Last month I reported what some very good news regarding new federal securities regulations that went into effect in September that conditionally allow start-ups and small businesses to use Internet advertising and other mass marketing means to raise investment capital for businesses. 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).
While Title II of the Jobs Act lifts an eighty year ban on public advertisement of private stock sales, it did nothing, unfortunately, to change the equally long standing federal law that prohibits offers to sell stock or other securities except to qualifying high net worth individuals and companies defined as “accredited investors.”
I am disappointed that the SEC has clearly elected not to propose regulations that would minimize the expense and bureaucratic red tape associated with raising capital through crowdfunding.
To be an accredited investor, a person must have a net worth of at least $1 million (not including the value the person’s primary residence) or have a yearly income of at least $200,000.
The law that will finally allow the actual sale of non-publicly traded stock and other securities to non-accredited investors over the Internet is Title III of the JOBS Act. And as I opined in my last article, Title II of the JOBS Act may well be groundbreaking in its own right, but it is Title III of the JOBS Act that has the greatest potential to ignite a true investment capital revolution by legalizing equity-based crowdfunding in the U.S.
“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.
“Equity-based crowdfunding” involves the solicitation and acquisition of capital by crowdfunding means where ownership interests, such as stock or secured debt is sold to persons who are not required to be accredited investors. This contrasts with “donationbased” or “gift-based” crowdfunding that has been successfully used for a number of years through online platforms such as Indiegogo and Kickstarter.
Unfortunately, at the time of writing my last article, the SEC still had not promulgated the regulations required by Title III to effectuate the law. This despite the fact that the JOBS Act itself required the SEC to do so by Jan. 1, 2013.
Coincidentally, however, just a few days after the publication of my article, in which I expressed my great disappointment over the SEC’s delay, miracle of miracles, the SEC finally announced the publication of Title III regulations for public comment on Oct. 23, 2013. Well, I guess better 296 days late than never.
Unfortunately, in response to the relatively straightforward crowdfunding provisions comprising the nine pages of Title III passed by Congress, the SEC apparently used all that overtime to generate 585 pages of proposed regulations and commentary. The proposed regulations effectively create a brand new regulatory scheme exclusively for crowdfunding. Needless to say, a detailed discussion of the proposed regulations is far beyond the scope of this article. So, instead I will highlight a few of what I think are some of the more important proposed provisions, particularly as they address certain issues and ambiguities generated by the statutory language of Title III adopted by Congress.
Crowdfund investors do not count as owners for purposes of applying sec registration requirements
Under the Title III of the JOBS Act there is no limit on the number of investors that are allowed to invest in an equity-based crowdfunded venture.
But under separate and unrelated federal law, companies cannot have more than 2,000 persons with an ownership stake in the venture unless it is registered with the SEC and complies with other costly regulations applicable to non-”microcap” companies. With the passage of Title III, a question arose regarding whether crowdfunding investors would be counted in the calculation of the number of a company owners.
The SEC addresses this issue in the proposed crowdfunding regulations and commentary by taking the position that crowdfunding investors should not be counted toward a company’s ownership total for purposes of determining whether SEC registration is required. This is good news for companies that wish to raise capital through equity-based crowdfunding but do not want to trigger non-microcap SEC registration and reporting requirements.
Funding target flexibility
Title III of the JOBS Act limits companies to raising a maximum of $1 million in debt or equity per year through equity-based crowdfunding. Unfortunately, the text of Title III is ambiguous regarding whether a company raising capital via crowdfunding would have to establish a specific funding target and either raise exactly that amount or nothing at all.
The proposed regulations address and resolve the matter by allowing entrepreneurs to set minimum and a maximum fundraising goals.
Investor’s may optionally use annual income or net worth to determine maximum crowdfunding investment limits
Congress passed Title III of the JOBS Actwith language limiting the amount of money individuals can invest in equity crowdfunding ventures in a 12-month period. Specifically, under Title III an investor cannot invest more than the greater of $2,000 or 5 percent of the investor’s annual income or net worth unless the investor’s annual income or net worth is greater than $100,000.
$100,000
For investors with income or net worth in excess of $100,000, the JOBS Act increases the investment maximum to 10 percent of the investor’s annual income or net worth, with a maximum yearly aggregate crowdfunding investment limit of $100,000.
Title III does not, however, specify which of the two numbers, i.e., an investor’s annual income, or net worth, should be used, or whether the decision to use one or the other should be made by the investor or some other party. In response, the SEC has proposed regulations that will allow investors to choose for themselves either the annual income or net worth calculation basis, thus providing to investors the option of using whichever calculation would provide a higher investment cap.
Responsibility for tracking investors’ aggregate crowdfunding investments
It has always been foreseeable that an investor could make crowdfunded investments in more than one company during a 12-month period. But Title III is silent as to who would be required to keep track of investors aggregate yearly crowdfunded investments for compliance with the investment limits imposed by Title III. Thus a question arose: would the SEC put the responsibility for investor crowdfunded investment limit tracking on the party offering the investment or on the potential investor? The SEC has answered this question by proposing that investors, and not the crowdfunded investment offerors, will be responsible for tracking investors aggregate 12-month crowdfunded investments. Needless to say this is good news for companies seeking to raise capital by using equity-based crowdfunding.
Crowdfunded companies will have to file annual SEC filing requirements
The SEC’s proposed regulations require companies seeking to raise capital through equity-based crowdfunding to report financial information to the SEC every year until they either go public, go under or get acquired. Some critics of this extended reporting requirement warn that costs associated with filing annual reports with the SEC will deter many companies from raising money through crowdfunding altogether.
Crowdfunding portals will be prohibited from offering advice
If the SEC’s proposed Title III crowdfunding regulations are adopted, crowdfunding portals will be barred from providing any type of investment advice to potential crowdfund investors. This means that the portal operator would be prohibited from highlighting one or more crowdfunded projects, as well as, filtering out offerings that the portal operator determines are unlikely to be funded.
Many of us involved in crowdfunding find the SEC’s proposed absolute ban on any investment advice provision by crowdfunding portals to be excessive, ill-advised, and short-sighted. One of the goals both Congress and the SEC seek to provide through Title III and the proposed rules is the protection of investors from unscrupulous persons who could use equity-crowdfunding to defraud them. Many of us have asked, if a crowdfunding portal operator is prohibited from even implementing a qualitative filtering function to weed out, or at least identify, ventures and projects that are patently unrealistic, impractical or otherwise clearly unlikely to succeed, how is attainment of the goal of investor protection enhanced?
And then there are the costs
Perhaps the biggest criticism of the proposed regulations is the costs they will impose on firms attempting to raise capital via equity-based crowdfunding under Title III. Here are some of the more important costs associated with compliance with the proposed rules:
- The SEC estimates that a crowdfund equity issuer will have approximately $6,000.00 in costs associated with the mandatory preparation and filing of “Form C” with the SEC.
- The proposed regulations also require the filing of an annual report on “Form C-AR.” The SEC estimates this cost to be at least $4,000 each year.
- Costs associated with mandatory criminal and regulatory background checks on all officers, directors and certain shareholders of the equity issuer’s company are estimated to be between several hundred to several thousand dollars.
The costs above imposed by the proposed regulation are in addition to the following costs resulting from obligations imposed by Title III itself
- The JOBS Act requires a CPA review of any equity crowdfunding in amounts over $100,000 and less than $500,000. Costs for such reviews are estimated to be from $1,000 to $5,000.
- The law requires a formal audit of any crowdfunding in amounts from $500,000 to $1M. Costs for such audits typically start at $5,000 and could range, in some cases, up to $100,000 or more.
Unfortunately, the Title III rules and comments promulgated by the SEC are, in my opinion, yet another stellar example of how our beloved federal bureaucracy is without peer when it comes to providing the greatest possible frustration of effective democratic governance that our tax money can buy. If adopted as proposed, the SEC regulations, will in my opinion, add a substantial amount of unnecessary costs and complexity to the equity-crowdfunding process.
While I do not think that the proposed regulations effectively destroy equity-based crowdfunding, as some observers have commented in the wake of the SEC’s action, I am disappointed that the SEC has clearly elected not to propose regulations that would minimize the expense and bureaucratic red tape associated with raising capital through crowdfunding. This, in my opinion, clearly flies in the face of congressional intent in passing Title III, which was supposed to provide to small businesses a new, fast and simple means to generate investment capital.
More importantly, however, is the fact that equity-based crowd funding is an inevitability. If the U.S. doesn’t get it right, another country will and that would be a shame considering how that will likely put small U.S. companies at a competitive disadvantage to their foreign counterparts. The SEC needs to get on the right side of history and progress on this one. Unfortunately, it has not yet shown any inclination to truly husband crowdfunding in a meaningful way that might upset Wall Street’s capital formation monopoly.
But I am still hopeful that the proposed regulations will provoke a ground swell of opposition that may yet motivate the SEC to promulgate regulations that are at least a bit simpler, and a bit less costly, and at least, a bit more likely to help, rather than hinder, American equity-based crowdfunding.
A copy of the SEC’s proposed regulations can be accessed at https://www.sec.gov/rules/proposed/2013/33-9470.pdf. Comments regarding the proposed regulations can be submitted to the SEC via an online form accessible at https://www.sec.gov/rules/proposed.shtml or sent to the SEC by email at rule-comments@sec.gov. Comments should be transmitted no later than February 3, 2014.
If you or your business is considering the use of crowdfunding to raise capital for a business or a project, I invite you to call my office number listed below.
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.
