Nexsen Pruet - Crowdfunding
Sharing the utility and best practices for equity crowdfunding and related initiatives (JOBS Act) to help emerging companies raise capital.
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On December 18, 2013, the SEC issued rules to complete one of the last rule-making requirements under the 2012 JOBS Act - the new rules for "Reg A+." The old Reg A exemption had fallen into almost complete disuse for more than 20 years principally for two reasons: (1) old Reg A was limited to offerings up to $5 million and (2) still required expensive SEC and state filings and reviews that rivaled the cost and time-commitment of a full IPO registration. New "Reg A+" is intended to improve the utility of this exemption.
"Reg A+" (which is technically now Tier 2 of Regulation A) will allow offerings up to $50 million and will pre-empt state registration, but still requires, of course, SEC filing and review of extensive disclosure documents similar to an IPO registration, including audited financial statements, and will limit investments to 10% of the investors' net worth or income. And there are other applicable requirements, of course. The old Reg A exemption (now called Tier 1) remains available in essentially the same format.
Most commentators believe these changes to Regulation A are important improvements, and as an interim step towards an IPO and fully registered company trading on a stock exchange, I agree. But "Reg A+" is not really a useful tool for seed-capital or development-capital formation by the typical start-up or other early-stage company. It wasn't supposed to be, and it is not. But it is good to know it is available for the right situation as an interim step.
For most start-ups and other early-stage companies, the best alternative for raising capital under the federal securities laws seems to remain the exemption under Rule 506. The new SEC rules under the 2012 JOBS Act that were issued in the last quarter of 2013 give these companies some new alternatives, like the potential for using general advertizing under new Rule 506(c) as long as the new requirments, like "verification" of accredited investors, are satisfied, and for select situations, maybe Crowdfunding for up to $1 million, when rules become effective and the funding portals come on line and develop a solid, efficient set of protocols, systems, and forms. There are limitations and drawbacks for these new alternatives, so they might not fit every situation, but they merit consideration when a young, innovative company is seeking early-stage capital. And as always, prospective issuers of securities should diligently avoid "gun-jumping" by consulting securities counsel and developing a rigid compliance plan before initiating any offering activities. See previous updates to this site for more information on Rule 506(c) and the Crowdfunding Rules.
As the marketplace absorbs the 600 pages of the SEC release by which the equity crowdfunding rules have been proposed, a few random observations:
1. The SEC does not appear to encourage equity crowdfunding as a DIY project in which issuers can undertake a lot of the work to save costs. The proposed rules will impose obligations to make and file formal, comprehensive disclosures on a new SEC Form C offering circular (with mandatory updates on new Form C-U, amendments on new Form C-A, annual reports on new Form C-AR, and terminaton notices on new Form C-TR) and to provide CPA "reviewed" financial statements for offerings between $100,000 and $500,000 and CPA audited financial statements for offerings exceeding $500,000.
2. The proposed rules permit the conduct of equity crowdfunding only by an issuer through certain intermediaries. Intermediaries handling equity crowdfunding must be either (a) securities broker-dealers or (b) funding portals, both of which must be licensed with the SEC and FINRA. The portals will have serious obligations under the SEC and FINRA rules, such as record-keeping, fidelity bonds, confirmation of issuers' compliance, management of investment limitations, anti-money laundering rules, transaction confirmations, risk-factor disclosures and acknowledgements, and other educational materials. The intermediaries will be prohibited from having a financial interest in the issuers. The intermediaries cannot pay employees for soliciting investments and cannot pay "transaction-based" compensation (i.e., a commission based on success of trhe investment). And funding portals that are not broker-dealers cannot handle investment funds, so they will need formal arrangements with Bank trust departments to provide escrow services, imposing yet another cost. All of these obligations suggest that the intermediaries will need to charge issuers more than nominal upfront fees to break even.
3. There are plenty of areas where foot-faults can occur by the unsohisticated issuer, and foot-faults can have very serious legal consequences. For example, an issuer can only conduct equity crowdfuding on one portal at a time. Severe restrictions are imposed on advertizing the offering. Regular business communicatons by the issuer are permitted, but restricted by the proposed rules. Any payments for solicitations and advertizing related to the offering must be disclosed in a formal way. Issuers are disqualified from equity crowdfunding if the issuer or any of its officers, directors, and certain other affiliates fail certain technical "bad boy" rules. Issuers who have an inadequately specific business plan, or whose business plan involves buying an unidentified company, are not eligible.
4. Equity crowdfunding issuers will have on-going responsibilities and costs under the proposed rules, including formal annual reports to the SEC and investors, transfer record-keeping like a transfer agent, and management of resale restrictions. And of course, the costs of managing a large number of small investors for shareholder meetings, voting, trades, inquiries, proxies, and other shareholder relations issues.
So the idea of using social media to conduct capital formation should not be interpreted to suggest that it will be easy, fast, or inexpensive. The regulators don't think in those terms. Under the proposed SEC rules, it might turn out that only the strongest emerging companies will be able to take advantage of equity crowdfunding and do it well enough for a successful outcome. It would be most unfortunate if equity crowdfunding became yet another Darwinian filter that inhibits opportunity when it was the intent of Congress to democratize start-up investing. We can hope that the new funding portal industry will be creative and thoughtful about developing systems and procedures that keep the field more open, diverse, flexible, and cost-effective. Perhaps we'll see more progress before the SEC and FINRA proposed rules go into effect in February 2014.
A few more recent articles on the newly proposed SEC multi-state equity crowdfunding rules that might go into effect as soon as 90 days:
Fox Business: http://smallbusiness.foxbusiness.com/finance-accounting/2013/10/24/sec-new-crowdfunding-rules-explained/
Washington Post: http://www.washingtonpost.com/business/on-small-business/new-crowdfunding-rules-the-good-and-bad-news-for-entrepreneurs-and-investors/2013/10/28/c634045e-3fe7-11e3-9c8b-e8deeb3c755b_story.html
Here's an article about the SEC's latest step on the multi-state equity crowdfunding journey under the JOBS Act. http://www.reuters.com/article/2013/10/23/us-sec-crowdfunding-idUSBRE99M03O20131023 The new SEC rule proposal, which will not go effective for at least 90 days, if then, is very long and imposes a lot of burdens on the start-up company like filing of financials and other information with the SEC, not to mention the requirement of a whole new regulatory scheme for funding portals. If you care to comment on the SEC's proposed rules, you may do so on the SEC website.
The SEC's Board of Commisioners has today taken an important first step towards adopting rules to permit equity crowdfunding as contemplated by the JOBS Act. Next steps include isssuing proposed SEC rules for comment and subsequent votes by the Board to approve the rules, so multi-state equity crowdfunding involving unaccredited investors like the JOBS Act contemplated is still not legal, but is a step closer. One area expected for comment will be whether "verification" of accredited investors will be required. And recall that there will also need to be a regulatory system for licensing the funding portals, etc. that is likely to come from FINRA. Progress, but not yet a full answer. Stay tuned....
An interesting recent development: Using the Georgia intrastate crowdfunding act and the federal intrastate offering exemption, a successful $100,000 US equity crowdfunding offering has been completed on Sparkmarket. It is a small step, and not one that can yet be lawfully duplicated many other places, but it is a step in an interesting and encouraging direction. Intrastate offerings (like SEC Rule 147) have a variety of restrictions and limitations to consider, including extra resale restrictions and limitations on where the proceeds can be used and by what kinds of companies. For a discussion of the Sparkmarket transaction, see http://us7.campaign-archive.com/?u=b2205a9a8fbf7e14de19c76da&id=247221c769&fb_action_ids=10151952021224777&fb_action_types=og.likes&fb_source=other_multiline&action_object_map=%7B%2210151952021224777%22%3A1422337977979048%7D&action_type_map=%7B%2210151952021224777%22%3A%22og.likes%22%7D&action_ref_map=%5B%5D
A few followers have communincated some ideas and questions to prompt a few thoughts on best practices, so here goes (for starters):
1. Select a reputable funding portal that has a solid set of procedures and a well-designed system, and later when equity crowdfunding is finally an established method or capital formation, a good history of success. A lot of time, money, and brand reputation could be lost if the funding portal does not do a good job or provide a platform that is efficient and reliable, with lots of good advice and recommendations. Consider portals that have an established pool of active investors or some kind of reliable pipeline.
2. The issuer needs to have in place before the crowdfunding round starts a sophisticated and well-designed company structure, addressing in advance issues like pre-emptive rights, cummulative voting, Board structure, voting rights, annual meetings, financial and other reporting, and especially buy-sell rights and restrictions. These should often include a take-along and a compulsory buy-out right to allow for flexibility if the issuer anticipates future rounds of capital formation, such as venture capital or other private equity investments.
3. Establish and manage realistic expectations. Go beyond just the legal requirements, but consider the challenges of managing the expectations of a large number of small investors, some of whom might not be experienced in investing in emerging companies where progress is seldom a straight path. Investor patience might be a quality that the issuer will need to prompt and reinforce. The value of transparency and effective disclosure might be at a premium for crowdfunded ventures.
4. Plan and budget for rigorous business planning and reporting, and budget for managing investor relations. A successful crowdfunding round could result in dozens and dozens of investors, while raising only $1,000,000 per year, forcing the issuer to address investor relation issues like a public company without the capital or infrastructure to easily do so. Set reasonable investment minimums to help address these kinds of issues, and plan in advance how you will manage these demands on resources when they arise.
5. Consider non-voting stock for crowdfunding rounds to minimize later costs and issues like proxy soliciation, etc. for annual meetings and other decision-making. Of course, this needs to be balanced against the diminished attractiveness of non-voting stock for potential investors.
6. Be sure that the use of proceeds is reasonable in light of the costs of raising capital in a crowdfunding round, including the costs of managing the "crowd" investors after a successful round.
7. Be sure the issuer is rasing enough money to reach designated milestones where value can be created for the investors. Consider min-max offering structures to provide adequate comfort to early investors.
8. Plan for reliable financial reporting. The issuer will need financial statements in the crowdfunding offering materials and SEC filings, but should also anticipate the need and cost of financial reporting throughout the life of the company. And consider whether the financial history of the company is sufficient, and sufficiently reportable, at the time of the crowdfunding round to attract a successful response from the crowd.
9. A failed crowdfunding effort will likely have a public impact on the company and its brand. So be prudent about the prospects of success, and don't jump into crowdfunding before the venture is ready.
10. Have a well-versed team of professional advisers to help you navigate the requirements. The rules (whenever they are eventually issued by the SEC) will require a lot of technical compliance, so the issuer of the securities will need a good team. Violation of the rules can have disasterous effects on the emerging company, setting it back years or even prematurely ending its venture. And of course, as with any securities offering, the issuer and its officers and directors can be exposed to personal liablity for a violation of the law.
More to come in later installments....
I will welcome your input on these "starter" best practices, and on other best practices for crowdfunding that we should consider. And remember, that until the SEC issues the rules, "equity" crowdfunding as contemplated by the 2012 JOBS Act is not yet legal.
Here's a different idea - crowdfunding on TV. Of course, equity crowdfunding as envisioned under the 2012 JOBS Act (on TV or the Internet or elsewhere) is still not legal under the US federal securities laws (still waiting on SEC rule-making and other requirements), but planning and jostling for position in anticipation of crowdfunding seem to be in full swing. See for example PeoplesVC to Launch First Crowdfunding TV Channel: http://www.crowdsourcing.org/document/peoplesvc-to-launch-first-crowdfunding-tv-channel-peoplesvc-tv/28062
"Caution" continues to be an important word for equity crowdfunding. See these recent articles:
States Greet Crowdfunding with Hostility: http://www.thestreet.com/story/12017576/1/the-deal-states-greet-crowdfunding-with-hostility.html
Tread carefully on equity crowdfunding: http://www.jsonline.com/business/tread-carefully-on-equity-crowdfunding-b9981502z1-220941091.html
The SEC's new rules governing the use of general solicitation in Rule 506 "private" placements are being justly criticized for the burdens they will impose on typical start-up ventures. See http://techcrunch.com/2013/08/17/sec-fundraising-rules/. Issuers will be required to comply with pre-offering and post-offering notice filing requirements with the SEC, file all of the solicitation materials with the SEC, display specified legends in the offering materials, and verify that all investors are accredited perhaps by obtaining tax returns or CPA certifications, or by engaging an independent firm to provide the verification service. These and other requirements will be expensive, and will often discourage the accredited investors from participating in the offering because they will likely (and perhaps correctly) perceive that the verification process is an intrusive invasion of their privacy. This will all cost start-ups money they don't have. And the risk of a foot-fault by a novice start-up who posts something on social media or the company website without complying with all the techical requirements will be significant - a one-year moratorium on selling securities as one of the potential penalties. These tough general solicitation requirements do not predict user-friendly crowdfunding rules when they are finally announced.
As these rules are being developed, some interesting things are happening in the ancillary marketplace. For example, a cottage industry seems to be developing to provide verification services for issuers who hope to use general solicitation to make Rule 506 exempt offerings. See
In the UK, regulators are investigating crowdfunding sites. I imagine the same is happening in the US, and will continue, as regulators are very concerned about the crowdfunding arena. See http://www.kensingtonandchelseatoday.co.uk/business-and-finance/9u56q8y9f9.html.
States other than Georgia and Kansas are exploring intrastate crowdfunding rules. An initiative to introduce equity crowdfunding legislation in South Carolina is being led by John Osborne in Charleston. See http://investscexemption.com/. Wisconsisn is also taking a look. See http://www.cpapracticeadvisor.com/news/11113250/wisconsin-considering-allowing-crowd-funding-of-public-businesses. One of the challenges for issuers using these state exemptions, of course, is the need to pair them with a federal exemption, like SEC Rule 147 for intrastate offerings. Rule 147 imposes some technical and other restrictions that any prospective issuer should consider, like out-of-state resale restrictions for a period of time after the offering.
Media and marketplace chatter is suggesting that the SEC is nearing the stage of issuing equity crowdfunding rules. After the recent SEC rules permitting general soliciation in Rule 506 offerings (a September effective date), maybe the time is soon coming when we'll get a look at what the SEC will require for equity crowdfunding. Some chatter suggests that equity crowdfunding might be available as soon as this Fall, but with all the requirements, I am not quite so optimistic. We can expect from the JOBS Act that licensing of the funding portals, disclosure obligations, and SEC filing requirements will be imposed, plus limitations like $1 million offering caps and investor qualifications and investment limits. See “Rules ready for selling stock via crowdfunding”
Some experts are becoming thoughtful about how equity crowdfunding might take shape and where it might be useful and where it probably will not. And example of analysis for the community bank marketplace is “Three’s a crowd but are they investors?”
Even when equity crowdfunding is legally available, there is a lot of work needed for implementation and best practices. For example, the private equity and venture capital industry has already expressed concern about how a crowdfunded company can undertake subsequent rounds of investment, and whether having a "crowd" of small investors in the company will interfere with the availability of later stage capital - so a best practice might be to always have a "take-out" and a "take-along" contract with the crowdfunding investors.
On July 24, 2013, the SEC finally issued the required rule changes to permit the use of general solitiation for securities offerings under the exemptions in SEC Rules 506 and 144A. The new rule changes will become effective September 23, 2013 in the absence of further actions by the SEC. When in effect, general solitation will be permitted in Rule 506 offerings as long as all purchasers are accredited investors, the issuer has followed all the new rule requirements to verify the accredited status of the investors, and the issue checks the proper boxes on its Form D filings to indicate the use of general solitiation. Other conditions may also apply. This is not yet the new rule-making needed for the availability of equity crowdfunding, but it represents an incremental step in that direction. This new rule should provide some flexibilty to emerging companies to help them identify accredited investors for investment opportunities.The full text of the new rule is available at the SEC website (SEC Release No 33-9415 and 34-69959) and in the Federal Register.
Apprentice Mechanic and Sales Associate at Granny's Auto Sales
Granny's Auto Sales
Director, Center for Entrepreneurial Development
Presbyterian College School of Pharmacy
The SEC is receiving comments on the proposed equity crowdfunding rules for 90 days after October 23. You may comment yourself at www.sec.gov, and I encourage you to do so. Or if enough of you want to tell me what comments you would like to submit and if there is enough of a consensus that I can distill common themes, it might make some sense for us to use our common connection on Innoventure.com to develop a set of comments that are widely enough supported that I could submit them to the SEC on behalf of our group of 100 or so to perhaps have additonal impact? If you have succinct comments on the SEC's rules that you would like to suggest for compilation, let me know on this site. Please, no lengthy essays or diatribes, just pithy points for changes in the rules that I might compile and circulate before submitting them. I have no idea how this request might shake out, so no promises that I can create a set of common comments, but I am willing to give it a shot if you are. Thanks.
One of the goals for this crowdfunding initiative on Innoventure.com is to identify and develop best practices for equity crowdfunding. I have seen a few best practices in the commentaries in the marketplace, and have a few ideas of my own, but it might be helpful if all of the followers of this Innoventure initiative contributed some ideas about best practices. So if you have a suggestion for best practices, or a question about a function or process where we could develop best practices, please send it to me by email throught the Innoventure Contact process. I will then compile and report back to everyone in a later Innoventure.com Update. Thanks.