By Sasha Bau, Esq., Sabari Bagchi, Esq., and Adam Valko
The Jumpstart Our Business Startups (“JOBS”) Act was signed into law in early 2012 with bipartisan support, designed to encourage funding of small businesses and ease various securities regulations. Title III, which deals with equity crowdfunding in the startup community, received a lot of attention because it was the first time the government developed a specific avenue for business to raise money through crowdfunding. Prior to these crowdfunding rules, businesses and other issuers could raise funds through the private placement exemption in the Securities Act of 1933. However, this exemption permitted general solicitation only to accredited investors, or those who possessed significant wealth.
While services like KickStarter and GoFundMe were already, and continue to be, an option for new businesses, neither of those outlets gives investors the right to own a piece of the business. KickStarter is rewards based, meaning investors receive a beta version of a particular product, t-shirts, a thank-you note, or some other token of the creator’s appreciation. GoFundMe, on the other hand, is donation based. Neither of these sites proved to be the right platform for businesses providing services as opposed to products, and very few investors are willing to donate money to a new business without receiving anything in return.
Title III was designed to assist small businesses in their development and ultimately create more successful startups. The rules for Title III, originally proposed in 2013, took a long time to officially implement, due to conflicting feedback from both sides of the industry. Generally, the feedback fell into three categories: commenters felt the rules were either dismissive, determined or disillusioned. After absorbing the comments from the public, the Securities and Exchange Commission (“SEC”) ultimately retooled the rules and proposed a new version of them in 2015, nearly two years later.
On October 30, 2015, the SEC adopted the final rules to permit companies to offer and sell securities through crowdfunding subject to certain investment limits, both on the business and investor side. The SEC’s stated goal is to provide a concise and simple way for small business to register and offer securities while protecting potential investors.
On January 29, 2016, companies’ offerings could begin to be registered through a “funding portal,” a new kind of financial intermediary. A funding portal is a single platform through which an offering of equity securities can be conducted. Funding portals must be registered with the SEC and follow strict rules as to what is, and is not, permitted activity. For example, funding portals may not offer investment advice or solicit purchases, sales, or offers to buy the securities displayed on its platform or portal. However, funding portals may advise issuers on the structure or content of offerings, advertise the portals existence, and provide communication channels for potential investors and issuers.
Considerations for Issuers
For new businesses and entrepreneurs, choosing a particular funding portal to list an offering is very important. Each portal may have different guidelines, services, and even individual procedures for taking payments from the issuer. Additionally, because each portal is required to be registered with the Financial Industry Regulatory Authority (“FINRA”), be sure to watch out for non-verified marketplaces looking to capitalize on the crowdfunding trend. FINRA’s website provides a list of approved and verified marketplaces to choose from. The following section provides more information on the FINRA-regulated portals.
In addition to the SEC and individual portal’s rules, it is important to keep in mind that states are permitted to regulate certain aspects of crowdfunding in their state. Issuers therefore must be aware of state regulations that may add additional hurdles to crowdfunding within a particular state.
Unlike private social media advertising and promotion of the offering is very limited. An advertising notice may contain only the bare-bones details of the offering, the portal through which it’s being conducted, and a brief description of the issuer’s business. This way, investors are not being improperly solicited and have the ability to research the company independently. Any additional “color” that an issuer wants to lend to its offering can only be posted on the funding portal, not on any third party media outlets.
Finally, and most importantly, businesses need to keep in mind the maximum amount allowed to be raised through crowdfunding, and the costs associated with raising such funds. Businesses may only raise $1 million over any 12-month period, which, in the world of startups, may not be enough to really jump-start a young business. The crowdfunding rules include an estimated cost for a business to raise, for example, between $500,000 and $1,000,000. The SEC estimates needing between $44,000 and $94,000 upfront, and $3,000 to $13,000 for each additional year to fulfill the SEC reporting requirements. Due to the reporting requirements, issuers who are already generating revenue may be better suited to undertake such disclosure requirements, especially if they have in-house legal or accounting services already. Both the funding limitation and costs associated are seen as a barrier to entry for new, emerging businesses which either (i) need to raise more than $1 million or (ii) cannot afford to pay the SEC thousands of dollars for associated costs. As the system continues to grow and progress, it will be interesting to see whether or not these factors discourage issuers from listing on the funding portals.
Considerations for Investors
On May 16, 2016, this crowdfunding system went officially “live,” meaning that companies could now begin to offer and sell securities to the investing public through the regulated funding portals. Now that any investor can contribute to new startup companies, there are important things the general public should know and look out for in these potential investments.
First, investors are limited in the amount they may contribute to any one offering, and all offerings total, in any twelve month period. If one investor’s annual income or net worth is less than $100,000, they may invest the greater of: (i) $2,000 or (ii) 5% of the lesser of their annual income or net worth. If both annual income and net worth is equal to or more than $100,000, they may invest 10% of the lesser of their annual income or net worth. Finally, during the 12-month period, the aggregate amount of securities sold to an investor through all crowdfunding offerings may not exceed $100,000. So, as you can see, the rules seriously limit a business’s ability to raise capital, and an investor’s ability to invest in one.
Investors need to undertake the appropriate due diligence, both on the funding portals they are using, and the individual companies they consider investing in. Investors should set out to learn as much as possible about the companies asking for their money, and be sure to know the consequences and next steps of investing in one. For example, after an investment, the company cannot contact an investor until it files its annual report at the end of its fiscal year, which could be up to 12 months away. Investors must be prepared to potentially be in the dark regarding the company for up to a year. These early-stage investments can be risky and volatile, so investors need to proceed with caution and be sure to completely research their investment. Likewise, investors should research how funding portals do their diligence on the companies placing their offerings there.
Potential investors should nonetheless approach these funding portals and opportunities with optimism, as they provide easy access to enter on the ground floor of what could potentially be the next Fortune 500 Company.
Most of the portals that have been registered with FINRA to date display a sleek homepage with high functionality, immediately displaying options to discover current companies, sign up as an investor, or read their FAQ or risks involved. For investors who may be new to the world of start-ups, these portals present the information in a concise, sleek, and easy to use way that will not intimidate or scare off potential investors. Additionally, the portals show investors opportunities that met their fundraising goal and the current status of those issuers.
Once a potential investor clicks on a particular “opportunity” or “open investment,” that issuer’s homepage is full of relevant financial data, facts, and business plan information, along with reviews from satisfied customers who have used the product or service (if applicable). Investors should feel comfortable navigating these portals, and any questions they may have can be answered via the portal itself, or the various contact information that each one provides.
Finally, when in doubt, FINRA provides a FAQ page for this exact purpose.
The response to these new crowdfunding offerings has yet to be seen, as it only officially kicked off a few months ago. The benefits of this new system, on both the company and investor side, are yet to be seen, but the SEC is clearly trying to capitalize on an emerging trend while protecting all parties. Businesses are able to supplement their previous friends and family, angel round, and seed round funding with additional investments of up to $1 million. It also provides young companies with increased exposure to the general public and the opportunity to grow via word of mouth. For investors, it is no longer a requirement to be an accredited investor or possess a certain amount of capital to invest in companies. Anyone, regardless of net worth or salary, can invest in, and own, a part of a new company and potentially grow with it. For too long, would-be investors who did not possess the kind of wealth to invest large sums of money in new companies were completely shut out. Now, with the SEC- regulated funding portals, casual investors are able to provide capital to companies in return for a small piece of equity.
It will be interesting to see this develop, and see the types of companies utilizing these crowdfunding portals, and to what extent they are used. Will the $1 million ceiling be raised? While businesses may not want 100’s of separate, small investors, they will like being able to raise more capital in an effort to grow their business faster. Stay tuned over the next few months through the end of the calendar year to see how this crowdfunding experiment goes. As soon as the SEC, or another independent institution, releases data on the success of these funding portals, we will be sure to provide that information.