Crowdfunding for Businesses and Impact of Government Regulations

Crowdfunding is a new and evolving fundraising tool social entrepreneurs use to raise money for their ideas and causes via the Internet. If regulated correctly, crowdfunding could become a powerful alternative method that for-profit entrepreneurs could use to raise capital to support a wide range of ventures and business models. To encourage the use of crowd funding to raise investment capital, Congress enacted Title III of the JOBS Act in April 2012. The law is designed to alleviate the funding gap and accompanying regulatory burdens faced by start-ups and small companies when they enter the capital markets to raise relatively small amounts of money for their nascent ventures. Background on Crowdfunding Crowdfunding has traditionally allowed social entrepreneurs to raise money by soliciting small contributions from large numbers of individuals. A crowdfunding campaign generally establishes a specific fundraising goal, and identifies how the entrepreneur will use the funds. Individuals interested in a crowdfunding idea can share information about that idea, and use the information to decide whether or not to fund the campaign based on the collective “wisdom of the crowd.” To date, by way of example, crowdfunding has been used to fund artistic endeavors like films and music recordings, where contributions are rewarded with a token of value related to the project (e.g., tickets to view the film) or the contributions reflect a pre-purchase of a finished product (e.g., a music album). In the United States, crowdfunding has not been used to make debt or equity investments in companies because such transactions would trigger federal and state securities laws. The Securities Act of 1933 requires transactions that result in the sale of a security to be registered unless an exemption exists. It’s not practical to raise small amounts of money without an exemption because of the high cost of registering, offering and selling the securities. Additionally, there are significant follow-up reporting requirements in the Securities Exchange Act of 1934. Existing exemptions from registration make private placements unavailable to crowdfunding transactions because of the large numbers of individuals targeted in the transactions, and the fact most fail to meet income or net-worth rules. The Securities and Exchange Commission’s (“SEC”) current regulations would require third parties that operate “funding portal” websites to register with the SEC as broker-dealers and comply with all applicable regulations. Those complex and burdensome rules are a powerful disincentive to creating a “funding portal” to help entrepreneurs crowdfund via the Internet. Congress’ Effort to Promote Crowdfunding Enter Title III, which Congress enacted to correct these problems. The law establishes a legal framework to allow entrepreneurs to raise small amounts of capital – $1 million or less – via the Internet through crowdfunding without being burdened by the traditional regulatory requirements that make fundraising cumbersome and expensive. It also promotes the creation of Internet-based funding portals to facilitate the sale of securities via crowdfunding without requiring those portals to register with the SEC as broker-dealers. One provision of Title III adds new Securities Act section 4(a)(6), which provides an exemption for crowdfunding transactions from the registration requirements in section 5 of the Securities Act. To qualify for the exemption, a crowdfunding transaction must meet the following requirements:

1. The company cannot raise more than $1 million in a 12-month period.
2. Individual investments in a 12-month period are limited to the greater of $2,000 or 5 percent of an investor’s annual income or net worth, if either is less than $100,000, or 10 percent of an investor’s annual income or net worth (but in no case more than $100,000) if either is $100,000 or more.
3. Transactions must be conducted through a single intermediary that is either registered as a broker-dealer or registered as a “funding portal.”
4. Transactions must occur over the Internet or other similar electronic mediums accessible to members of the public so they can share information before deciding to invest.
5. Companies that can offer and sell securities in crowdfunding transactions are limited to those organized under the laws of any state of the United States or the District of Columbia.

Companies, and intermediaries who facilitate transactions between companies and investors in reliance on Section 4(a)(6), must disclose certain financial and non-financial information to investors, and take steps to provide notices and information to the SEC. Companies selling securities via crowdfunding transactions are prohibited from engaging in general advertising and solicitation of such offerings, and securities sold in those transactions, while not restricted securities, are subject to restrictions on transfer for one year after the sale. Companies or intermediaries who have violated one of the “bad actor” provisions in Rule 262 of Regulation A or Rule 506 of Regulation D are prohibited from offering securities via crowdfunding, and intermediaries are prohibited from facilitating such transactions. The SEC is developing rules to exempt, conditionally or unconditionally, “funding portals” from having to register as brokers or dealers under the Exchange Act. SEC’s Regulations May Kill Crowdfunding The SEC’s proposed rules, while well intentioned, will almost certainly kill most, if not all, crowdfunding transactions of securities before they get off the ground. The proposed rules impose disclosure and reporting requirements on nascent stage companies that will crush them under the cost, burden, and legal liability of compliance. The rules would regulate small private offerings exempt under section 4(a)(6) as though they’re public offerings, and effectively convert small private companies into public reporting companies. For example, Congress authorized the Commission to eliminate or substantially limit the requirement that companies raising capital through crowdfunding provide prospective investors with “audited” financial statements for offerings above $500,000. In its place, these companies could provide investors with “reviewed” financials as required under existing Regulation A, which allows companies to raise as much as $5,000,000. The SEC declined the option, however, despite the fact many start-ups may not have revenue to report during the initial years of existence. The cost, complexity, and management burden of preparing audited financial statements are a powerful disincentive to crowdfund. As a second example, the financial and non-financial disclosure requirements imposed on crowdfunding companies will kill most offerings. The SEC could have allowed small crowdfunding companies to raise capital with an optional, simplified disclosure format to provide information to investors. It did not. The cost, management burden, and legal liability associated with proposed disclosure requirements – which are largely the same as registering an initial public offering – will overwhelm small businesses, particularly those seeking to raise less than $1,000,000, and effectively kill crowdfunding via the Internet. As a third example, Congress gave the SEC considerable discretion to reduce the burden of annual reporting and on-going disclosure requirements on start-ups that crowdfund to raise money. The SEC has instead chosen to require crowdfunding companies to disclose the same financial and non-financial information to prospective investors in perpetuity. The proposed reporting and disclosure requirements on $1 million crowdfunding offerings exceed the disclosure and reporting requirements on $5 million Regulation A offerings. Private start-ups will be buried under same disclosure and reporting rules imposed on publicly held and reporting companies. No start-up would take on such a burden simply to raise $1 million via crowdfunding. The SEC’s proposed rules are subject to public comment before they become final. There is still reason to hope the SEC will relax the requirements on crowdfunding transactions, and not regulate them out of existence before they can get started.