On October 30, 2015, the SEC approved final rules under Title III of the Jumpstart Our Business Startups Act of 2012. Two weeks later the rules were published in the Federal Register [pdf], and equity crowdfunding will finally launch in May 2016.
Title III legalizes equity crowdfunding and allows all investors, regardless of income or net worth, to invest in startups and growing private companies via Internet-based crowdfunding sites.
The SEC’s final rules, along with commentary about how the final rules evolved from the proposed rules, took up 686 pages. They include rules that apply to issuers of Title III securities, investors, and intermediaries (funding portals and broker-dealer platforms). Here we have distilled the rules for issuers down to a four-page summary.
Rules for Issuers
To offer equity on a crowdfunding portal (or through a broker-dealer operating an online offering platform under Title III ), the issuer must be a private company based in the United States and organized under the laws of a state or territory of the United States or the District of Columbia. Some categories of issuers are prohibited from using the new equity crowdfunding exemption. For example, investment companies, including mutual funds and private equity funds, may not raise capital via crowdfunding portals. Likewise a company will be disqualified if it has previously failed to file ongoing reports with the SEC as required by a previous offering of securities. In addition:
Issuers may raise up to $1 million in any 12-month period through equity crowdfunding portals that are registered with the SEC. (Some legislators, notably Rep. Patrick McHenry of North Carolina, have proposed increasing the raise limit to $5 million.)
All Title III offerings must go through an Internet-based intermediary, either a funding portal or a broker-dealer platform; and the intermediary must be registered with both the SEC and FINRA. Issuers may not sell securities on their own websites using the Title III exemption.
Each issuer must provide accurate information, both to the SEC on Form C and to investors through the funding portal, concerning the following:
- Its full name, legal status (form of entity, state, and date of organization), physical address, and website URL.
- Names of officers, directors, and shareholders owning 20 percent or more of total equity. Also how long each officer and director has served in that position, and the business experience of each officer and director over the past three years. If any of those officers, directors, or 20 percent shareholders is identified by the SEC as a “bad actor,” the company will be disqualified. A bad actor, according to securities law, is a convicted felon, person subject to a finance-related injunction or restraining order, person subject to SEC disciplinary action, etc.
- Description of the business, number of employees, and business plan.
- Capital structure—how the company currently finances its operations, which may include long-term debt, specific short-term debt, common equity, and preferred equity. A description of current debt should include the amount, interest rate, maturity date, and other “material” terms. Descriptions of equity offerings conducted in the previous three years should include dates, exemptions relied on, types of securities, amounts sold, and use of proceeds.
- Amount of capital the issuer is attempting to raise by the Title III offering (the target amount), the deadline for raising that amount, and the purpose and intended use of the proceeds raised from crowdfunding investors. The issuer must state whether it will accept funds in excess of its target amount, and if so the maximum it will accept and how it will allocate those extra funds.
- Price of the securities being offered via Title III crowdfunding, or method used to determine the price. If the issuer does not set a fixed price at the start of the crowdfunding campaign, it must provide a final price before closing the offering—and an investor would have a right to rescind a commitment to purchase after the price is finally determined.
By the way, after the issuer files Form C (electronically via the SEC’s EDGAR data system), the SEC is not required to review or in any way evaluate the issuer’s disclosures. It is possible that the commission will challenge offerings that appear to contain misleading statements or significant omissions. But investors should not assume that offerings on a crowdfunding portal have been reviewed by the SEC.
Each issuer must provide an accurate description of the terms and risks of its offering, including the following:
- Class of securities currently offered and previously issued (and the differences between them), and how the rights of existing shareholders will affect the rights of new crowdfunding investors/shareholders.
- Holdings of 20 percent security holders.
- How new crowdfunding equity is valued, and how that value may be affected by future rounds of capital investment and other corporate actions.
- Risks associated with minority ownership (including lack of control and discounted valuation), future corporate actions, and related-party transactions.
- Restrictions, if any, on the sale or transfer of the securities, in addition to the mandated one-year holding period (with exceptions as noted below).
Issuers must state whether they or any of their predecessors have failed to comply with the ongoing reporting requirements in previous Title III offerings.
Issuers seeking to raise $100,000 or less must provide financial statements, certified by the company principal executive officer, typically the president or CEO. For those seeking between $100,000 and $500,000 in capital, as well as first-time Title III issuers seeking to raise up to $1 million, financials must be reviewed by an independent accountant. Except for issuers who have never before sold securities via Title III crowdfunding, those seeking $500,000 to $1 million must have the financial statements audited by a certified public accountant. (If Congress increases the raise limit to $5 million, the audit requirement may kick in at $3 million.). Note that an audit may cost the issuer in the neighborhood of $15,000 to $25,000, a key point that we will discuss further. For each period for which financial statements are provided, the issuer must include a summary of operations during that period.
Issuers may sell shares to an unlimited number of investors in a deal, within the $1 million raise limit.
Issuers must state, even though the portal has already done so in its educational materials, that their campaigns are all-or-nothing; and that if they fail to receive commitments for the target amount by the specified deadline, investors will receive prompt refunds.
Issuers may not engage in general solicitation as defined in Title II offerings, and are strictly limited as to how they may advertise their offerings outside of the crowdfunding portals. The SEC rules allow issuers to publish a “limited notice,” known in the securities industry as a “tombstone” notice, which directs potential investors to the portal where the full terms and disclosures of the offering are listed. A tombstone ad may include a statement that the issuer is conducting an offering of securities, and specify the type of securities, on a specific crowdfunding portal, with the portal’s URL and/or hyperlink; the price of securities and closing date of the offering period; factual information about the company’s industry, location, website, and contact information; and a brief description of the issuer’s business. Publishers of tombstone ads must disclose that they are compensated by the issuers.
If the issuer compensates a third party to promote its offerings (limiting its communications to the kinds of information that can be conveyed in a tombstone notice), that third party must disclose such compensation in its promotional messages. A paid promoter can’t legally pretend to be an objective reviewer, for example.
Issuers must file their offerings with the SEC on a newly created Form C and make that information available to investors at least 21 days before any sales can be made on a funding portal. Filings include information about officers, directors, and 20 percent shareholders; offering share price; target offering amount (raise) and deadline to reach the target; whether the company will accept investments above the target amount; financial statements; related-party transactions; and other information.
Issuers must describe the intermediary’s financial interest in the issuer’s transaction, including the amount of compensation for conducting the offering on the portal, and whether that compensation consists of cash or equity. Issuers may compensate intermediaries with equity if the latter accepts such compensation, as long as it is at the same share price and on the same terms as in the crowdfunding offering.
Offering information posted to a Title III crowdfunding portal may be presented in any number of formats, including text-based and PDF documents, videos, graphics, slide decks, etc. All the required information must be easily accessible on the portal itself, not linked to on other websites. The issuer may, of course, refer to additional information, beyond what is required on the portal, that appears on other websites.
After a successful funding round is complete, issuers have to file annual reports with the SEC, and share them with investors as well (more details about these annual reports in a future column). The current offering documents must state where on the issuer’s website investors will be able to read the annual reports in the future, and the dates by which they will be available each year.
Issuers may participate in equity crowdfunding offerings and other kinds of exempt offerings at the same time; these would be known as parallel offerings. Thus, it is possible to seek $1 million from everyday investors through a Title III offering and to seek concurrently an unlimited amount of capital from accredited investors through a Reg D offering, for example. The two parallel offerings must be treated as distinct rather than integrated.
Under both federal and state law, issuers (including company officers, directors, sellers, and promoters of the offering) will be held liable for any fraudulent or intentionally misleading statements or material omissions made in connection with their offerings. If an issuer fails to “exercise reasonable care” and knowingly makes untrue or misleading statements, it must reimburse investors for their purchase of securities, plus interest. The issuer and its officers and directors bear the burden of proof in a dispute with investors with respect to this liability.
Because Title III and the SEC rules thereunder are voluminous and complex, the SEC created a “safe harbor” for “insignificant deviations” from the restrictions and requirements of the regulations, so long as the issuer acts in good faith to comply.
The Exchange Act of 1934 typically requires an issuer to go public if the company has more than 2,000 shareholders, or more than 500 shareholders who are non-accredited investors. Title III exempts crowdfunding securities from this shareholder threshold, with the expectation that crowdfunding is likely to bring in many investors.
Source Note: The authors relied on various sources for commentary and help with interpretation of the SEC rules, most notably a summary published by CrowdCheck in Virginia.
— David M. Freedman has worked as a financial and legal journalist since 1978. Matthew R. Nutting is a corporate lawyer with the firm Coleman & Horowitt in Fresno, CA. Freedman and Nutting are coauthors of “Equity Crowdfunding for Investors: A Guide to Risks, Returns, Regulations, Funding Portals, Due Diligence, and Deal Terms” (Wiley & Sons, 2015) .