What You Need to Know About the New SEC Crowdfunding Rules

“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…

What You Need to Know about SEC Crowdfunding Rules

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.

verge startup pitches at the hi-fiOf 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:

  1. 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).
  2. Portal. The company must conduct the raise through a registered third party “funding portal.”
  3. 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.
  4. 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.
  5. 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)

New SEC Crowdfunding Rules 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:

  1. For offerings of $100,000 or less, financial statements must be certified by the company’s CEO.
  2. For offerings between $100,000 – $500,000, financial statements must be reviewed by an independent auditor.
  3. 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:

  1. 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.
  2. If annual income or net worth is $100,000 or more, invest 10% of the lesser of annual income or net worth.
  3. Invest not more than $100,000 per annum aggregate in crowdfunding offerings.
  4. 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

Crowdfunding Rules for InvestorsVenture 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.

Can Indiana’s New Crowdfunding Law Help Your Business?

Photo Credit: LendingMemo.com

Photo Credit: LendingMemo.com

As of July 1, Hoosier entrepreneurs seeking to raise capital (join the club, right) now have a new tool: crowdfunding.  Indiana’s new crowdfunding law sailed quickly and almost unopposed through the General Assembly—140 yeas to 1 nay.  Despite any instinctual suspicion some may have of a law that both parties agree on, this legislation may actually be useful to you.  Here are six questions to consider in deciding whether to Hoosier crowdfund:

  1. Can I raise capital from out-of-state investors?

No.  For the time being, federal law still prohibits you from crowdfunding on a national scale.  The SEC, which is currently under congressional mandate to make rules permitting crowdfunding, has yet to finalize those rules.

Rather than wait for the feds, a handful of states have chosen to pass their own crowdfunding laws.  They can do this because of the “intrastate” exemption in the Securities Act of 1933.  That Act, which generally protects us all from snake oil salesmen by prohibiting the sale of securities outside of highly-regulated public markets such as the NYSE and Nasdaq, does not apply to offerings that are exclusively intrastate because the SEC only has jurisdiction over interstate offerings.  Indiana has now joined the ranks of states using this exemption to permit local companies to crowdfund the intrastate sale of securities.

Notably, as written, the new law only applies to companies organized under Indiana law.  If you’re local but incorporated under Delaware law, you can’t use the new exemption.

  1. How much can an entrepreneur raise?

Under Indiana’s new law, Hoosier entrepreneurs may raise up to $2 million in a 12-month period via crowdfunding if they provide potential investors with audited company financial statements.  Without audited financials, the limit is $1 million.  Of note, crowdfunding can piggyback on traditional methods to raise additional capital.

  1. From whom?

You may raise capital through an Indiana crowdfunding campaign from Indiana residents only.  As the issuer, you’ll need to verify that each investor is an Indiana resident (a driver’s license number would likely suffice).  Also, you may accept no more than $5,000 from any single investor, unless that investor is an accredited investor.

  1. How, and how much will it cost?

This answer, of course, varies and is somewhat detailed and complicated, but here are some basics:

(A) You must provide a disclosure document to all prospective investors.  The document must contain certain basic information about your company, including a business plan, intended use of the proceeds, amounts to be paid to owners and officers, the identity of all persons owning at least 20% of the company, the terms and conditions of the securities offered, and more.   Lawyers and accountants will most likely be involved.

(B) You must use a third party web portal (think Localstake).  The web portal operator may but is not required to be a registered broker-dealer, and will certainly charge a fee.

(C) You’ll have to provide quarterly reports to investors so long as any crowdfunded shares are outstanding.

Costs are difficult to calculate, but by comparison, estimates under the proposed SEC rules range from $6,500 to $26,000 for a $100,000 raise, and $80,000 and $190,000 for a $1,000,000 raise, plus a couple thousand dollars per year for ongoing reporting (see here and here).

  1. Any concerns?

Sure.  The law may be ignored.  If the cost of capital is prohibitively high, entrepreneurs will ignore crowdfunding and stick with tried-and-true methods.  Also, the $5,000 per investor limit likely will complicate reaching higher raise targets.

Another worry is that, unlike the draft SEC rules, Indiana’s law doesn’t cap an individual’s 12-month contribution, so conceivably grandpa could make fifteen $5,000 investments in one year and blow his savings.  Securities Commissioner Carol Mihalik has reminded issuers that fraud remains illegal and will be prosecuted, but there is potential for investors to lose their shirts.

Finally, some venture capitalists have expressed their disinclination to participate in a Series A where there’s a mob of crowdfunders populating the cap table.

  1. What happens when the SEC finally adopts national crowdfunding rules?

Indiana’s crowdfunding laws will gather dust.  The current exemption for intrastate offerings is probably the least used ’33 Act exemption.  The reason is simple: though exempted from federal law, intra-state offerings are still governed by state laws, and these “Blue Sky Laws” almost invariably mimic their federal counterparts.  So if nearly identical regulations must be followed, companies rarely chose to limit their pool of prospective investors to only one state.

There will be differences between Indiana’s crowdfunding law and its federal counterpart, but these differences are unlikely to matter.  To take the most notable difference: our law allows raises of up to $2 million, while the SEC rules (if finalized as drafted) would limit raises to $1 million.  But raising more than $1 million will be difficult when the investor pool is limited to Hoosiers at $5,000 a pop, and the lure of a national pool with the higher proposed individual limits will be irresistible to most, even if it means shelling out for audited financials (which the proposed SEC rules require for any plus $500,000 raise).

In short, if you are seeking to raise less than $2 million dollars exclusively from Hoosiers in many small increments, you just got the green light.  But you’ll have to keep waiting for the SEC to finalize its rules if you want to run a national crowdfunded equity sale.