On Sept. 23, new securities regulations went into effect allowing start-ups and small businesses to use Internet advertising and other mass marketing means raise investment capital for business. The new law lifts a longstanding ban on public advertisement of private stock sales that had been in place since the days of the Great Depression. Companies may now advertise stock sales widely, through means such as social networks and email. But, as was the case before the new regulations, the offer to sell stock and other securities will still be limited by law to qualifying high net worth individuals and companies defined as “accredited investors.”
The new rules were promulgated by the Securities and Exchange Commission as a part of the implementation of Title II of the Jumpstart Our Business Startups Act of 2012 (the “JOBS Act”). And while most of the pre-existing legal limitations regarding the sale of securities (e.g., to accredited investors) are still in place, allowing businesses to broadly use the web, social media and email to market investments is widely expected to usher in a new era of capital formation. But as groundbreaking as the implementation of Title II of the JOBS Act may be, it is only a prelude to the true investment capital revolution that is expected to be unleashed when the investment crowdfunding provisions of Title III of the JOBS Act are finally implemented.
The good news is that a number of financial news sources have recently reported that the SEC is quite close to publishing the proposed regulations for commentary, and that it is likely to do so by the end of the year.
For those unfamiliar with the term, “crowdfunding” is a method of raising capital for a project, venture, or enterprise through the pooling of numerous, and usually relatively small, financial contributions or investments from the public, usually via the Internet to accumulate large aggregated amounts of capital.
Generally, there are two types of crowdfunding. The first is often referred to as “donation- based” or “gift-based” crowdfunding. This type of capital formation does not provide to the persons donating the money any stock or other ownership of the project, venture or enterprise for which the capital is being raised. The gift-based “investment” of capital, therefore, is not expected to provide, nor can it legally promise to provide, any financial-return to the gifting “investor.” This type of crowdfunding has been successfully used for a number of years through online platforms such as Indiegogo (Indiegogo.com) and Kickstarter (Kickstarter.com) where small amounts of capital from large numbers of individuals are aggregated into substantial amounts of capital.
The success of donation-based crowdfunding is credited by many as the inspiration, if not the motivation, behind the crowdfunding provisions of Title III the JOBS Act. But unlike gift-based crowdfunding, Title III of the JOBS Act will allow companies for the first time to use online crowdfunding to raise capital by selling ownership interests, such as stock or secured debt, in companies, projects, ventures, and other enterprises, to persons who are not required to be accredited investors. This type of crowdfunding is often referred to as “equity-based crowdfunding”. Crowdfunding under Title III of the JOBS Act will, therefore, allow companies to both market and sell stock over the Internet to potentially hundreds of millions of ordinary people, around the world. By doing so, Title III might well revolutionize the process of procuring investment capital by enabling companies to tap into very large and heretofore untapped sources of capital.
Title III of the JOBS Act contains a number of restrictions regarding how equity-based crowdfunding will be conducted. For example, companies will be limited to raising $1 million in debt or equity per year, and investors will be able to cancel their investment within a certain time period. And while there is no limit on the number of investors that are allowed to invest in an equity-based crowdfunded venture, individuals will be limited in the amount of money they can invest in such ventures within a 12-month period. Specifically, if the investor’s annual income is less than $100,000, the investor’s maximum crowdfunding investment will be limited to the greater of $2,000 or 5 percent of the investor’s annual income or net worth. If the investor’s annual income or net worth is greater than $100,000, the limit increases to 10 percent of the investor’s annual income or net worth, with a maximum aggregate crowdfunding investment limit of $100,000.
The JOBS Act also requires that crowdfunding transactions be conducted using a registered broker dealer or a “funding portal.” Such funding portals will likely be used to effectively preclude the stock issuers from directly selling their own securities. Additionally, the issuer must also provide investors with “certain disclosures” to ensure that investors understand the risks involved in the offering. They must also provide annual reports regarding the operation of the company to its investors, and file annual reports with the SEC, as prescribed by the SEC in yet to be published (and long overdue) regulations.
Also, to further protect investors, the JOBS Act, also provides investors with the right to bring lawsuits against crowdfunding companies for material misstatements and omissions during fundraising or regarding subsequent operation of the crowdfunded company.
Given the statutory crowdfunding regulations in place, and the additional regulations that are yet to be generated by the SEC, persons and companies that use equity-based crowdfunding under the JOBS Act to should be mindful that directors, principal officers, and other individuals operating a company funded through crowdfunding authorized by Title III will be taking on a significant amount of responsibility, and be exposed to a significant amount of liability. Nevertheless, while substantial, the restrictions, obligations and responsibilities imposed on equity-based crowdfunding companies by the JOBS Act are not expected to deter large numbers of start-up companies and other enterprises from seeking capital via equity-crowdfunding means.
Unfortunately, for those anxiously awaiting the commencement of lawful equity crowdfunding, there has been great disappointment over the SEC’s failure to generate and publish rules pertaining to Title III crowdfunding. Nearly a year after the passing of the statutory deadline for the SEC to do so, such rules are yet to be published by the SEC for commentary. And unfortunately, once the SEC publishes the proposed regulations there will be yet another delay of some months until the final rules are implemented.
The good news is that a number of financial news sources have recently reported that the SEC is quite close to publishing the proposed regulations for commentary, and that it is likely to do so by the end of the year. Many of the same sources also report that the SEC is expected to have the final rules in place sometime next year.
But perhaps most heartening for proponents of equity-based crowdfunding is the fact that there appears to be an unstoppable political momentum across the country to make equity-based crowdfunding a reality at the state level notwithstanding the federal government’s foot dragging in regard to Title III of the JOBS Act. Several states have enacted or have introduced their own legislation authorizing equity-based crowd funding as a way to expand investment in local businesses and create jobs. Rather than waiting for SEC rulemaking, these states are enacting intrastate crowdfunding exemptions.
Kansas and Georgia were the first to pass intrastate equity-based crowdfunding legislation. Similar bills are currently pending in the state legislatures of North Carolina, Washington, Wisconsin and Michigan. I find the bill pending in Michigan, HB 4996, particularly interesting because, if passed, it would have interstate applicability. Specifically, HB 4996 provides specified legal protection to crowdfunding investment offerors for inadvertent out of state investment acceptance.
It is indeed encouraging to see that so many states impatient with the dysfunctions of the federal government are willing to enact their own regulations rather than wait for the SEC to finally act. Some state government securities regulators, like those in Kansas and Georgia, have even gone so far as to side-step their own legislatures to more quickly implement crowdfunding rules to encourage crowdfunding investment in their states. All this state action, I believe, clearly shows broad-based political support for equity crowdfunding.
Hopefully, this will help motivate the SEC regulators to quickly perform their long-overdue obligations, mandated by law, to publish Title III regulations. But even if it doesn’t, I am confident, and glad, that the SEC has to be getting the message that many states will act to make equity crowdfunding a reality regardless of what the SEC does or does not do.
And hopefully, what appears to be an unstoppable political momentum for equity crowdfunding will effectively deter the SEC from generating regulations that make equity crowdfunding unreasonably difficult or that are otherwise inconsistent with the spirit of Title III.
I have always believed that equity-based crowdfunding of businesses and business projects through the robust use of the Internet and related technologies would eventually become a reality in U.S. The fact that it is taking so long is, of course, disappointing. But part of the reason why it has taken so long is rooted in the fact that our legal and financial systems are very highly developed and very conservative compared to most other countries.
And that fact, I believe, ultimately will result in a well-regulated equity-based crowdfunding industry that will benefit more than the investors and crowdfunding businesses using it. A well-regulated crowdfunding system will, I predict, provide huge benefits to the whole country if the market for crowdfunded securities in the U.S. is viewed with the same high regard as our publicly traded equities market.
U.S. stock markets are far and away the largest in the world in large part because our country’s highly evolved legal and financial system, coupled with a stable political environment has provided a level of investment security to foreign investors that is unobtainable anywhere else in the world.
There is a good chance, I believe, that once established, a well-regulated equity- based crowdfunding industry will become a gigantic magnet for huge untapped pools of world capital to flow into the U.S.
With a little luck, perhaps true equity-based crowdfunding will become a legal reality in 2014. I certainly hope so. If you or your business is interested in discussing laws pertaining to crowdfunding a business or a project, I invite you to call my office listed in the bio on page 10.
Nothing in this article is intended to be, or should be considered to be, legal advice.
Gregory A. Piccionelli is an entertainment and Internet attorney and free speech advocate. He can be reached at (818) 201-3955 or greg@piccionellisarno.com.
