Can your business use the new crowdfunding law to raise funds?
Whether your business can use the new federal crowdfunding law, the JOBS Act, to raise funds for your business depends on your circumstances. However, entrepreneurs and business advisors should be warned that this law is new and many of the details have yet to be flushed out by the U.S. Securities and Exchange Commission (SEC) and the courts.
This article gives a general overview of the JOBS Act and how entrepreneurs might consider using it to fund their business ventures.
In general, the purpose behind the JOBS Act was to have less regulation and government accountability for investments in relatively small ventures (generally those under $5 million).
Did the JOBS Act make a securities offering targeted at under $5 million economically sound?
The JOBS Act (“the Act”) has, as of April 5, 2012, already changed, or will be changing a number of sections in the Securities Act of 1933 (“Securities Act”) and the Securities Exchange Act of 1934 (“Exchange Act”) that impact how the entrepreneurs of various calibers acquire funding for their endeavors. This memorandum will outline in broad strokes some of the changes that have already gone into effect and those that are expected to go into effect in the near future; focusing in on the effects that the Act will have on those seeking investment capital of $5 Million or less.
The concept of “crowdfunding” adopted by the JOBS Act will have direct impact on how small businesses will access investment capital in the future. Title III, Section 302(a) of the JOBS Act directs the SEC to add §4(6) to the Securities Act by December 31, 2012. Once added, § 4(6) will permit the offering and sale of securities without registration by an issuer who is a U.S. company, is not registered, and is not an investment company, so long as the issuer does not exceed $1 Million in 12 months in total offerings, including those relying on the crowdfunding exception. Despite removing the registration requirement, some disclosure the scope of which is discussed below will still be necessary. Furthermore, this new regime of public offerings imposes other limitations on the participants including restrictions on how much an investor can spend on such securities, and advertisement for such an offering, which are also addressed below. Lastly, § 4(6) requires the offering to be distributed through an intermediary, the “funding portal;” some characteristics of this new entity are addressed below as well.
Disclosure requirements for issuers
Despite the elimination of the need to register the securities with the SEC for issuers relying on crowdfuding exception, there is still a need for some disclosure by the issuers. The issuer will need to file with the SEC, provide to investors, crowfunding intermediaries, and make available for potential investors the following information:
- Its name, legal status, physical address and website address.
- The names of its directors, officers and stockholders of 20% or more.
- A description of its business and anticipated business plan.
- A description of its financial condition detail of which will depend on the level of crowdfunding activity undertaken by the issuer during the preceding 12 months in the aggregate. For aggregate offering amounts with targets of:
- $100,000 or less:
- the issuer must provide income tax returns for its most recently completed year (if any), and
- financial statements certified by the principal executive officer;
- more than $100,00 but below $500,000:
- the issuer must provide financial statements reviewed by a public accountant who is independent of the issuer, using standards and procedures to be established by SEC;
- more than $500,000 (or such other amount as the SEC establishes):
- the issuer must provide audited financial statements.
- A description of the intended use and purpose of the proceeds.
- The target offering amount, the deadline to reach the target offering amount, and regular updates regarding the progress in meeting the target offering amount.
- The price to the public of the securities or the method for determining the price.
- Prior to sale, each investor must be provided in writing the final price and all required disclosures.
- Each investor must be provided a reasonable opportunity to rescind its purchase commitment upon disclosure of final price.
- A description of the ownership and capital structure of the issuer, including:
- a detailed description of the terms of the offered securities and each other class of the issuer’s securities including details as to how these terms can be modified, and a summary of how the rights of offered securities may be modified, diluted or qualified by other classes of issuer’s securities;
- a description of how the issuer’s principal stockholders’ exercise of their rights could negatively affect the purchasers of the securities being offered;
- the name and ownership level of each stockholder holding more than 20% of any class of securities issued by the issuer;
- how the offered securities are being valued, and examples of methods for how the issuer may value its securities in the future, including during corporate actions;
- the risks to purchasers of the securities relating to minority ownership in the issuer and future corporate actions, including additional share issuances, a sale of the issuer or of assets, or transactions with related parties. (See footnote 1.)
- $100,000 or less:
Beyond diminishing the scope of required disclosure, the JOBS Act also removes the securities offered using the crowdfunding exception from the applicable Blue Sky Laws (See footnote 2) by designating such securities as “covered securities.” (See footnote 3) Thus, further decreasing the overhead expense associated with conducting a public offering. Lastly, for any issuer relying on the crowdfunding exception for offerings of securities, it will be necessary to file with the SEC and disclose to the investors on yearly basis “reports of the results of operations and financial statements of the issuer.” (See footnote 4)
Limits on total expenditures
The JOBS Act creates a new system for limiting how much an individual investor can spend on securities issued relying on the crowdfunding exception. Any individual purchaser of securities issued under this exception is permitted to purchase within a 12-month period preceding the date of purchase a maximum of $2,000 or 5% of their income or net worth, whichever is greater, in securities if their income or net worth is under $100,000; or, a maximum of 10% of their income or net worth with an aggregate maximum of $100,000, if their net worth or income is equal to or more than $100,000. (See footnote 5.) Compliance with said limits is to be confirmed by funding portals. (See footnote 6.)
Relying on crowdfunding exception comes with other limitations. The issuer is prohibited from advertise the details of the upcoming offering and can only direct potential investors to the funding portal. (See footnote 7.) The JOBS Act also prohibits issuers from compensating third-parties for utilizing advertisement channels established by the funding portal to reach out to the potential investors unless the fact of compensation is disclosed, and the issuer complies with other rules to be established by SEC. (See footnote 8.) Furthermore, the securities acquired from an issuer relying on the crowdfuding exception cannot be sold for one year from the date of purchase unless the purchaser is the issuer, an accredited investor, or a member of the family of the purchaser and the transfer is the result of death, or divorce, or similar action, or the security is registered prior to transfer. (See footnote 9.)
The funding portals, beyond their primary purpose of being an offering intermediary, are expected to limit the possibility of fraud associated with a public offering where only limited disclosure is required. In order to become such a funding portal one will have to register with SEC and will be required to provide a host of fraud preventing activities including reviewing the qualifications of issuers and investors. (See footnote 10.) Brokers can register as funding portals. As it appears, the funding portals are expected to become a type of mini stock exchanges by maintaining an online board of securities offered by various issuers. Considering the expense associated with maintaining such a listing service as well as meeting the fraud prevention guidelines, it is surprising that the JOBS Act forbids “compensat [ing] employees, agents, or other persons for [investor] solicitation or based on the sale of securities displayed or referenced on its website or portal.” (See footnote 11.)
Overall, the crowdfunding option will become a great source of investment capital for small business. Once the new rules will go into effect on or after 12/31/2012, small business will be able to utilize the public market without the huge expense associated with a conventional IPO. Despite the expense being reduced, complying with the requirements outlined above will result in costs which should be evaluated and balanced against the limited influx of capital permitted during any 12 month period.
Emerging Growth Companies
The JOBS Act also establishes a new classification for companies with “total annual gross revenues of less than $1,000,000,000,” the “Emerging Growth Companies” (“EGCs”). (See footnote 12.) By creating this new classification SEC can now designate different disclosure and registration rules for EGCs that wish to conduct an Initial Public Offering (“IPO”). A few notable changes are as follows:
- 2 years of audited financials in S-1 registration form instead of 3; (See footnote 13)
- Executive compensation disclosure is now at par with “smaller reporting companies”;
- Filings with SEC regarding future IPO will remain confidential but are required to be disclosed 21 days before a “road show”; (See footnote 14)
- Issuer, or those acting on their behalf, may communicate the details of the upcoming offering with qualified institutional investors or institutional accredited investors to “test the waters”; (See footnote 15)
- Brokers may distribute “research reports” about an issuer proposing an IPO to potential investors; this communication will no longer be considered “gun jumping.” (See footnote 16.)
The addition of these new standards will probably lead to an increase in IPOs as it will decrease the cost, and decrease possibility of failure and embarrassment associated with it. These, and a host of other changes not discussed here, went into effect upon the passage of the JOBS Act and EGCs can already rely on them. These provisions will likely have little utility for small businesses seeking investment capital under $5 Million.
Small Company Capital Formation
The JOBS Act also makes changes to Regulation A which will be fully effective when the SEC will issue the outlined rules. The few notable changes are as follows:
- Increase the dollar cap of an offering from $5 Million to $50 million during prior 12 months; (See footnote 17)
- Blue Sky Laws will be pre-empted because the securities issued in such offering will be classified as “covered security.” (See footnote 18.)
The utility of Regulation A offering with the new changes is yet to be established because the SEC has yet to issue the rules outlined therein. Re-classifying these securities as “covered securities” will likely lead to an increase in the amounts of offering under this exception. However, because reliance on this exception will require inclusion of audited financials in the SEC filings, that could make this exception less attractive. Nonetheless, once SEC issues specifics regarding public advertisement permitted for offerings under this exception, reliance on it can become very attractive as it also permits for “testing the water” prior to the offering.
Access to Capital for Job Creators
90 days after passage of the JOBS Act the changes to limitations on public advertisement permitted for private offerings of securities exempt from registration under Rule 506 and resale of unregistered securities under Rule 144A should have gone into effect. The changes that are still pending were supposed to remove the general solicitation and advertisement bans for offering under Rule 506 to so long as the purchasers are “accredited investors.” (See footnote 19.) Similarly, the ban on general solicitation and advertisement should have been removed from offerings under Rule 144A. (See footnote 20.) In addition, Rule 144A should have been amended so to permit the “offering” of securities “to persons other than qualified institutional buyers,” and to permit sale of such securities “only to persons that the seller and any person acting on behalf of the seller reasonably believe[s] is a qualified institutional buyer.” (See footnote 21.) As none of the new rules have been adopted yet, it is difficult to say how they will operate and whether there will be any change in their utility for those seeking influx of $5 Million of capital or less.
The JOBS Act is meant to create new avenues for business owners to access investor capital previously available only to companies capable of absorbing the cost of going public or meeting the fees associated with private offerings. The soon to go into effect “crowdfunding” regulations will likely achieve this goal and can become a great source of capital for companies seeking to raise under $5 million of investment capital. However, before any entity commits to relying on this exception, the funding portal selected should be evaluated with a microscope. The funding portal is charged with being the first line of defense for preventing fraud in the new mini-exchanges and its effectiveness in this endeavor is key to success of any offering under this exception.
Once the changes to Regulation A offering rules are finalized, this avenue can also gain utility because of the flexibility it offers. With regards to the changes to Rule 506 and Rule 144A offerings, limitations on who can buy the offered securities under these exceptions makes them of limited utility to smaller business owners, despite the removal of solicitation and advertisement ban. As for the new EGC IPO rules, those can become a great source of investment capital if it will be possible to dedicate the time and other resources to gather the information outlined by the abbreviated, but still substantial, disclosure rules.
This memorandum is not intended to provide legal advice, and should not be relied upon for making a business or legal decision. Questions regarding the issues addressed here should be directed to:
JUX Law Firm
901 Marquette Ave, Suite 1675
Minneapolis, MN 55402
This article was written by Dmitriy Bondarenko.
 15 U.S.C. 77d-1(b)(1)(A)-(I).
 Individual State laws governing offering of securities.
 15 U.S.C. 77r (b)(4)(C).
 15 U.S.C. 77d-1(b)(4).
 15 U.S.C. 77d (6)(B)(i)-(ii)
 15 U.S.C. 77d-1(a)(8)
 15 U.S.C. 77d-1(b)(2).
 15 U.S.C. 77d-1(b)(3).
 15 U.S.C. 77d-1(e).
 See 15 U.S.C. 77d-1(a).
 15 U.S.C. 78a(c)(80)(C) .
 15 U.S.C. 77b(a)(19) & 15 U.S.C. 78c(a)(80).
 15 U.S.C. 77g(a)(2)(A).
 15 U.S.C. 77f(e).
 15 U.S.C. 77e(d).
 15 U.S.C. 77b(a)(3).
 15 U.S.C. 77c(b)(2)(A).
 15 U.S.C. 77r(b)(4)(D).
 JOBS Act, Section 201.
 JOBS Act, Section 201.