“Bureaucracy defends the status quo long past the time when the quo has lost its status.” — Dr. Laurence J. Peter
When Congress passed the JOBS Act it mandated that the Securities and Exchange Commission finalize new crowdfunding rules within nine months. Well, the SEC missed the deadline by nearly three years, but on October 30, 2015, it finally approved the new rules. They “go live” April 2016 and there are some details you really ought to know…
Verge regulars know that last year Indiana passed its own, intra-state crowdfunding law (see my prior Verge article). While the Indiana-specific rules are now likely to gather dust because they limit your pool of potential investors to only Hoosiers, the federal rules may prove to be a robust marketplace for small-scale capital raises. Here’s a quick snapshot of the SEC’s final rules.
But First, Why New Rules?
As most know, selling securities is a highly regulated activity. Securities must be sold on public exchanges, unless there’s an exception.
The exception most familiar to entrepreneurs is the 506(b) safe harbor, which allows companies to sell securities to accredited investors in a private placement. Accredited investors include, among others, banks, high net worth individuals and trusts, and the issuer’s officers and directors; that is, those with sufficient knowledge and resources to “know better” and to absorb any losses from risky investments. Sites like CircleUp and AngelList have used crowdfunding for a few years, but they limit access to accredited investors.
Of course, there’s potential upside to investing in startups, and the “99%” who lack the income to qualify as accredited investors are presently shut out from investing in early and mid-stage companies.
Crowdfunding solves that problem by creating a new safe harbor where start-ups can raise money off of the public exchanges.
5 New SEC Crowdfunding Rules for Companies
Here are a few key rules for companies crowdfunding under the new SEC guidelines:
- Max Raise. A company may raise up to $1 million in a 12-month period from the crowd. (Note: under Indiana’s law, a company that provides Hoosiers with audited financials may raise up to $2 million).
- Portal. The company must conduct the raise through a registered third party “funding portal.”
- Target/Deadline. Through the portal, the company must set a target offering amount and a deadline to reach that amount, and it must allow investors to back out of any commitment up to forty-eight hours before the deadline.
- Investor Disclosures. The company must disclose certain company information to investors. The amount of disclosure required is similar to what start-ups are accustomed to disclosing to accredited investors: risk factors, business plans, financial statements (balance sheets, income statements, and cash flows), governance, and the like. You’ll want an experienced lawyer’s assistance.
- Annual Reporting. The company must file annual reports with the SEC, but with nowhere near the depth required of publicly-traded companies. Failure to comply with this or other SEC rules could strip you of your exemption. Not good.
Ding Dong the Wicked Audit is Dead (Sort Of)
For financial disclosures, the SEC’s proposed rules had called for audited financial statements for all raises above $500,000. There was tremendous push-back due to costs; for instance, Slava Rubin, Indiegogo co- founder and CEO, called audits, “a massive deal breaker.” Fortunately, the SEC slackened the requirement for first-time crowdfunders. The new rules require:
- For offerings of $100,000 or less, financial statements must be certified by the company’s CEO.
- For offerings between $100,000 – $500,000, financial statements must be reviewed by an independent auditor.
- For offerings greater than $500,000, financial statements must be reviewed by an independent auditor for first time crowdfunders, but for any follow-on crowdfund campaign the financial statements must be audited.
4 Crowdfunding Rules for Investors
Individuals will be allowed to invest based on annual income or net worth. Under the new rules, an individual may:
- If annual income or net worth is less than $100,000, invest the greater of $2,000 or 5% of the lesser of annual income or net worth.
- If annual income or net worth is $100,000 or more, invest 10% of the lesser of annual income or net worth.
- Invest not more than $100,000 per annum aggregate in crowdfunding offerings.
- Sell the securities, but only after holding them for one year.
Importantly, funding portals may rely on the investor’s representations concerning annual income, net worth, and the amount of the investor’s other crowdfunding investments, unless the portal has reasonable basis to question the investor’s representations. That is, there’s no affirmative obligation on the company or the portals to prod into investor’s private financial affairs to verify the investor’s representations.
Outlook for Investors and Entrepreneurs with the New SEC Crowdfunding Rules
Venture capitalists aren’t sweating. At $1 million a crowdfunded project is small even for a seed round, where average deal size hovers around $4 million and which constituted a mere 1% of 2014 VC dollars ($719 million of $48.3 billion).
On the other hand, one commentator noted that if U.S. families invested 1% of their assets in start-ups via crowdfunding, it would unleash $300 billion annually. The success of state-specific crowdfunding rules and of non-equity platforms such as KickStarter, Go Fund Me, and Kiva indicate there’s a sizable market for small denomination equity investments. And there’s certainly no dearth of start-ups looking for capital.
Ongoing SEC rules and reporting requirements will always be a deterrent to start-ups and will hamper crowdfunding’s potential, but as quality funding portals develop and the public acclimates to the new investing landscape, crowdfunding may become a useful tool for small-scale capital raises.
How will these rules change how you grow your business? Will you invest using the new Crowdfunding rules? Let us know in the comments below.
© 2015 Faegre Baker Daniels. All rights reserved.