Today is the day that will change the way small businesses raise equity capital in the United States. For that’s the day that the Securities and Exchange Commission’s crowdfunding rules go into effect, allowing entrepreneurs to raise money from every person in the country, regardless of his or her net worth, financial sophistication, location or intelligence.
What’s “real crowdfunding”? It’s not Kickstarter, where companies typically pre-sell their products based on semi-thought-through prototypes. It’s not GoFundMe, where well intentioned donors pay for a stranger’s cancer treatment. And, it’s not CircleUp, where wealthy investors put money into curated consumer product companies. “Real crowdfunding” is where any company can ask any American to invest in it and expect a return on her investment, which may include a capital gain or dividends.
The catch is that “real crowdfunding” came about during the height of the most recent financial crisis when banks stopped lending and the stock market tanked. So, Congress wanted to look like it was helping small businesses raise money and passed compromise legislation which, like all compromises, was messy and had the added attraction of being despised by the Securities and Exchange Commission. As a result, the SEC took its own sweet time in passing regulations that would put the law into effect. Which is why the Crowdfunding Act of 2012 is (seemingly suddenly) being introduced in 2016.
And because the SEC hated the law, it created a complex regulatory scheme with the legitimate excuse that these rules will be the only way to protect investors (against themselves).
So, with that quick and dirty introduction, here are ten of the more salient aspects of the new, “real” crowdfunding regime:
- Anyone can invest, but only so much. Of course, it depends on your income or your net worth. You can invest the greater of $2,000 or 5% of the LESSER of your annual income or net worth, if your annual income and net worth is less than $100,000, or, 10% of the LESSER of your annual income or net worth up to $100,000 if BOTH your annual income and net worth is equal to or greater than $100,000.
- You don’t have to be smart to invest, but you do have to go to school. The rules require that the funding portal deliver to the investor educational materials that explain in plain English just how risky the investment will be and to urge you to consider whether the investment is appropriate for your lifestyle. You must then answer a questionnaire and click that you understand that you can lose all of the money that you plan to invest.
- Companies can crowdfund, but only so much. A company can only raise up to $1 million within a 12 month period using the crowdfunding rules.
- Companies can’t crowdfund people who have already invested. If the investor has put in her maximum in any one or more companies during a 12 month period (see #1 above), the company can’t take her money.
- You can crowdfund on the Internet, but only with registered portals. Companies can only raise money using websites that have registered with the SEC and the Financial Industry Regulatory Authority. Not on Kickstarter, not on Indiegogo and not on the other well-known “crowdfunding” websites. (Although Indiegogo has said that it intends to become a registered funding portal).
- You can crowdfund on the Internet, but you can’t advertise. So, no putting ads on cable TV at 3AM after the Zumba infomercial. The only thing a company can do is post a notice that says that it is crowdfunding on a particular website and describes the terms of the offering, and that all communications regarding the offering must be made through the funding portal.
- Companies don’t need to register with the SEC like an IPO, but they need to register. Companies must put a disclosure document on the web portal and file it with the SEC that, while not technically a prospectus that you would see in a public offering, does contain a fairly detailed discussion about (among other things) the company, its directors, officers and major stockholders, the terms of the deal, the company’s capital structure, the company’s business and business plan, the securities being offered, the targeted offering amount and the offering deadline. Most important of all, it must contain relevant risk factors that explain why the investment is speculative or risky. (And, according to the SEC, they all are).
- Crowdfunding companies don’t need audited financial statements, unless they do. If the company is raising $100,000 or less, it just needs to show potential investors its federal income tax return and its financial statements certified by the chief executive officer. If the amount targeted is more than $100,000 up to $500,000, the company must show financial statements that have been “reviewed” by an independent accountant. And, the same for first time crowdfunders up to $1 million. But if the company has crowdfunded previously and is raising more than $500,000, the financials must be audited.
- Money can be raised quickly, but not too fast. The funding portal must have all of the company’s information posted for at least 21 days and investors can cancel their “commitments” at any time within 48 hours prior to the funding deadline.
- There is a morning after. A company that crowdfunds must file with the SEC and post on its website an annual report with financial statements until: it becomes a public company, it has filed one annual report and thereafter has less than 300 stockholders of record, it has filed its annual reports for 3 years and has less than $10 million in assets, all of its securities have been repurchased, or the company is dissolved.
Oh, and by the way, that stock you bought in the crowdfunding deal, you can’t sell it for a year except to an accredited investor or to your unwitting brother-in-law.
Seriously though, once a company gets through the regulatory morass, it’s not that hard to do and may be a real help to small local businesses that have been around awhile and are looking for a little capital to grow, or for startups that have a great idea that folks are willing to gamble on.
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The SEC published a guide for crowdfunding issuers and investors today here:
Jeff Koeppel is a corporate and securities lawyer who spent three years honing his skills in the U.S. Securities and Exchange Commission’s Division of Corporation Finance. Thereafter, he has been in private practice helping clients avoid the pitfalls of the federal and state securities laws. His blog on crowdfunding can be found at: www.jeffkoeppel.wordpress.com.