Intrastate Equity CF
Published on March 30, 2016
By David M. Freedman and Matthew R. Nutting
The Jumpstart Our Business Startups (JOBS) Act was signed into law in March 2012. Title III of the act, which legalized equity crowdfunding, could not launch until the SEC issued final rules for the operation of funding portals. For 37 months after the law was signed, U.S. entrepreneurs, intermediaries, and investors waited for the SEC to issue final rules.
Meanwhile, some states decided to get their own jumpstart going. Relying on the intrastate exemption from SEC registration, at least 24 states—led by Kansas and Georgia—have enacted legislation or promulgated regulations that allow unlimited numbers of non-accredited investors (everyone) to participate in small private securities offerings.
See an updated list of equity crowdfunding rules in each state (and D.C.), with limits for issuers and investors.
In October 2013, an intrastate funding portal in Georgia called SparkMarket became the first equity crowdfunding portal in the United States to facilitate the equity financing of a private company (Bohemian Guitars LLC) with participation by non-accredited investors.
The Intrastate Exemption
The purpose of the intrastate offering exemption, under Section 3(a)(11) of the Securities Act, is to “facilitate the financing of local business operations,” according to the SEC. For an offering to qualify for the exemption, the company making the offer must (1) be organized in the state where it is offering the securities, (2) carry out a significant amount of its business in that state, and (3) make the particular offer and sale of securities only to residents of that state. The company is responsible for making sure securities offered under the intrastate exemption are not sold to any out-of-state residents. If that happens, the company could be in violation of federal securities law. As long as the in-state issuers and intermediaries comply with Section 3(a)(11), they can avoid the (often) more complex federal securities laws in favor of the (usually) more relaxed state regulatory framework.
Section 3(a)(11) requires that securities sold through the intrastate exemption may not be resold to residents of other states within a certain time period, usually nine months. The law intends that intrastate-offered securities “come to rest” within the state.
Beyond that fundamental framework, the federal government is essentially backing away from regulation of intrastate offerings, except to protect investors from fraud. Even intrastate offerings are subject to the antifraud provisions of federal securities law, as well as the respective state antifraud laws. Issuers, therefore, still must ensure that investors are not misled by any oral or written communication concerning the company’s operations or the terms and risks of the investment. Some states, like California, provide additional layers of protection for investors by, for example, considering whether or not an offering is fair before allowing it to be listed.
Under the umbrella of Section 3(a)(11), each state has its own “blue sky” securities laws and regulations that govern intrastate securities offerings and sales within its borders. These laws vary from state to state.
Each state requires issuers to register their intrastate securities offerings with that state’s securities commission, or else qualify for an exemption from state registration. In other words, there are two levels of registration: federal and state. All intrastate offerings qualify for the federal exemption from SEC registration, but then they must go through the process all over again at the state level: register with the state or qualify for a state exemption. Each state establishes its own exemptions for intrastate offerings. Registering securities offerings at the state level is not as mega-expensive as registering with the SEC at the national level, but it is still expensive. So small, private companies making an intrastate offering usually seek to qualify for a state exemption if they can.
It may appear at first glance that by creating their own intrastate securities laws and regulations, the states are just adding a layer of complexity onto an already complex federal securities regulatory framework. The main reason each state wants its own system, however, is to provide a less regulated—and usually less expensive—option for startups to raise capital within its borders, to spur economic development at the local and state level. (We should not ignore the fact that states earn revenue in various ways as a result of their securities regs.)
The Surge of Intrastate Exemptions
Before 2011, intrastate offerings were typically open to participation by large (or unlimited) numbers of accredited investors, plus limited numbers (usually between 35 and 75, depending on the state) of non-accredited investors who had prior relationships with the issuers—we referred to them previously as the three Fs: founders, family, and friends. (We do not refer to these “connected” non-accredited investors as “the crowd” because their ranks are extremely limited.) In this regard, these traditional intrastate offerings were similar to Regulation D offerings. Starting with Kansas in 2011, though, there has been a trend toward writing new state-level exemptions that allow unlimited numbers of non-accredited investors to participate in small intrastate offerings. “Small” typically means up to $1 million or $2 million of capital. And starting with Wisconsin and Michigan in 2013, some states have begun to mimic the language of the Title III crowdfunding exemption at the state level. We can divide the intrastate exemptions into the following three categories:
- In some states, the intrastate securities exemption allows, but does not require, intrastate offerings to be listed on equity crowdfunding portals. These states include Alabama, Colorado, Georgia, Maine, Massachusetts, Michigan, Tennessee, and Washington.
- Some states established intrastate securities exemptions that require offerings to be made on crowdfunding portals, as does Title III at the national level. These states include Arizona, Wisconsin, Indiana, Iowa, New Jersey, and Texas. We can correctly refer to these as intrastate crowdfunding exemptions.
- In at least one state, Idaho, it is not yet clear whether equity crowdfunding (for non-accredited investors) will be permitted under the existing intrastate securities exemptions.
No two states’ intrastate exemptions are exactly the same. For example, most of the states set a maximum capital raise of $1 million or $2 million, but at least one state (Illinois) sets a $4 million limit.
Also, the maximum investments that non-accredited investors can make vary from state to state. (See the above table for details.) Most of these investment limits are fixed dollar amounts per year or per offering. For example, Alabama and Indiana limit non-accredited investors to a flat $5,000 per year, while at least four states (Georgia, Michigan, Tennessee, and Wisconsin) set the limit at $10,000 per offering (with no limit on the number of offerings per year). Washington, Massachusetts, and Mississippi set limits based on non-accredited investors’ income or net worth, similar to Title III at the national level.
Intrastate equity crowdfunding is an attractive option for investors who are interested in community development and supporting local businesses. So far, the investment limits for non-accredited investors are actually more permissive in intrastate equity crowdfunding.
About the authors
David M. Freedman, based in Chicago, 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, Regulations, Funding Portals, Due Diligence, and Deal Terms (Wiley & Sons, June 2015).
“State of the States: List of Current Active and Proposed Intrastate Crowdfunding Exemptions” (updated December 2015), by Anthony J. Zeoli, Chicago attorney focusing on securities, corporate, banking, and real estate law. Zeoli wrote the Illinois intrastate securities exemption.