Investment Crowdfunding Will Be Legal But Will It Be an Improvement?

Joseph R. Soraghan

By Joseph R. Soraghan

In the JOBS Act adopted in April 2012, Congress required the Securities and Exchange Commission (“SEC”) to adopt rules legalizing (i.e., exempting from the requirement to register with the SEC) the offer and sale of securities by small business issuers (which cannot afford registered public offerings) using mass media, to-wit: the Internet, social media, etc. Historically, both state and federal exemptions required “privateness” and forbade “general solicitation.”

On October 30, 2015, the SEC, in a 686 page release, finally adopted rules (see pages 547-686) to allow investment crowdfunding (the use of mass media to make offers and sales to non-accredited investors, i.e., persons with less than $1 million net worth and incomes under $200,000 annually). The rules will become effective in April 2016.

Supporters argue that these rules simply bring the offering and sales of securities into the modern age of mass media and allow persons of limited means to participate in the great boom of entrepreneurship. Critics, on the other hand, point out that those are the very persons who are the least investment sophisticated and the most vulnerable to financial fraud.

What Was Available Before Investment Crowdfunding?

A number of exemptions presently exist for raising capital without SEC registration, and will continue to exist. Those that are most practical, and thus most available, include the following:

  • No Use of General Solicitation. Issuers may presently solicit sales of an unlimited dollar amount to an unlimited number of accredited investors under SEC Rule 506(b). No particular private placement memorandum is required under that rule to obtain the exemption, although use of at least some written disclosure is advisable to assure that prospective investors are informed of the basics and risks of the business. Also, sales may presently be made, under both federal and state exemptions, for sales to a very limited number of non-accredited investors, generally allowing $1 million to be raised per 12-month period. No general solicitation is allowed in either type offering.
  • Sales to Accredited investors with General Solicitation. Under relatively new Rule 506(c), adopted October 23, 2013, companies may make offerings unlimited in dollar amount and number of purchasers to accredited investors, and general solicitation may be used if the issuer has significantly more evidence than required under Rule 506(b) that every purchaser is accredited. That is, different from other existing exemptions, the issuer need not have reasonable grounds to believe that every person solicited is accredited. However, sales may be made only to accredited investors, and the issuer must be able to “verify” that each purchaser is accredited. This verification requirement is strict and difficult of compliance. The SEC instructions give companies only “factors to consider” in determining what is sufficient “verification.” The SEC’s instructions imply that the company should require prospective investors to provide private information, such as net worth statements, tax returns, W-2 forms, and/or pay stubs to establish their net worth or income. The SEC makes that suggestion even though it admits “the privacy concerns” which such prospective investors may have.

Other exemptions are also available, although they are significantly less practical and usable by early stage companies than the above. Such other exemptions also prohibit general solicitation and require that all purchasers be “suitable,” generally meaning being investment sophisticated and affluent.

“Regulation Crowdfunding”: A Method for True Investment Crowdfunding

The new rules noted above, collectively called “regulation crowdfunding” by the SEC, will allow the use of general solicitation to solicit investors who are not accredited. Conceptually, this 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.

That is the concept. The actual benefit of the new rules is in some doubt.

Using 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 investor is also quite limited: Investors whose annual net income or net worth is less than $100,000 may purchase only the greater of (1) $2,000 or (2) the lesser of 5 percent of their annual income or net worth. And no investor may purchase more than $100,000 or 10 percent or the lesser of their annual income or net worth.

And these may be the least of the practical restrictions on the benefit of the new rules. This exemption requires an issuer to prepare a detailed private placement memorandum (“PPM”), to include:

  • The company’s financial statements (certified by the CEO, reviewed by a public accountant, or audited, respectively, if the offering amount is less than $100,000, $100,000 to $500,000, or in excess of $500,000);
  • A description of the business;
  • Information about management and 20 percent shareholders;
  • And much other information.

Development of a PPM, even under present looser requirements, is frequently the major expense of a private offering. (A PPM is not required to obtain the accredited investor exemptions presently available.) And the issuer will be required to file such financial statements annually with the SEC thereafter.

Perhaps the most significant limiting factor of the new rules is the requirement thereunder that the issuer use an “intermediary” through which to make the offering. The intermediary may be either a broker-dealer or a “funding portal.” The intermediary is required to do the following:

  • Furnish investors with educational materials about the process, including the above PPM;
  • Make information available on the intermediary’s site no less than 21 days before any sale;
  • Provide a communication channel to permit discussions about offerings; and
  • Review and have a reasonable basis for its belief that the investment limitations are being met.

A funding portal other than an already registered broker-dealer must register with the SEC and become a member of the Financial Industry Regulatory Authority (“FINRA”). The responsibilities and prospective liabilities of portals and broker-dealers in these offerings will be significant, with a cost commensurate therewith. The SEC is also considering additional requirements for intermediaries to protect investors.

Is Investment Crowdfunding Right for You?

A successful crowdfunding offering will bring a large number of new (small) investors into the company. For some more mature—even if entrepreneurial—companies, this may be a boon. For example, it could better enable a trading market in its stock to develop—albeit only under the restrictions of Rule 144.

However, for most entrepreneurial companies, this is not the case. For most, taking on a large number of new voting investors will be problematic:

  • Most entrepreneurial companies will need to raise funds in later rounds, usually from angel investor groups and venture capitalists, and also anticipate exit strategies which may include the purchase of the business by venture capitalists, private equity firms or strategic buyers. After a crowdfunded prior capital raise, all of these possible future transactions will be significantly more difficult and less likely because such future sources of financing and acquisition typically seek to invest in or purchase companies with very few voting security holders.
  • Companies with numerous shareholders may find it significantly more difficult to attract high value directors and consultants and the cost of director and liability insurance coverage may increase significantly. Having a large number of shareholders may create a need for costly investor relations efforts. Numerous small shareholders may use their votes in problematic ways, such as frequent exercise of their rights to inspect the company’s books and records, to bring derivative claims (theoretically on behalf of the company) or claims against alleged “oppression” by the majority shareholders. Investment crowdfunding will not be appropriate for S-corporations, which are limited to 35 shareholders.
  • LLCs taxed as partnerships, which already have very complicated tax and accounting issues arising from that status, would have those problems exacerbated by a significant increase in the number of equity holders.
  • It is always possible that an investment crowdfunding offering may fail to raise sufficient funds and the issuer may desire to shift to a traditional method of financing. However, the use of general solicitation in any kind of prior financing (because of the securities law doctrine which “integrates” past sales into a present non-general solicitation offering) would prevent a company from shifting to another method. This is because all other exemptions, state and federal, prohibit general solicitation and are thus unavailable for use in capital raises up to a year after the last generally solicited sale.

Of course, these problems caused by the existence of many new but small voting investors can be avoided by offerings in which non-voting securities are offered, such as debt securities and some types of preferred shares.

A Final Thought

Investment crowdfunding will not be a panacea, and it is unlikely it will generate the employment boom touted by Congress upon passage of the JOBS Act. However, it is one more method of financing which for some entrepreneurs will be appropriate and beneficial. Used in careful conjunction with other methods of capitalizing a company, it will be of significant benefit. For example, there is reason to believe it may be used frequently in financing real estate developments.

Posted by Attorney Joseph R. Soraghan. Soraghan practices in legal matters pertaining to business operations and growth. He guides businesses in financing, contracts, acquisitions, mergers, and sales. Soraghan frequently resolves commercial disputes as an arbitrator or mediator, or through litigation.

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