Raising Equity and Crowdfunding: The Business Forum Show, January 22, 2014
Background on Federal Securities Law In the aftermath of the 1929 stock market crash and in the midst of the Great Depression, Congress enacted the Securities Act of 1933. This Act created the SEC as the federal regulatory agency having jurisdiction and oversight over the raising of investment capital. Under the Act, an issuer must either register its offering with the SEC (this is said to be a “public offering”) or make the offering under one of several exemptions set forth in the Act. Most small private company offerings are made under exemptions set forth in Regulation D. Rule 506 is one of the Regulation D offerings and allows an unlimited amount of funds to be raised, provided that the issuer does not engage in general solicitation or general advertising of investors. The importance of the prohibition on general solicitation is this: unless the issuing company or someone with close ties to it knows of any “accredited investors” interested in investing, the issuing company faces a steep uphill climb to realizing its fundraising goal(s). In the brewery context, experience shows that those most interested in owning part of a brewery are typically “non-accredited”, meaning that they lack the net worth and/or annual income sufficient to qualify as “accredited.” The process for soliciting these “non-accredited” investors – who the law deems to be unsophisticated and entitled to greater disclosures and protection – has been complicated and expensive. Two recent developments at the SEC aim to loosen some of the legal restrictions to raise money in private offerings: (1) the lifting of the SEC’s prohibition against general solicitation and general advertising in accredited investor offerings; and (2) the introduction of proposed “crowdfunding” regulations pursuant to the JOBS Act. The New Rule 506(c) On September 23, 2013, the new Securities and Exchange Commission (“SEC”) rule which lifts its long-standing prohibition on general solicitation and general advertising for certain private securities offerings under Rule 506 of Regulation D goes into effect. The new rule creates another means of raising funds from accredited investors under Rule 506. The “old” rule – whereby no general solicitation is made – is now found as Rule 506(b). New Rule 506(c) allows issuers to engage in general solicitation and general advertising to market their offerings, so long as: (1) all purchasers of the securities are accredited investors; (2) the issuer takes “reasonable steps to verify” that the purchasers of the securities are accredited investors; and (3) all terms and conditions of Rules 501, 502(a) and 502(d) are satisfied. “Reasonable steps to verify” is the key verbiage of this new so-called “easier” way to raise funds. Under current Rule 506 offerings, typically the issuer verifies accredited investor status via a check-off box in its subscription agreement. That, however, is not enough under Rule 506(c). An issuer looking to engage in general solicitation to find investors under Rule 506(c) is going to have to review tax returns, bank statements, personal financial statements, or receive a written opinion from an attorney, CPA or financial advisor. This can be a cumbersome task fraught with liability. In short, the wisest course of action, in my opinion, when it comes to the new Rule 506(c) is to proceed as if it does not exist. The 506(b) offering, while restricting an issuer’s ability to cast a wide net for equity investors, remains far simpler to comply with and less fraught with potential liability for the brewery and its professional advisors. Crowdfunding When the Jumpstart Our Business Startups Act aka the JOBS Act, was passed into law on April 5, 2012, a centerpiece of the legislation was the creation of an exemption to permit securities-based crowdfunding without registering the offerings with the Securities and Exchange Commission (SEC). Up until the JOBS Act, crowdfunding platforms such as Kickstarter were primarily of use to artists and non-profits seeking funds for a specific project; given the myriad of Federal and state securities laws issues involved with raising funds without registering the offering with the SEC, crowdfunding was not, prior to the JOBS Act, a viable means of raising business capital. Since the passage of the JOBS Act, startup businesses and entrepreneurs have eagerly awaited the SEC’s regulatory framework for crowdfunding. Finally, it seems that the wait is over. The SEC commissioners have unanimously approved a proposed regulatory framework for offerings conducted under the crowdfunding provisions of the JOBS Act. The proposal is intended to facilitate capital raising by small businesses while at the same time providing investor protection measures. The comment period will be open for 90 days. The proposal will permit companies to raise up to $1 million through crowdfunding offers during any 12-month period. Investors would be permitted to invest during any 12-month period up to $2,000.00 or 5 percent of their annual income or net worth, whichever is greater, if both their annual incomes and net worth are less than $100,000.00. Investors may invest up to 10 percent of their annual income or net worth, whichever is greater, if either is equal to or more than $100,000.00. Investors would not be permitted to purchase more than $100,000.00 of securities during any 12-month period through crowdfunding. Securities that are purchased in a crowdfunding transaction may not be resold for a year under the proposal. The holders of the securities would not count toward the threshold that requires a company to register with the SEC under Exchange Act Section 12(g). Companies that conduct crowdfunding offerings must file certain information with the SEC and make it available to investors and to the intermediary that is used to facilitate the offering. The offering documents must include information about officers, directors, and holders of more than 20 percent of the issuer’s securities. The disclosure would include a business description, a description of the use of the proceeds from the offering, and the price of the securities being offered. The proposed disclosure also would include certain related-party transactions, a description of the financial condition of the company, and its financial statements. Companies would be required to update the offering document to include material changes and to provide updates about the progress in reaching the targeted offering amount. Crowdfunding issuers also must file annual reports with the SEC and provide annual reports to investors. The new framework requires that crowdfunding transactions take place through an SEC-registered intermediary, which will be either a broker-dealer or a funding portal. The intermediaries will conduct the offerings through online platforms. Intermediaries will be required to provide investors with educational materials that outline the risks of investing. They also must take measures to reduce the risk of fraud. Funding portals may not offer investment advice or make recommendations. They may not solicit purchases, sales, or offers to buy securities offered or displayed on their websites. The proposed rules impose restrictions on compensating people for solicitations and prohibit the funding portals from holding, possessing or handling investor funds or securities. The proposal includes a safe harbor under which funding portals can engage in certain activities consistent with these restrictions. Archived segments are available by visiting The Business Forum Show page of my website, and be sure to tune in live (or listen to a podcast recording of the show) here. NOTE: a portion of the above information is excerpted from “Federal Securities Law Reports” Issue No. 2605, November 1, 2013.
In my most recent appearance on The Business Forum Show, Host Kevin Hunter and I discussed the basics of raising equity capital and recent efforts to make “crowdfunding” legal for for-profit businesses. You can listen to the show here.