The Floodgates are Open
This is our third and final installment on crowdfunding. The two previous installments dealt with rewards-based crowdfunding and the development of equity crowdfunding under Reg D. This final installment deals with equity crowdfunding under Title III of the JOBS Act.
[Editor’s Note: This is the seventh installment in a series of articles dedicated to the 95% of people in the U.S. who have never invested in a startup, a venture capital fund, a private equity fund, or a hedge fund even though they are permitted to do so and even though doing so may make sense to achieve property diversification. Read Installments #1, #2 , #3. #4, #5 and #6.]
The JOBS Act established a new kind of angel investing under Title III of the Act, which is also known as the “crowdfunding exemption.” This profound shift allowed all Americans, not just the wealthiest 5 percent, to invest in startups and small businesses over the Internet. The language of Title III explicitly referred to “funding portals,” rather than to the then-prevalent industry term “offering platforms.”
On May 16, 2016, the SEC adopted Regulation Crowdfunding to implement Title III crowdfunding. Soon thereafter crowdfunding portals, open to all investors, began launching. From a regulatory point of view, crowdfunding portals are only distantly related to Reg D platforms. From a technology point of view, they are siblings: most Title III portals are derived directly from Reg D platform infrastructure.
Title III is the only part of the JOBS Act that opened the floodgate—closed since the Securities Act of 1933—for masses of non-accredited investors to participate in the private equity markets. The decisive stroke of Title III was that it amended the Securities Act of 1933 by adding a new paragraph to Section 4(a) of the Act, designated as new Section 4(a)(6). Some lawyers and regulators may refer to equity crowdfunding as Section 4(a)(6) crowdfunding, but (partly because that’s hard to remember) most people call it Title III crowdfunding, Regulation CF, or simply equity crowdfunding.
Following is a summary of the most important provisions of Title III and Regulation Crowdfunding as they relate first to issuers, second to investors, and finally to the intermediaries (portals and broker-dealers).
Title III and Regulation Crowdfunding Provisions for Issuers
To make an offer of 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 USA. Investment companies, including mutual funds and private equity funds, may not raise capital via crowdfunding portals. In addition:
- An issuer may raise up to $1,070,000 (adjusted for inflation at least once every 5 years) in any 12-month period through equity crowdfunding portals that are registered with the SEC and FINRA.
- An issuer must provide accurate information concerning: its name, legal status, physical address, and website URL; the names of officers, directors, and shareholders owning 20 percent or more of total equity; the description of the business, business plan, capital structure and selected financial information (how the company finances its overall operations and growth; sources of funds that may include long-term debt, specific short-term debt, common equity, and preferred equity); the offering amount, deadline for raising that amount, and intended use of the proceeds raised from crowdfunding investors; and the price of the securities offered via crowdfunding, or method used to determine the price (in the latter case, an investor would have a right to rescind a commitment to purchase after the price is determined).
- Issuers must provide an accurate description of its ownership and capital structure, including: the class of securities 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; the 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; and risks associated with (a) minority ownership, (b) future corporate actions, and (c) related-party transactions.
- Issuers seeking to raise $107,000 or less must provide disclosure of the amount of total income, taxable income and total tax as reflected in the issuer’s federal income tax returns certified by the principal executive officer, and financial statements certified by the principal executive officer to be true and complete in all material respects. If, however, financial statements that have either been reviewed or audited by an independent public accountant are available, the issuer must provide those financial statements instead and need not include the information reported on its federal income tax returns or the certification of the principal executive officer.
- Issuers seeking between $107,000 and $535,000 in capital must provide financials reviewed by an independent public accountant. If, however, financial statements that have been audited by an independent public accountant are available, the issuer must provide those financial statements instead and need not include reviewed financial statements.
- Issuers seeking more than $535,000 and up to $1,070,000 and relying on Regulation CF for the first time must provide financials reviewed by an independent public accountant. If, however, financial statements that have been audited by an independent public accountant are available, the issuer must provide those financial statements instead and need not include reviewed financial statements. Issuers seeking more than $535,000 and up to $1,070,000 that have previously relied on Regulation CF must provide financial statements audited by an independent public accountant.
- Issuers may sell shares to an unlimited number of investors in a deal, within the $1,070,000 raise limit.
- Issuers are permitted to publish a notice advertising certain specific offering terms and directing investors to the crowdfunding portal where the offering is being conducted. Additional communications with potential investors regarding offering terms must take place through the crowdfunding portal.
- Issuers must file offering information with the SEC.
- After a funding round is complete, issuers have to file annual reports with the SEC and share them with investors.
- Issuers may participate in equity crowdfunding offerings and Reg D, Rule 506(c) general solicitation offerings at the same time; these would be known as concurrent offerings.
- 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.
- Title III and Regulation Crowdfunding Provisions for Investors
Investing Limits Prevent Catastrophic Losses
The amount of money that an investor can plow into equity crowdfunding deals each year depends on the investor’s net worth and/or income (adjusted for inflation at least once every 5 years). Congress set these limits to help prevent catastrophic losses from being incurred by unsophisticated investors in high-risk investments.
- Individuals (together with their spouse) with an annual income and net worth, excluding the value of their primary residence, of less than $107,000 may invest the greater of $2,200 or five percent of the lesser of their annual income or net worth. In any case, anyone can invest at least $2,200 in equity crowdfunding each year.
- Individuals (together with their spouse) with an annual income or net worth, excluding the value of their primary residence, of $107,000 or more can invest up to 10 percent of the lesser of their annual income or net worth, but not more than $107,000 per year.
- Investors may self-certify that they are not exceeding their investment limits (in other words, they do not have to submit tax returns or other documentation to prove it) unless an intermediary has a reasonable basis to question the reliability of the certification. In addition, intermediaries are free to implement additional measures to ensure compliance with the investment limitations.
- When registering on a funding portal, investors must review educational materials, positively affirm that they understand the risk of loss of their investment and that they are able to bear such a loss and answer questions demonstrating an understanding of the level of risks of private equity investments.
- Investors must hold shares for at least one year after purchasing them via equity crowdfunding, with some exceptions (for example, they may sell shares back to the issuer, to an accredited investor, as part of an offering registered with the SEC, or to a member of their family, certain estate planning vehicles, or in connection with death or divorce).
- An investor in crowdfunded securities may file a lawsuit against an issuer for rescission of funds if the issuer has made material misstatements or omissions in connection with the offering. This is not unique to crowdfunded offerings.
- Title III and Regulation Crowdfunding Provisions for Intermediaries
Final Do’s and Dont’s
All funding portals that are not broker-dealers must register with the SEC and a registered national securities association (currently FINRA is the only one). In addition:
- Registered funding portals that are not broker-dealers may not offer investment advice or make recommendations to or solicit investments from, individual investors. In addition, they may not compensate employees, agents or other persons for solicitation or based on the sale of securities displayed or referenced on their platforms.
- Broker-dealers and funding portals may establish objective criteria for accepting and rejecting issuers that apply to their funding platforms (i.e., they may “curate” their offerings based on, for example, industry or geographic location).
- An intermediary may not pool investors’ funds into a single investing entity (as MicroVentures does for Reg D investments).
- Intermediaries must provide “investor education” content on their portals that helps investors understand, among other things, the risks of investing in private equity, including loss and illiquidity. They must ensure that investors review that material and affirm that they understand the risks, by completing an investor questionnaire and making a representation to the intermediary.
- Intermediaries must conduct background checks on officers, directors, and 20 percent equity holders of each issuer, as a means to reduce the risk of fraud. Intermediaries must disqualify an issuer if one of its officers, directors, or “participants” (such as promoters) in the offering is a “bad actor,” as defined by the SEC (e.g., convicted felon, person subject to a finance-related injunction or restraining order, person subject to SEC disciplinary action, etc.).
- An intermediary may potentially be liable in an offering where there is a fraudulent or intentionally misleading statement made by an issuer.
- Directors, officers, or partners of an intermediary may not have a financial interest in an issuer using their services, and may not compensate any third-parties (including promoters, finders, or lead generators) for identifying potential investors.
- Intermediaries may have a financial interest in an issuer using their services only if that financial interest is received as compensation for the services provided to the issuer in connection with the offering on the intermediary’s platform and consists of securities of the same class and having the same terms, conditions and rights as the securities being offered through the intermediary’s platform.
- Funding portals that are not broker-dealers may not receive, manage, or hold investor funds. They must use a third-party escrow service for that purpose, and release the funds to the issuer only when the offering is successful; otherwise, the funds are returned to investors.
- Intermediaries must make reasonable efforts to ensure that investors do not exceed their limits based on income and/or net worth.
Some Final Words About Crowdfunding
FINRA and the SEC issued final rules for Title III crowdfunding in January and May of 2016, respectively. It remains to be seen if equity crowdfunding will fail or succeed in the USA. If you are a “new” investor in private securities, and you decide to invest in equity crowdfunding, you can minimize the possibility of painful loss by exercising caution, taking it slow and educating yourself about private capital markets, diversifying your equity crowdfunding portfolio, and limiting your potential losses to a small percentage of your total investment assets.
We have and will continue to see a proliferation in the number of equity crowdfunding sites. While many, if not most, will focus on start-ups, they will not be limited to start-ups.
Before you, as an accredited investor, make any investment on any crowdfunding site, you really need to make three independent decisions:
- Are you comfortable with the particular crowdfunding site? How the portal screens the issuers that apply to be listed on it will be critical to most investors because most investors will not do much of their own due diligence and will instead rely on the portal’s pre-screening mechanisms.
- Are you comfortable with the asset class? If your investment portfolio already has exposure to an appropriate percentage of, say, early-stage VC, do you nonetheless want to invest in XYZ if it is also an early-stage company?
- Are you comfortable with the specific underlying investment?
[Editor’s Note: This series is based on Jonathan Friedland’s book