Equity Crowdfunding Fundamentals
Although equity crowdfunding is now legal, the Securities and Exchange Commission (SEC) has 270 days to implement the equity crowdfunding provisions found in Title III of the Jumpstart Our Startups Act (JOBS Act) adopted last week. Until the SEC releases the regulations it proposes to adopt for equity crowdfunding in accordance with Title III of the JOBS Act (expect to see something from the SEC at the end of November or early in December 2012), it is impossible to know exactly how the process of equity crowdfunding will work. However, the JOBS Act may be dissected to provide the following idea of what is coming.
Who Can Raise Capital with Equity Crowdfunding?
In order to utilize equity crowdfunding, an issuer of equity securities (1) must be organized under the laws of a state or territory of the United States or the District of Columbia; (2) must not already be subject to the reporting requirements of the Securities Exchange Act of 1934, as amended; and (3) must not be a “bad actor” at the time of the offering.
Organization Type and Place
Organizing as a corporation, limited liability company (LLC), or a limited partnership in any of the fifty states, the District of Columbia, or Puerto Rico, Northern Mariana Islands, United States Virgin Islands, American Samoa, Guam, or Minor Outlying Islands will satisfy the organizational condition. While it does not appear that S-Corps or general partnerships would be prevented from utilizing equity crowdfunding, the 100 shareholder limit for S-Corps and the difficulty in managing a general partnership with hundreds, if not thousands, of general partners makes the use of these organizational forms seem unattractive.
Reporting Under the Securities Exchange Act of 1934
While the Securities Act of 1933, as amended, regulates the issuance of securities by corporations and other business organizations, the Securities Exchange Act of 1934, as amended, primarily regulates the secondary trading of securities between people unrelated to the issuer. The Securities Exchange Act of 1934 forces companies to make public information that investors are likely to use when making investment decisions. Securities that are traded in interstate commerce, are from issuers having total assets in excess of $1 million, and are held by record of 500 or more persons are subject to the reporting requirements of the Securities Exchange Act of 1934 prior to the JOBS Act. After the JOBS Act, assets must be in excess of $10 million, and securities must be held by 2,000 or more persons or 500 or more non-accredited investors.
The definition of “bad actor” is not defined in Title III of the JOBS Act. Rule 262(a) of Regulation A disqualifies an issuer if he or his predecessors or any affiliated issuer has filed a registration statement that is the subject of a pending Section 8 examination, is subject to a pending Rule 258 or similar proceeding for a period of five years after a felony or misdemeanor conviction in connection with the purchase or sale of securities or a false filing with the SEC, is subject to a court order or similar in connection with the purchase or sale of securities, or is subject to a false representation order under 39 United States Code § 3005 within the past five years. Rule 262(b) of Regulation A disqualifies an issuer if any of her directors, officers, or general partners or any beneficial owner of 10% or more of an issuer, promoters, or anyone connected with an issuer in any capacity has been convicted within the last ten years of a felony or misdemeanor related to the purchase and sale of securities; has within the past five years been the subject of a court order related to the purchase and sale of securities; is subject to an order of the SEC under Section 15(b), 15B(a), or 15B(c) of the Securities Exchange Act of 1934 or Section 203(e) or (f) of the Investment Advisers Act of 1940, is suspended or expelled from or in association with a member of a registered national securities exchange or registered national securities association for acts or omissions inconsistent with just and equitable principles of trade; or is subject to a false representation order under 39 United States Code § 3005 within the past five years. As the SEC has proposed to use Rule 262 for Rule 506 offerings, and because the Dodd-Frank Act requires new rules to be substantially similar to Rule 262, it is likely that for purposes of equity crowdfunding, the term “bad actor” will be defined very similarly to the definition used in Rule 262.
Who May I Sell Securities to Using Equity Crowdfunding?
Number of Investors
The JOBS Act does not appear limit the number of shareholders to whom securities may be issued through equity crowdfunding. The JOBS Act even exempts securities acquired in equity crowdfunding transactions from Section 12(g) of the Securities Exchange Act of 1934, which the JOBS Act also amends. The SEC may impose limits on the number of shareholders and even if it does not, an issuer should strongly consider his or her ability to manage investor demands if there are too many individual shareholders.
Per Investor Limits?
Investors are limited in the amount of money that may be invested in each issuer, and the limits depend upon the income or net worth of the individual investor. Investors earning less than $100,000 per year or with a net worth of less than $100,000 may only invest the greater of $2,000 or 5% of annual income or net worth. Investors with annual income or net worth greater than or equal to $100,000 may only invest the 10% of annual income or net worth with a limit of $100,000.
What is the Annual Capital Limit for Equity Crowdfunding?
In each twelve-month period, an issuer may raise up to $1 million using equity crowdfunding transactions. This limit must be reviewed by the SEC for adjustment at least every five years.
What Disclosures Must Equity Crowdfunding Issuers Make?
The official name of Title III of the JOBS Act is the “Capital Raising Online While Deterring Fraud and Unethical Non-Disclosure Act of 2012” (CROWD FUND Act). The name alone should make it clear to would-be issuers that while the mechanisms of funding and the numbers and identities of investors have loosened, the investor protections already in place to deter fraud and non-disclosure of material risks will not be relaxed.
At a minimum the issuer must disclose:
(1) The name, legal status, address, and website of the issuer;
(2) The identities of the directors, officers, and each shareholder having more than 20% securities ownership of the issuer;
(3) A description of the business plans of the issuer and a copy of the business plan of the issuer;
(4) disclosure of the financial condition of the issuer, including:
(a) A copy of the issuer’s income tax returns for the previous year (if any were required to be filed) and a copy of the issuer’s financial statements certified by the principal executive of the issuer as true and complete in all respects; or
(b) A copy of financial statements reviewed using professional standards and procedures by a public accountant independent of the issuer for offerings between $100,00 and $500,000; or
(c) A copy of audited financial statements for offerings greater than $500,000;
(5) A description of how the invested funds will be used by the issuer;
(6) The minimum target amount and target date to reach that amount, along with regular updates of the issuer’s progress toward the target;
(7) The price of the securities offered or the method of calculating the target price if unknown during the offering, provided potential investors have rescission rights after disclosure of the final price of securities once settled;
(8) A description of the capital structure of the issuer, including:
(a) A recital of the terms for each of the classes of securities, descriptions of how terms may be modified, a summary comparing the securities with a description of how rights may be limited by dilution or other processes;
(b) A description of how rights exercised by the issuer’s principal shareholders could affect investors negatively;
(c) The identity of each owner of more than 20% of any classes of securities;
(d) How the offered securities are valued with examples of methods for how the issuer may value securities in the future;
(e) The risks to minority investors and the risks inherent to corporate actions, including additional issuances and sales of securities, and the risks of transactions made with parties related to the issuer;
(9) Any other information the SEC may require to be provided.
Those familiar with pre-crowdfunding methods of raising capital will recognize that much of the information required to be disclosed for equity crowdfunding under the JOBS Act is the information disclosed in the private placement memoranda for private placements of securities under Rules 504, 505, and 506, making it clear that issuers of securities who want to take advantage of equity crowdfunding are strongly advised to retain competent legal counsel with experience in securities issuance.
Once funded, issuers will be required to file ongoing reports and financial statements with the SEC and make the same available to investors at least annually. The SEC may prescribe other reporting to be completed annually or more frequently to protect investors.
The typical rescission rights (e.g., the right of an investor to recover his or her entire investment plus interest) will apply to equity crowdfunding if the issuer makes a material misstatement or omission in the offering documents. For purposes of this section, the issuer includes not only the entity issuing its own securities, but the directors, officers, and any other person or entity who offers or sells the security on behalf of the issuing entity (read: the intermediary). This warrants a reiteration that prospective equity crowdfunding issuers should retain legal counsel experience in the issuance of securities and, because liability may befall the intermediary, expect the intermediary to review and approve of disclosure documents before allowing an issuer to proceed with an offering.
How is an Equity Crowdfunding Offering Executed?
Use of Intermediaries
Either a licensed securities broker or a registered funding portal must be used as an intermediary between the issuer and the investors. Intermediaries must register with the SEC and any self-regulatory organizations which may be established.
Responsibilities of Intermediaries
Intermediaries are required to make disclosures to investors about the risks of investments and to positively affirm that each investor understands the risks prior to allowing an investor to make an investment and accepts the possibility of, and is able to endure, the loss of the entire investment. It is also the responsibility of the intermediary to ensure each investor does not invest beyond the limits set based upon his or her annual income or net worth. This duty potentially exposes intermediaries to liability to investors who lose all or part of an investment if the investor can successfully prove that he or she did not understand the risk of his or her investment.
The onus of deterring fraud also falls onto the intermediary. Intermediaries are required to conduct background checks on each officer, director, or holder of more than 20% of the securities. This duty also presumably opens up intermediaries to liability if a background check does not discover that the issuer or one of the issuer’s principals or 20% shareholders is a bad actor.
Finally, intermediaries must ensure that funds are not released to an issuer until the minimum investment target set by the issuer is met. This ensures that the issuer only receives funds if such funds are sufficient to meet the minimum set of goals set forth in the business plan of the issuer.
Solicitation of Investors
Issuers may not advertise an offering but may publish notices and use the internet to direct potential investors to the intermediary facilitating the issuer’s offering.
An intermediary that is not a licensed broker may not (1) offer investment advice; (2) solicit offers for sales; (3) pay others for solicitation of sales; or (4) handle funds or securities.
Intermediaries may be compensated, but the JOBS Act does not provide guidance on the regulation of this compensation.
Applicability of Blue Sky Laws
The JOBS Act preempts state law, but it also goes a step further and prohibits states from requiring registration or offering requirements for equity crowdfunding offerings. However, the principal state in which the issuer is located, as well as any state where more than 50% of its shares are issued, may require a notice filing and filing fees.
When May Investors Resell Securities?
Securities purchased in equity crowdfunding offerings must hold those securities for one year after the purchase, unless the securities are repurchased by the issuer, sold to an accredited investor, or sold as part of a registered public offering. Transfers to family members in connection with circumstances such as death and divorce and, although not stated, presumably between the purchaser and a trust for which the purchaser is the settlor will be permitted before one year has passed since the purchase.