Background and Overview of Crowdfunding
On October 23, 2013, the Securities and Exchange Commission (“SEC”) unanimously voted to propose legislation under Title III of the Jumpstart Our Business Startups "JOBS" Act to allow companies to offer and sell securities through on-line crowdfunding portals to the general public. For the past several years, Internet-based fundraising has been used outside of the traditional capital markets through either donation-based platforms where investors simply donate funds or receive a tangible gift or perquisite in exchange for their financial assistance or through investment platforms accessible only by accredited investors. Crowdfunding, however, has not been a legal method to offer and sell securities, such as stock or bonds to the general public, as such an offering would require SEC registration. Among other things, the purpose of the JOBS Act was to address the challenges faced by startups and small businesses in raising capital with reasonably low costs. The proposed rules under Title III of the JOBS Act would create an exemption from registration under federal securities law and would permit companies to raise capital from the general public in exchange for equity and/or debt through on-line crowdfunding.
Creation of Funding Portals
Currently, there are a number of entities, such as kickstarter.com, indiegogo.com, rockethub.com, and crowdfunder.com, that operate websites to host donation based and accredited investor crowdfunding transactions. The proposed rules would now require crowdfunding transactions offered to the general public to take place through a similar on-line intermediary that is either registered as a broker or is registered as a newly created entity, known as a Funding Portal. The proposed rules permit Funding Portals to conduct the offering and sale of securities over the Internet without having to register as a broker. In order to protect investors, Funding Portals would be required to become a member of a registered national securities exchange, such as FINRA, and would not be permitted to solicit the crowdfunding offerings taking place on its website platform, offer investment advice, compensate employees or agents for soliciting offerings listed on its platform or handle investor funds or securities. In addition, the Funding Portal is intended to monitor against fraud by prohibiting certain issuers from using its site and protect investors by enforcing investment limits established by the SEC.
Summary of the Proposed Rules
Under the proposed rules, in order for a company to qualify to raise capital through crowdfunding under Title III of the JOBS Act, the proposed transaction must meet the following criteria:
- The amount to be raised by the entity must not exceed $1 million in a 12-month period.
- The permitted investments to be made by an individual are limited to (1) the greater of $2,000 or 5% of annual income or net worth, if annual income or the net worth of an investor is less than $100,000 and (2) 10% of annual income or net worth, if annual income or net worth of the investor is $100,000 or more.
Under the proposed rules, entities attempting to raise capital through a crowdfunding campaign would only be permitted to utilize one Funding Portal (or other type of on-line intermediary) to conduct the offering. Entities would also be required to file the following information with the SEC and broker or Funding Portal to be made available to potential investors:
- Name, legal status, physical address, and website address of the entity;
- A description of the ownership and capital structure of the issuer, the names of all the directors and officers of the entity and each person holding 20% or more of the entity’s shares;
- Business description, future business plans of the entity, and a stated purpose and intended use of the proceeds to be raised;
- Description of the entity’s financial condition (further discussed below);
- The target offering amount and deadline to raise such amount and;
- The price of the securities to be offered to the public and the method for determining the price.
As discussed, issuers attempting to raise capital through crowdfunding under Title III would be required to provide to investors a description of the entity’s financial condition. The discussion of financial condition should include a discussion of the issuer’s historical results from operations and liquidity and capital resources and if the historical results from operations are representative of what investor’s should expect in the future. If the entity is a startup, the discussion should focus on the entity’s future goals and potential obstacles. In addition to a discussion of financial condition:
- Entities offering $100,000 or less are required to file financial statements with the SEC certified by the principal executive officer of the company for the most recently completed year and make available to the investors income tax returns for the most recently completed year,
- Entities offering more than $100,000 but not more than $500,000 are required to file financial statements with the SEC that have been reviewed by an independent public accountant and,
- Entities offering more than $500,000 are required to file financial statements with the SEC that have been audited. Entities requiring an audit have the option to have an audit conducted under the auditing standards issued by either the American Institute of Certified Public Accountants or the Public Company Accounting Oversight Board.
Under the proposed rules, entities will be required to file the above information on a newly created Form C. For example, an entity conducting its initial offering will check “Form C: Offering Statement,” while a company filing its annual report would check the “Form C-AR: Annual Report” box on the Form C, or an entity filing an amendment to its offering would check the “Form C-A: Amendment” on the Form C. The company must continue to file annual reports on Form C-AR for as long as the securities issued under these crowdfunding rules remain outstanding. The SEC believes the use of one form will be more efficient and simplify the process for startups and small businesses.
Potential Economic Impact of Crowdfunding
Startups and small businesses can typically obtain access to capital through multiple sources, including debt, equity or hybrid security offerings, bank loans, or registered or unregistered offerings. Certain reports have suggested that the overall crowdfunding industry raised $2.7 billion globally in 2012 and the industry is projected to grow to $5.1 billion in 20131. Startups and small businesses typically look for means of raising capital other than registered offerings as such offerings have proven to be costly. In addition, startups may have difficulties in attracting venture capital firms and angel investors based on the nature the types of companies those investors tend to target. While crowdfunding in the United States has typically been “donation-based” or “reward-based” industry reports have shown that equity-based crowdfunding (accessible to accredited investors) is the fastest-growing of all the crowdfunding categories, growing at 114% compound annual growth rate in 20112. The proposed rules should contribute to the continued growth of equity-based crowdfunding in the United States, by targeting a previously untapped investor base, and hopefully provide startups and small business a new avenue to raise capital.
This article was intended to be a brief overview of the proposed crowdfunding legislation under Title III of the JOBS Act. For the full set of proposed rules please visit http://www.sec.gov/rules/proposed.shtml
John Schuyler contributed to this article.