Regulation Crowdfunding: Is It Right for You?

To much ballyhoo, on October 30, 2015, the Securities and Exchange Commission (“SEC”) finally adopted rules to allow investment crowdfunding (which the SEC calls “Regulation Crowdfunding”). That is, it allows the use of mass media (Internet, etc.) (called “general solicitation”) to make offers and sales to non-accredited investors. Those are persons with less than $1 million net worth and annual incomes under $200,000. (Under present rules, general solicitation may be used only to solicit purchases from “accredited” investors.) The new rules will not become effective before April 2016.

“Regulation Crowdfunding”: A Method for True Investment Crowdfunding

Conceptually, allowance of general solicitation to solicit non-accredited investors is a sea change, in direct conflict with the basic investor protection philosophy of the SEC and state regulators since adoption of the Securities Act of 1933. The actual benefit of the new rules, however, is in some doubt.

In an offering under the new rules, an issuer may only raise up to $1 million in a 12-month period. And the amount which may be purchased by each purchaser also is quite limited: investors whose income or net worth is less than $100,000 may purchase only the greater of (1) $2,000 or (2) the lesser of 5% of their annual income or net worth. And no investor may purchase more than $100,000 or 10% of the lesser of their annual income or net worth. This assures that a significant capital raise will result in many investors. And this new exemption requires an issuer to prepare a private placement memorandum (“PPM”) with financial statements, a description of the business and management, and much other information.

And perhaps the greatest limiting factor of the new rules is the requirement that the issuer use an “intermediary” through which to make the offering. This may be either a broker-dealer or a “funding portal.” The intermediaries, most of which will be funding portals, become legally responsible for numerous significant and complex tasks, including vetting of the issuing company. Also, funding portals must register with the SEC and become members of the Financial Industry Regulatory Authority (“FINRA”). Meeting all these requirements will be expensive to the portal, and thus to the issuing company. The SEC is also considering placing additional requirements on intermediaries to protect investors.

Is Investment Crowdfunding Right for You?

An issuer considering crowdfunding should also consider other factors, most springing from the large number of new small investors in the company particularly if those investors have voting power.

Of course, for a business which would be benefitted by a large number of shareholders (e.g., to create or enhance a possible trading market), regulation crowdfunding is likely appropriate. But for most entrepreneurial companies, this is not the case.

Most such companies will, in the relatively near future after this offering, need to raise funds in later rounds from angel investor groups and venture capitalists and will also need to anticipate possible exit strategies which include purchase of the business by venture capitalists, private equity firms or strategic buyers. But after even a successful crowdfunded capital raise, all of these possible future exits will be significantly more difficult and less likely because such future sources of financing and acquisition typically seek to invest in or purchase only companies with few voting security holders. Such companies may also find it more difficult to attract high value directors and consultants and may need to undertake costly investor relations efforts. Also, those numerous small shareholders may use their votes in problematic ways, such as shareholder derivative actions and disruptive inspection of the company’s books and records. In addition, investment crowdfunding will not be available for S-corporations, which are limited to 35 shareholders.

It is always possible that the crowdfunded offering may fail to raise sufficient funds, and the issuer may desire to shift to a traditional method. But the use of general solicitation in any prior financing (because of the securities law doctrine which “integrates” past sales into a present non-general solicitation offering) would prevent the issuer from shifting to another method. All other exemptions, state and federal, prohibit general solicitation and are thus unavailable for up to a year after the last generally solicited sale.

These problems caused by the existence of many small voters could be eliminated by using generally-solicited offerings in which non-voting securities are offered, such as debt securities and some types of preferred shares.

Investment crowdfunding will not be the panacea touted by the Congress which passed it. However, it is one more method of financing and used in careful conjunction with other methods, will be of significant benefit.

Earlier article: SEC Finally Proposes Rules to Allow Crowdfunding