Crowdfunding is a fairly recent and ever-changing method for raising money through the internet. In its current form, both entrepreneurs and artists have used crowdfunding to fund their projects. A few of the popular companies like Kickstart and Indiegogo use websites to facilitate crowdfunding transactions. Of course, individuals who give financial support on these platforms essentially function like benefactors because there is no expectation of a financial return.
But this is going to change soon, and “equity crowdfunding” will become a reality as another avenue for emerging companies to raise capital. When President Obama and Congress passed the Jumpstart Our Business Startups (JOBS) Act in 2012, they lifted the ban against equity crowdfunding, and asked the SEC to come up with changes to existing rules. Equity crowdfunding, unlike its counterpart that is currently in practice, will allow individuals to actually invest in companies and become equity holders.
The SEC has put forward a set of proposed rules to regulate crowdfunding, and we are still waiting for the agency to finalize these rules. The proposed ones are a good indication of what’s to come. The regulatory framework under these rules has the following basic features:
By far the most important feature is that there will be an exemption from registering with the SEC if your company chooses to issue securities through crowdfunding. Here’s one thing to keep in mind: You’ll have to meet a series of requirements to qualify. Below is an overview of some of the more important conditions that have to be met.
There is a limit to an offering amount and limitations on how much an investor may contribute. As a company, you can raise a maximum amount of $1 million over a twelve-month period. The amount that investors can invest in the company is pegged to their annual income or net worth. So an investor would be permitted to invest, over the course of twelve-month period, up to $2,000 or 5% of her annual income or net worth, whichever is greater, if both her annual income and net worth are less than $100,000. But if an investor’s annual income or net worth is equal to or more than $100,000, she can invest 10% of her annual income or net worth, whichever is greater.
To qualify for the exemption, the issuing company also has to provide a number of disclosures. Investing in emerging companies is always a risky venture; so the SEC is making sure ordinary folks who want to invest are sufficiently protected. The disclosures are not insignificant, so the issuer preparing them should make sure they are SEC compliant.
Because the disclosures from the issuer are considerable, let me highlight some of the important provisions to keep in mind.
First, you need to provide information about your officers and directors, as well as owners of 20 percent or more of the company. You must give a description of your business and a detailed description of the purpose and intended use of the offering proceeds. With respect to the target offer, you have to specify the amount you wish to raise, the deadline to reach this amount, and the price to the public of the securities. Furthermore, you need to describe the terms of your securities, including the number being offered, whether the securities have voting rights, any limitations placed on those rights, among others.
In addition, you need to explain how your securities were valued and inform your investors that restrictions apply to their transferability. But that is not all, because you also have to provide a description of your financial condition: For instance, your indebtedness if any, your operating history, including a discussion of historical earning and cash flows and whether they are a good indication of what is to come in the future, how the proceeds from the offer will affect the issuer’s liquidity and the necessity of these funds and other additional funds to the viability of the business, and so on.
Part of making the issuer’s financial condition transparent to the investor involves the issuer providing financial statements. These statements have to be reviewed by an independent public accountant when the target amount is larger than $100,000 but less than $500,000, and audited by such an accountant, using accredited standards of accounting – for targets up to $100,000, only income tax returns of the most recently completed year have to be made available.
The proposed rules require that the offer and sale of your securities be done on a platform of an intermediary, whether that intermediary is a broker/dealer or funding portal. The platform can be a website where the offer and sale of securities can take place. What’s more, you can only rely on that one platform during the twelve-month period of engaging in crowdfunding. Some of the information you are required to disclose will be made available to potential investors on the funding portal’s platform.
As intermediaries between investors and companies seeking funding through crowdfunding, funding portals themselves have to be registered with the SEC and are tasked by the proposed rules to provide certain safeguards to investors. For example, they have to make available information about the issuer and the offering, enable communication and discussions about offerings on their platform, offer educational materials to investors, and take steps to prevent fraud. The lesson to you as the issuing company is that you need to be careful when choosing a funding portal: Find one that is registered with the SEC.
At this time, we are still waiting for the SEC to come out with the final rules on crowdfunding. Some of the requirements might of course be revised, but chances are that the overall regulatory framework under the final rules will be quite similar, and so the proposed rules should be a good indication of what crowdfunding will look like when it finally becomes legal. Once the final rules come out, I will update my discussion and report whether the final rules announce any major departures from the current proposal.