Crowdfunding means using the internet to raise money, often in small increments, from a potentially large number of sources. Websites such as Kickstarter and Indiegogo provide platforms for obtaining donations to fund artistic or charitable projects without any expectation of a return. Attempts by profit-seeking companies to use crowdfunding to solicit investments online, however, have run afoul of securities laws.
Even via the internet, securities offerings must be registered, which is very difficult and expensive, or else exempt from registration. The problem is that crowdfunding doesn’t fit under existing exemptions for private placements, because it targets large numbers of investors lacking the income or net worth to be “accredited investors.”
Last year, the S.E.C. stopped an attempt to raise $300 million online to buy out Pabst Brewing Co. in an offering that was not registered or exempt. The promoters had secured over $200 million in pledges before they were shut down. Despite violating the registration requirement for securities offerings, they succeeded in demonstrating crowdfunding’s potential for raising capital.
The JOBS Act was enacted on April 5 with the goal of facilitating capital formation and creating jobs. Part of this new law gives the S.E.C. until the end of 2012 to issue detailed rules implementing a crowdfunding exemption from the registration requirement for securities offerings. On April 23 the S.E.C. warned that issuing securities through crowdfunding won’t be legal until its rules take effect.
Although crowdfunders must wait for the S.E.C. rules, the JOBS Act has already set some parameters for the new crowdfunding exemption:
-An issuer may sell up to $1 million of securities in any 12-month period to an unlimited number of investors (so, the crowdfunding exemption is geared for startups and other small businesses, not for takeovers of Pabst).
-The maximum amount of securities that an issuer may sell per year to any particular investor is the greater of $2,000 or 5% of the investor’s annual income or net worth (if less than $100,000), or 10% of the investor’s annual income or net worth (if $100,000 or more).
-Public (i.e., S.E.C. reporting) companies, investment companies, non-U.S. companies, and companies subject to “bad actor” disqualifications can’t use the crowdfunding exemption.
-Offerings under the crowdfunding exemption must be conducted through an intermediary registered with the S.E.C. as a broker or “funding portal.”
-Advertising of crowdfunded offerings is not permitted, except for notices directing potential investors to the intermediary’s platform.
-An issuer must disclose certain information, including its business plan, capital structure, planned use of proceeds, and (depending on the target offering amount) income tax returns and officer-certified financial statements, unaudited financial statements reviewed by an independent accountant, or (if more than $500,000) audited financial statements.
-Issuers must disclose the target offering amount, and investors may rescind their commitments until this amount is reached.
-Crowdfunded offerings issue “covered” securities, which are exempt from State “blue sky” registration requirements, but not antifraud provisions.
-Securities issued under the crowdfunding exemption must be held for at least one year before they can be transferred, with limited exceptions.
Concern about crowdfunding’s potential for fraud – picture “boiler rooms” peddling fake securities to unsophisticated investors on the internet’s massive scale – led to the requirement for crowdfunded offerings to be conducted by registered intermediaries acting as gatekeepers. Intermediary brokers or “funding portals” that operate online platforms for crowdfunding must disclose information to investors, educate investors about risks, protect investor privacy, make sure the offering caps are not exceeded, obtain background checks on an issuer’s officers, directors, and holders of more than 20% of its equity, and perform any other tasks required by the S.E.C. and the intermediaries’ self-regulatory organization (possibly FINRA). Fees to intermediaries will increase the cost of capital for issuers – by how much depends in part on what the S.E.C. rules require.
Besides the expense of offering securities through intermediaries and of disclosing required information, crowdfunded offerings will have other drawbacks startups should consider. One is that crowdfunding issuers will have an ongoing reporting obligation to file annual financial statements, in a form to be specified by S.E.C. rules. Another is that confidential, proprietary, or competitive information may be required to be publicly disclosed.
In addition, issuing companies – and their officers and directors personally – face potential liability for securities fraud if these disclosures contain a material misstatement or omission. They also risk lawsuits for breach of fiduciary duty brought by disgruntled shareholders. This risk is multiplied by having thousands of shareholders instead of a few.
Having thousands of shareholders can also cause corporate governance and control headaches for a startup. Obtaining sufficient shareholder votes for various approvals may become difficult. Just notifying shareholders of annual meetings may become expensive. Even more problematic, a crowdfunded company with thousands of shareholders may find it difficult to attract later-stage investments from venture capital firms, which do not like complicated capital structures and large shareholder bases.
The initial holders of shares purchased in a crowdfunded offering are not counted toward the threshold number of shareholders of record triggering S.E.C. reporting requirements, such as filing 10-Ks, 10-Qs, 8-Ks, etc. The JOBS Act raised this threshold to 2,000 record holders or 500 record holders who are not accredited investors. It’s possible, though, that the S.E.C.’s crowdfunding rules may count subsequent transferees of crowdfunding securities, many of whom may not be accredited investors, toward the shareholder threshold for reporting. This could lead to the disastrous result of requiring crowdfunding issuers to become S.E.C. reporting companies after the one-year holding period expires.
The bottom line for now is that much of the utility of crowdfunding will depend on the forthcoming S.E.C. rules. Still, many features of the new crowdfunding exemption are already clear. Startups and others excited about crowdfunding’s potential for raising capital should use this interim period before crowdfunding becomes available to educate themselves, to analyze crowdfunding’s costs and benefits, and to compare it with alternatives such as Rule 506 private placements to accredited investors.
J. Victor Peterson is an attorney with Lathrop & Gage in Chicago. Opinions expressed here are his own.
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