have issued guidance to help streamline the verification process, many accredited investors will balk at the idea of disclosing personal financials.

Portal Crowdfunding – Equity Sales to the General Public

Pursuant to its authority under the JOBS Act, the SEC has proposed, but not finalized, rules that would permit companies to sell up to $1 million in securities to the general public (i.e., to both non-accredited and accredited investors), in any twelve-month period without having to register those shares with the SEC or state regulators.

Although superficially akin to the Kickstarter model, the SEC rules would impose significant regulatory requirements on participating startups, investors and intermediaries, including:

1. Individuals’ non-Rule 506(c) crowdfunding investments would be capped for any 12-month period (ranging from $2,000 to $100,000 based on their annual income and net worth);

2. The transactions would need to be conducted through an SEC-registered (a) broker or (b) “funding portal” intermediary used exclusively for crowdfunding transactions;

3. Companies would have to disclose to the SEC, investors and brokers/portals, among other things:

a. their business plan, entity type, capitalization and greater than 20% shareholders;

b. a description of the transaction, including the target offering amount, target deadline, price per share (including valuation methodology), use of proceeds and risks to purchasers; and

c. annual reports (including financial statements.)

4. Companies would not be permitted to advertise except through their broker/portal intermediaries.

There is speculation that lawmakers will revisit this regulatory framework, but until they do, entrepreneurs cannot engage in this type of equity crowdfunding. As such, the existing online portals facilitate only Rule 506(c) crowdfunding, and not the broader contemplated crowdfunding activity.

State Crowdfunding

As of June 2014, twelve states have adopted intra-state crowdfunding laws permitting companies organized and (typically) headquartered in those states to sell securities exclusively to in-state residents via public advertising. Like their federal counterpart, these laws all impose some form of offering size limits (typically $1-2 million), income and net-worth based investment limits, and disclosure requirements. In contrast, most states laws are silent as to the use of brokers and funding portals. Companies located in states permitting intra-state crowdfunding should consult local counsel before engaging in such offerings, because their use may restrict the company’s ability to rely on other useful exemptions downstream. The three states with the highest volumes of early stage transactions, Massachusetts, New York and California, have not adopted intrastate crowdfunding laws, possibly indicating that such efforts are more about economic development than relaxing longstanding state securities laws.

Conclusion

Crowdfunding options for startups are beginning to take shape. As with all financing options, however, entrepreneurs should be mindful of how fundraising activities impact their balance sheet, capital structure and long term ability to attract investors to grow their businesses.

Summary Chart: Crowdfunding Options for Startups

	506(c) Crowdfunding	JOBS ACT Portal Crowdfunding	Intrastate Crowdfunding	Non-Equity Crowdfunding (e.g. Kickstarter)
Securities Registration Exemption	Rule 506 of Regulation D under the Securities Act; State law preempted	Section 4(a)(6) of the Securities Act; State law preempted	Section 3(a)(11) of the Securities Act/State law	N/A (no sale of securities)
Legal to Rely on Exemption	Yes	No (SEC final rules pending)	Yes (depending on State)	Yes
Company Can Issue Equity to Investors	Yes	Yes	Yes	No
Offer to General Public	Yes	Yes	No (In-State Only)	Yes
Sell to General Public	No (Accredited Investors Only)	Yes	No (In-State Only)	Yes
Engage in Advertising	Yes	No (only through broker or portal website)	Yes (In-State Only)	Yes
Maximum Offering Amount	No	$1,000,000 (in any 12-month period)	Varies by State	No
Maximum Investment Amount per Investor	No	Yes	Yes	No
May Limit a Company’s Ability to Rely on Other Registration Exemptions	Yes	Yes	Yes	No

This article was prepared by Jeremy Halpern, Co-Chair of the Emerging Companies Group at Nutter McClennen & Fish LLP. For more information, please contact Jeremy or your Nutter attorney at 617.439.2000.

This article is for information purposes only and should not be construed as legal advice on any specific facts or circumstances. Under the rules of the Supreme Judicial Court of Massachusetts, this material may be considered as advertising.