Over a year has passed since President Barack Obama signed into law the Jumpstart Our Business Startups Act, better known as the JOBS Act. One of the central features of the Jobs Act deals with crowdfunding, which is the concept of raising capital in relatively small increments from large groups of people, often using the power of the Internet.
Most of us are familiar with campaigns to raise funds for charitable, artistic, or political causes through Kickstarter and similar sites. In these scenarios, supporters usually receive a reward, such as a product sample, in return for their contribution. Soon entrepreneurs will be able to tap into this potentially very lucrative fundraising mechanism when starting their businesses by giving their investors a stake in their profits. This new concept is called equity crowdfunding.
Equity Crowdfunding And The Law
One of the main attractions of crowdfunding is that capital may be raised in small increments from a large number of people. However, it is important to realize that your new shareholders have rights under federal and state laws. Securing an exemption from these laws is critical for a startup or other emerging company because otherwise the company must undergo the costly process of registering the securities it sells to investors with regulators, which is often prohibitively expensive.
Currently crowdfunding does not fit nicely into any of the existing exemptions provided by federal securities laws. Regulation D, which is the primary exemption from the registration requirements of the federal securities laws, generally limits the number of non-accredited investors (primarily persons who are neither millionaires nor earn more than $200,000 annually) to 35. Although the smallest Regulation D offering exemption (Rule 504) does not have an investor limitation, it, like the other exemptions under Regulation D, generally does not permit general solicitation of investors or advertising of the offering.
A New Exemption
The Jobs Act created a new crowdfunding exemption from the regulation requirements of the Securities Act of 1933 that permits companies to raise up to $1 million within any 12-month period subject to certain restrictions. Although companies that take advantage of the new exemption will not be required to register their securities with regulators, they must comply with disclosure and filing obligations, are limited in the dollar value of securities they can sell in the aggregate ($1,000,000) and to each investor ($10,000), and must conduct the sale of their securities through either a registered broker or funding portal.
Before you head online to raise money for your newest business idea, please be aware that the crowdfunding exemption provided by the JOBS Act is not available until final rules interpreting the law are adopted by the Securities and Exchange Commission (SEC). Although the JOBS Act directed the SEC to adopt rules to implement the crowdfunding exemption by December 31, 2012, the SEC still has not released rules, and such rules likely will not be adopted until the end of 2013. Many aspects of the crowdfunding exemption will be subject to the SEC's rulemaking process.
The costs to comply with the crowdfunding exemption may be challenging for many startup companies. For example, the JOBS Act requires the inclusion in a company’s disclosure documents of financial statements reviewed by an independent public accountant for any offering over $100,000 but under $500,000. If a company raises $500,000 or more, then it will need to provide audited financial statements. Other types of exemptions from the securities laws do not require these disclosures, and therefore may be a more cost-effective alternative for many startups.
Equity crowdfunding may also present an issuing company with additional risks. Besides the fact that governance of a company with a large number of shareholders is more problematic and unwieldy than governance of a company with a lesser number of shareholders, there are also potential risks and pitfalls, such as:
Many startup companies fail within the first year or two of business. Having a large number of investors lose their investment could potentially increase the risk of suits being filed under the securities laws for rescission of the investments. Such an action would be filed against both the company and its promoters and control persons.
Companies should be diligent that they not exceed the $1,000,000 sales limit on crowdfunding or otherwise engage in activities that would require registration of the securities under state or federal securities laws. Those actions could also give rise to lawsuits by the investors for rescission of their investment.
Companies utilizing equity crowdfunding should not create offering documents without the use of a licensed professional. Both the disclosure obligations and the obligation to comply with offering procedures are essential to obtain the exemption and should be thoroughly reviewed by securities attorneys and accountants.
Because of the risks referenced above, a successful startup may also face more difficulties in securing successive rounds of financing from more traditional investors.
Despite these risks, the unique possibilities that equity crowdfunding provides will certainly attract entrepreneurs of all types. Although equity crowdfunding may serve as a useful capital-raising vehicle for some startup companies, it is not a fundraising panacea for early-stage companies and remains subject to rulemaking by the SEC. A careful analysis of the risks and rewards is essential in determining if this could be the right path for your business.
Richard B. Hadlow is a partner in the Tampa office of Holland & Knight LLP. He has substantial experience in advising clients in corporate transactions, including entity formation and governance, mergers and acquisitions, public and private offerings of securities, and compliance with securities laws. Paul S. Lawler is an associate with Holland & Knight's corporate group and a Certified Public Accountant. Comments? Contact 83 Degrees.