Crowdfunding: the Basics
As generally understood, crowdfunding involves the practice of funding a project or venture by raising small amounts of money from a large number of people, typically via the internet. This type of fundraising is expected to be useful primarily to small startup businesses that may not have access to traditional fundraising methods, such as venture capital, angel investors or bank lending. Crowdfunding may also be used in conjunction with these other types of fundraising, particularly for consumer facing business that would like to engage customers or generate positive publicity.
Any offering of a security in or into the United States must either be registered with the SEC or be made pursuant to an exemption from registration. Small startups will typically not be able to or will not want to pursue registration, so unregistered or "exempt" offerings will be preferred. These offerings have traditionally been restricted to sophisticated (or "accredited") investors that understand the risks involved in such offerings and have the financial security to sustain a complete loss of the investment. The new crowdfunding rules will facilitate offers and sales to unsophisticated investors, raising various federal, state and other issues and liabilities.
Section 4(a)(6) of the Securities Act
The Securities Act and its related rules set out a number of exemptions from registration with the SEC. For example, Section 4(a)(2) sets out an exemption that is used for private offers and sales to accredited investors and the new Section 4(a)(7) is intended to facilitate secondary sales between accredited and institutional investors. In order to provide an exemption for crowdfunding, the JOBS Act amended the Securities Act by adding a new Section 4(a)(6) and instructing the SEC to issue rules it determines may be necessary or appropriate for the protection of investors to carry out the exemption.
The SEC adopted rules under Section 4(a)(6) in order to clearly set out what is required in order to conduct a proper, exempt crowdfunding transaction to investors in the United States. These rules are contained in "Regulation Crowdfunding" and include Rules 100, 210-205, 300-305, 400-404 and 501-503.
- Set out the requirements for any offering made in reliance on Section 4(a)(6).
- Provide a framework for the funding portals and brokers through which all such offerings must be conducted;
- Create a registration regime for funding portals, which also relates to the new FINRA rules that have been proposed;
- Set out the resale restrictions for securities sold in crowdfunding offerings.
- Exempt securities sold in Section 4(a)(6) offerings from counting toward the Exchange Act registration threshold in Section 12(g).
Significantly, although states may enact anti-fraud measures in related to Section 4(a)(6) offerings, securities sold under this exemption are "covered securities" and therefore exempt from state blue sky registration requirements.
Capital Raising Limitation for Issuers
An issuer may not raise more than $1 million during any 12 month period (Rule 100(a)). Section 4(a)(6) offerings may be combined with offerings made in other exempt offerings. The limit, however, must be calculated by aggregating funds raised in Section 4(a)(6) exempt offerings by the issuer, its predecessors and entities it controls or with which it is under common control.
Investment Limitations for Investors
Investors are limited to the following amounts in any rolling 12-month period, aggregated across all issuers and Section 4(a)(6) offerings in which the investor:
- For individuals with either an annual income or net worth that is less than $100,000, the greater of:
- $2,000; and
- 5% of the lesser of the investor's annual income and net worth.
- For individuals with both an annual income and net worth of at least $100,000, 10% of the lesser of:
- the investor's annual income (not to exceed an amount sold of $100,000 to each individual); and
- net worth (not to exceed an amount sold of $100,000 to each individual).
Crowdfunding issuers may rely on the crowdfunding intermediaries (assuming the issuer does not have actual knowledge to the contrary) to determine if an investor has reached its limit.
Transactions Must Be Conducted Through an Intermediary and Online Only
Section 4(a)(6) offerings may only be made through a registered broker-dealer or through a funding portal and each Section 4(a)(6) offering (or offerings happening at the same time) can only be made through one intermediary. The offerings must be made through the internet, exclusively through the intermediary's platform in order to allow for public access to and sharing of information.
Ineligible Issuers and Bad Actors
The following issuers may not rely on Section 4(a)(6):
- Non-US issuers.
- Reporting companies.
- Investment companies and companies excluded from that definition by Sections 3(b) and (c) of the Investment Company Act (which would include most hedge funds).
Issuers that failed to make required Form C filings in the two years before a crowdfunding offering and issuers with no business plan or a business plan to engage in a merger with an unidentified company or companies are also ineligible to rely on Section 4(a)(6), though the exemption for the former becomes available once the issuer makes any missed filings.
Finally, an issuer is unable to rely on the crowdfunding exemption if any "covered person" was involved in a "disqualifying event." The definition of a "covered person" is very broad and would likely include any party related to the issuer (including directors, officers, general partners or managing members) or the offering (promoters or other persons that are compensated in relation to the offering).
A "disqualifying event" would include certain securities-law related injunctions and restraining orders entered in the last five years and certain regulatory orders entered in the last ten years, though there is an exception for disqualifying events that the issuer did not know of and, in the exercise of reasonable care, could not have known of.
General Disclosure Requirements
Issuers relying on the Section 4(a)(6) exemption must file information with the SEC and provide it to potential investors through the relevant crowdfunding intermediary. In addition to the information explicitly required in the rules, the SEC has the authority to require additional disclosure.
Form C: Offering Statement
A Section 4(a)(6) issuer is required to prepare and file a Form C on EDGAR. Form C includes, among other things, information on:
- The issuer's directors and officers, including their history with the company, business experience for the past three years and other information.
- The issuer's 20% or greater beneficial equityholders.
- The issuer's business and business plan.
- The use of proceed, the offering price (and how it will be determined), the target offering amount and the deadline to reach it.
- A description of how and when investors may cancel an investment commitment.
- Extensive information on the issuer's share capital, ownership structure and the terms of the securities offered.
- the intermediary for the offering and the compensation being paid to the intermediary;
- risk factors that are material to the investor's decision;
- material terms of the issuer's indebtedness; and
- any material information necessary in order to make the statements made in the Form C disclosure, in light of the circumstances under which they were made, not misleading.
Financial Requirements of Form C
A Section 4(a)(6) issuer must provide the following financial information (with the amounts aggregated for all offerings under Section 4(a)(6) in a rolling 12-month period):
- Offerings of $100,000 or less. The issuer must provide US GAAP financial statements (including a balance sheet, income statement, statement of cash flows and statement of changes in owners’ equity) for the two most recently completed fiscal years (or the period during which the issuer has been operating if less than 2 years). These statements, as well as the amount of total income, taxable income, and total tax as reflected in the issuer's federal income tax returns for the most recently completed fiscal year (if any), must be certified true and complete by the issuer's principal executive officer. However, if the issuer has financial statements that have been reviewed or audited by an independent accountant, the issuer must include those financial statements instead, in which case it will not be required to include its tax return information or certification from its principal executive officer.
- Offerings of more than $100,000 but not more than $500,000. The issuer must provide US GAAP financial statements reviewed (in accordance with AICPA standards) by a public accountant independent of the issuer. The statements must be accompanied by the accountant's review report. However, if the issuer has audited financial statements, it must include those instead.
- Offerings over $500,000. The first time an issuer conducts an offering of more than $500,000 but not more than $1 million, it will be subject to the same financial statement requirements as issuers raising more than $100,000 but not more than $500,000. Issuers that have previously raised funds through a crowdfunding transaction must provide audited US GAAP financial statements, along with the audit report.
An issuer is also required to provide a narrative discussion of its financial condition, historic results of operations and liquidity and capital resources (which would be similar to a MD&A section).
Amendments and Other Disclosure
Issuers are required to amend the Form C disclosures for any material change in the offer terms or disclosure previously provided to investors. If any such change is made, investors must reconfirm their investment commitments.
Issuers must also provide updates on its progress in meeting the target offering amount within five business days after it has received commitments for 50% of the targeted offering amount and within five business days after receiving commitments for 100% of the targeted offering amount. The issuer must also file information if the offering is oversubscribed and it will accept proceed in excess of the target offering amount.
Each issuer that sold securities in reliance on Section 4(a)(6) is required to file with the SEC and post to its website an annual report within 120 days of the end of each fiscal year. The annual report must include information that is similar to Form C. The annual reporting requirement continues until one of the following events occurs:
- The issuer becomes a reporting company.
- The issuer has filed at least one annual report on Form C-AR and has fewer than 300 holders of record.
- The issuer has filed at least three annual reports and has total assets of no more than $10 million.
- All the issuer's securities sold under Section 4(a)(6) are purchased by a third party or repurchased by the issuer.
- The issuer liquidates or dissolves its business under state law.
An issuer can terminate its reporting obligations by filing a Form C and checking the "Form C-TR: Termination of Reporting" box if it is no longer subject to the ongoing annual reporting requirement.
Advertising and Communications
Section 4(a)(6) issuers may only advertise their offerings through a notices containing certain limited information (such as basic information on the issuer and offering) that directs readers to the appropriate crowdfunding platform. Further information is then available to potential investors through the platform. The notice may be distributed electronically, including through social media or the issuer's website.
Restrictions on Promoter Compensation
Section 4(a)(6) issuers may not compensate or make a commitment to compensate (directly or indirectly) any person to promote its offering, unless the issuer takes reasonable steps to ensure that the compensation or commitment to compensate is clearly disclosed. This restriction applies both to employees of the issuer working to promote the offering as well as other third parties.
Offerings made pursuant to Section 4(a)(6) will not be integrated with any other offerings by the issuer that are made pursuant to an exemption from registration with the SEC. Therefore, as noted above, issuer may conduct an offering pursuant to Section 4(a)(6) at the same time that it conducts an exempt offering pursuant to Rule 506(c). In this instance, however, though the advertising for both would likely need to comply with the advertising and solicitation requirements of Section 4(a)(6) because the requirements of Section 4(a)(6) are more restrictive than for a Rule 506(c) offering. Furthermore, a Section 4(a)(6) offering being made alongside a Rule 506(b) offering is theoretically possible, but an issuer would need to be satisfied that the investor's in the Rule 506(b) offering was not generated through general solicitation (which is prohibited in Rule 506(b) offerings). This may be difficult in practice.
Resales and Restrictions on Types of Securities Offered
As noted above, both debt and equity securities may be offered pursuant to Section 4(a)(6) as there is no restriction on the type of securities that may be offered.
During the one-year period beginning on the date of purchase, securities sold in a Section 4(a)(6) offering can only be transferred:
- To the issuer, an accredited investor
- As part of an SEC-registered offering
- To a family member (or trust for the benefit of a family member) of the purchaser; or
- In connection with the death or divorce of the purchaser or other similar circumstance.
Exemption from the Section 12(g) Stockholder Cap
Section 12(g) of the Exchange Act of 1934, as amended, requires an issuer to register a class of equity securities (and thereby making the company a reporting company) when its assets and the number of record shareholders of that class of securities exceed certain thresholds. Holders of equity securities issued in Section 4(a)(6) offerings are exempt from the record holder count, as long as the issuer:
- Is current in its ongoing annual reporting requirements.
- Has total assets of no more than $25 million (as of the end of its last fiscal year).
- Uses a SEC-registered transfer agent.
Liability for Material Misstatements or Omissions
A Section 4(a)(6) issuer will be liable to investors for written or oral material misstatements or omissions. The term "issuer" includes any person who:
- Is a director or partner of the issuer.
- Is a principal executive officer, principal financial officer, controller or principal accounting officer of the issuer.
- Offers or sells securities in the offering.
It is unclear whether investors would have the right to bring an action against the funding portals (or any other intermediary) that participated in a Section 4(a)(6) offering.
Framework for Crowdfunding Intermediaries
As discussed above, an offering made pursuant to Section 4(a)(6)(C) must be conducted through a broker or funding portal. Section 4A(a) places the following requirements on these crowdfunding intermediaries. The following sections set out the requirements and restrictions on these intermediaries.
Registration with the SEC and FINRA
A crowdfunding intermediary must register as a broker (under Section 15(b) of the Exchange Act) or as a funding portal (under Securities Act Section 4A(a)(1) and Rule 400). The rules set out a process, form and other requirements for funding portal registration. At this point, it is unlikely that non-US entities will be able to register as funding portals, though this may be possible in the future. All intermediaries must also register with FINRA, which is discussed further below.
Prohibition on Financial Interests
Directors, officers and partners of intermediaries may not have any financial interest (direct or indirect) in an issuer using their services. A financial interest in an issuer means a direct or indirect ownership of, or economic interest in, any class of the issuer’s securities. An intermediary may have a financial interest in a crowdfunding issuer if:
- The intermediary receives the financial interest as compensation for the services provided to the issuer in connection with a crowdfunding offering conducted through the intermediary's platform; and
- The financial interest consists of securities of the same class and having the same terms, conditions and rights as the securities the company issues to crowdfunding investors through the intermediary's platform.
Otherwise, the rules prohibit a financial intermediary from receiving a financial interest as compensation for providing the intermediary's services to the issuer in connection with a crowdfunding offering.
Measures to Reduce Risk of Fraud
Intermediaries must take certain affirmative anti-fraud measures, including:
- Conducting background and other regulatory checks on issuers and related parties.
- Denying access to an issuer or its offering if the intermediary believes there is a potential risk of fraud.
Intermediaries are also required to have a reasonable basis to believe a crowdfunding issuer is in compliance with crowdfunding regulations and has set up a system to keep an accurate share registry (or the equivalent for debt securities).
Account Opening and Educational Materials
An intermediary (or any associated person) may not accept an investment commitment until the investor has opened an account with the intermediary.
In connection with opening the investor account, an intermediary must provide investors with educational materials in plain English. These materials must include, in part, information setting out:
- The process for the offer, purchase and issuance of securities.
- The types of securities that may be offered on through the intermediary and the risks associated with each type of security, including the risk of dilution and the risks associated with investing in securities offered and sold under Section 4(a)(6).
- The restrictions on the resale of securities offered and sold under Section 4(a)(6).
- The information that an issuer is required to provide in annual reports, as well as the frequency of the delivery of that information.
- The invest limits for individual investors and the limitations on an investor’s right to cancel an investment commitment.
- The manner in which the intermediary will be compensated in connection with offerings and sales of securities under Section 4(a)(6).
The investor must provide the intermediary with a representation that the investor has reviewed the educational material, understands that the entire amount of his or her investment may be lost, and that the investor is in a financial condition to bear the loss of the investment.
Issuer Information and Investor Limitations
Information about the issuer and the offering must be made available no later than 21 days before the first day securities are sold to any investor.
Intermediaries are responsible for ensuring that an investor does not exceed the investment limits and they may do so by relying on an investor's representations about its income, net worth, and total crowdfunding investments made in the last 12 months through any crowdfunding intermediary.
Closing an Offering and Cancelling an Investment
Although there is a procedure for closing an offering earlier than the deadline when it reaches its target funding amount before that time (subject to detailed conditions and notice periods), investors must be given an unconditional right to cancel their commitment for any reason until 48 hours before the deadline for the offering.
Communication between Investors and the Issuer
In order to generate helpful information for investors with respect to the offering and the issuer, intermediaries must provide communication channels to permit discussions among investors, and between investors and the issuer. The rules requiring these channels are quite detailed.
In addition to the rules and regulations discussed briefly above, there are numerous other rules and requirements related to the relationship between intermediaries and crowdfunding investors, including requiring portals to take certain steps to preserve investor privacy. These rules are complex and potential participants in Section 4(a)(6) offerings should consult with legal counsel in advance of any related activities.
FINRA Registration as a "Funding Portal"
A crowdfunding intermediary must register with the SEC as a “funding portal” (or a broker) and must register with FINRA. The activities of a "funding portal" would, if not otherwise exempted, cause the portal to meet the definition of a "broker" under the Exchange Act, and the portal would be required to register as such.
However, according to the SEC, “Funding Portal” means any person acting as an intermediary in a transaction involving the offer or sale of securities for the account of others that “does not (1) offer investment advice or recommendations; (2) solicit purchases, sales, or offers to buy the securities offered or displayed on its website or portal; (3) compensate employees, agents, or other persons for such solicitation or based on the sale of securities displayed or referenced on its website or portal; (4) hold, manage, possess, or otherwise handle investor funds or securities; or (5) engage in such other activities as the Commission, by rule, determines appropriate.”
FINRA’s Proposed Rules
As required, FINRA has proposed rules relating to registration as a funding portal, based on the SEC's definition set out above. The rules as first published in draft form were far more strict and potentially burdensome on funding portals than the final proposed rules. For example, rules concerning the implementation of written anti-money laundering programs and the maintenance of fidelity bond coverages have been eliminated.
These rules have not yet been accepted by the SEC.
The proposed rules:
- subject all funding portal members and persons associated with funding portal members to the Funding Portal Rules and FINRA Bylaws and FINRA Regulation Bylaws (as these terms are defined and more fully discussed in the proposed rules);
- set out the application process for funding portals, which is intended to assist FINRA in determining whether the funding portals are capable of complying with federal securities laws and FINRAs funding portal rules;
- provide that Funding Portals shall observe high standards of commercial honor and just and equitable principles of trade;
- set out restrictions on communications with the public and prohibits communications that predict or project performance or make exaggerating claims or forecasts;
- require that each Funding Portal to establish and maintain a supervisory system to supervise the activities of each member to ensure compliance with the securities laws and regulations, including disclosure of any associated person with any issuer who has been involved in securities fraud or is a named defendant in a case of securities, insurance or other financial fraud
- require each funding portal member each year to report an annual statement of gross revenue prepared according to U.S. GAAP; and
- set out the disclosure requirements for funding portals, which largely mirror the SECs requirements set out above.
It appears that the capital markets in the United States may finally be opening up to new participants and fundraising methods. When combined with the changes to general solicitation and advertising that have opened-up options for private offerings to sophisticated investors in reliance on Rule 506(c), the new rules proposed by the SEC and FINRA provide participants with a variety of fund raising options. Whether through SEC registered offerings, private placements to sophisticated investors through Rule 506 offerings or through crowdfunded transactions facilitated by funding portals, it appears that the digital capital markets may be set to take off.
Photo credit to: Thomas Hawk
About the author - Dan McNamee
Dan is a U.S. trained and qualified lawyer (New York) with extensive experience in capital markets and M&A transactions in the United States, Europe, Asia and Africa. This background has provided extensive exposure to rules, regulations and regulators (including the SEC and FINRA) governing many forms of capital raising in the United States. With this foundation in the traditional capital markets space, Dan is seeking to help grow the crowdfunding market in the United States in a manner that encourages capital formation, protects investors and meets the extensive requirements of the nation's regulators.
Born and raised in Cleveland, Ohio, Dan has worked and lived throughout the United States, in London and elsewhere in Europe. In his spare time, Dan has contributed a significant amount of pro bono work to a number of organizations, including the Clinton Health Access Initiative, and enjoys suffering as he watches Cleveland's consistently terrible sports teams lose.