President Obama signed the “Jumpstart Our Business Startups Act” (the JOBS Act) on April 5. Part of this law authorizes crowdfunding for the first time. (Until now, crowdfunding could only be done legally by a company that actually pre-sold its goods or services at a discount.)
However, that doesn’t mean the crowdfunding provisions take effect immediately. The Act gives the Securities and Exchange Commission 270 days to issue regulations for crowdfunding offerings. You can’t crowdfund before the SEC issues those regulations. Still, the Act is expected to open up crowdfunding for several smaller companies.
The crowdfunding exemption applies to issuers that do not sell more than $1 million to investors under any exemption during any 12-month period. Companies that want to raise more than 1 million dollars in 12 months will not be able to use crowdfunding.
In short, the amounts that investors can invest are limited by their income and net worth. Crowdfunding must be done through “Conduits” registered with the Securities and Exchange Commission (SEC). Issuers may not advertise, except for notices directing investors to the conduit. Issuers must also file annual reports with the SEC. In terms of financial disclosures, offers of less than $100,000 in a year are only required to provide financial and income tax returns certified by their CEO. With offerings between $100,000 and $500,000 in a year, the finances must be reviewed by a certified public accountant. For offers between $500,000 and $1 million, the financials must be audited.
Inverter Quantity Restrictions
There are some restrictions on how much investors can invest. Investors who have an annual income of less than $100,000 or whose net worth (presumably excluding primary residence) is less than $100,000 may only invest in any 12-month period, whichever is greater of $2,000 or 5 percent of annual income or net worth of the investor. One thing companies using crowdfunding will need to consider is whether they want to set higher minimums for the investment, since the administrative time for a small investor is often as long as for a large investor. If $1,000,000 was raised by having 500 people invest $2,000 each, the administrative time per investor could be a substantial part of the $2,000 contributed by each investor.
If the investor’s annual income or net worth (again, presumably excluding primary residence) is equal to or greater than $100,000, then the investor may invest 10 percent of the investor’s annual income or net worth in any 12-month period. , not to exceed a maximum amount of $100,000.
(There is an inconsistency in the wording of the statute regarding these two categories. Presumably, to fit into the second category, the investor must have income greater than $100,000 AND (not “or”) net worth greater than $100,000. Expect the SEC to address this in their regulations.)
The use of registered conduits is required
For better or worse, the transaction must be conducted through a licensed broker-dealer or funding portal (either of which we will call the “Conduit”) that has registered with the SEC for crowdfunding. The Conduit must also register with any applicable self-regulatory organization, such as FINRA. (There are people who are not brokers who must register with FINRA.) Part of the duties of the Conduit are: provide information to investors regarding the risks; ensure that each investor reviews investor education information; and confirm that the investor understands that it is risking the loss of the entire investment, that the investor could bear such a loss, that the investor understands the level of risk applicable to investments in new companies, emerging businesses and small issuers, and understands the risk of lack of liquidity.
The Conduit must also obtain a securities regulatory compliance and background check on each officer, director and person who owns more than 20 percent of the outstanding capital of each issuer whose securities are offered. In addition, the conduit must ensure that all offering proceeds are only released to the issuer when the total capital raised from all investors is equal to or greater than the target offering amount, and allow all investors to cancel their investment commitments. . (There are also other requirements.)
Issuer Actions Required
Issuers using crowdfunding also have requirements to meet. The issuer is required to file with the SEC.
In addition, an issuer using the crowdfunding exemption may not advertise the terms of the offering, except for notices directing investors to the funding portal or broker, and not less than once a year file with the SEC and provide to investors reports of the results of operations and financial statements of the issuer. This is unusual as most private placement offerings do not require annual filings with the SEC.
Non-financial disclosures
In terms of non-financial disclosures to investors, the issuer must provide, among other things: a) the names of the directors and officers (and any person holding a similar status or performing a similar function), and each person having more than 20 percent of the issuer’s shares; and b) the anticipated business plan of the issuer. Not much of a surprise there.
The issuer must also disclose, among other things, 1) the target offering amount, the target date for reaching the target offering amount, and regular updates on the issuer’s progress in meeting the target offering amount; and 2) a description of the issuer’s ownership and capital structure. The latter must include, in addition to other matters, (a) the terms of the securities of the issuer being offered and each other class of securities of the issuer; (b) a description of how the exercise of the rights of the issuer’s major shareholders could adversely affect purchasers of the securities being offered; and (c) how the securities being offered are valued and examples of methods for how the issuer may value such securities in the future.
financial disclosures
The financial description requirements depend on the amount being raised. For offerings that, together with all other issuer crowdfunding offerings within the preceding 12-month period, total $100,000 or less, the issuer must provide: (i) the issuer’s filed income tax returns for the year most recent complete, if applicable, and (ii) the issuer’s financial statements, which must be certified by the issuer’s chief executive officer as true and complete in all material respects (but need not be audited).
Where the current offering plus other crowdfunding offerings by the issuer total more than $100,000 but less than $500,000, the issuer must provide financial statements reviewed (but not audited) by a CPA who is independent of the issuer.
When the total of the current offering and crowdfunding offerings in the last 12 months total more than $500,000, audited financial statements are required. Given the cost of audited financial statements and the $1,000,000 limit on offers, some issuers may decide not to take the crowdfunding approach.
Priority of state law
Fortunately, crowdfunding provisions appear to take precedence over state law regarding state registration, documentation, and offering requirements. The provisions still allow states to take enforcement action. States may require the filing of notices (as is done with Rule 506 offers), but not charge filing fees. (Section 305.)
Much will depend on the regulations issued by the SEC.
