Title III of the Jumpstart Our Business Startups (JOBS) Act of 2012 allows all investors, regardless of income or net worth, to invest in startups and growing private companies via funding portals that are registered with the Securities and Exchange Commission.
The JOBS Act created four new securities exemptions, which allow growing companies to bypass the expensive process of registering their securities with the SEC (i.e., they can stay private). The purpose of the JOBS Act was to make it easier and less costly for entrepreneurs, startups, and small businesses (issuers) to raise capital from investors and lenders. Capital is needed to fuel growth, and thereby to boost the economy and create new jobs. The act aims to accomplish that objective mainly by loosening some of the most onerous restrictions on the ability of small companies to raise capital in the private securities markets.
Title III of the JOBS Act was implemented in October 2015 when the SEC issued rules for (a) issuers of securities under Title III, (b) the operation of crowdfunding portals and broker-deal platforms, and (c) the amount of money that people can invest in Title III offerings based on their income and net worth. The SEC refers to this set of rules as “Regulation CF.”
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:
Each issuer must provide an accurate description of the terms and risks of its offering, including the following:
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, financials must be reviewed by an independent accountant. Those seeking $500,000 to $1 million must have their financial statements audited by a certified public accountant, except for first-time Title III issuers. Those who have never before sold securities via Title III crowdfunding are exempt from the audit requirement and must simply have their financials reviewed. (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. For each period for which financial statements are provided, the issuer must include a summary of operations during that period.
The difference between a review and an audit is explained nicely by the AICPA at http://www.aicpa.org/InterestAreas/PrivateCompaniesPracticeSection/QualityServicesDelivery/KeepingUp/Pages/what-is-the-difference-between-compilation-review-audit.aspx.)
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 of the JOBS Act (under Regulation D, Rule 506c), 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 promotions. 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.
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.
After a successful funding round is complete, issuers have to file annual reports with the SEC, and share them with investors as well. 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. The SEC specifies that annual reports must be posted on the issuers’ websites within 120 days of the issuer’s fiscal year-end. The reports do not have to be audited or reviewed by outside accountants. Annual filing requirements under Title III continue until one of the following occurs:
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.
The ability of everyday people to invest small amounts of money in private companies represents a monumental shift in the private capital markets. The traditional rules that locked most non-accredited investors out of the markets aimed to protect presumably unsophisticated investors from the riskiest kinds of investments. With Title III, Congress attempted to balance the new freedom to invest, on the one hand, with requirements and restrictions designed to protect inexperienced angel investors, on the other hand. Such requirements include greater offering disclosure (as previously listed), and such restrictions include limits on the amount people can invest (and possibly lose). 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, detailed here. Congress’s intent was to help prevent catastrophic losses being incurred by unsophisticated investors in high-risk securities.
If an individual’s annual income or net worth is less than $100,000, he or she may invest the greater of (a) $2,000 or (b) 5 percent of the lesser of his or her annual income or net worth, over the course of the year.
If the annual income and net worth of the individual are both greater than $100,000, he or she may invest up to 10 percent of the lesser of his or her annual income or net worth, but not more than $100,000, per year.
Spouses may combine their incomes for the purpose of the income test. In calculating net worth, investors may not include the value of their primary residence.
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.
When registering on a funding portal, investors must demonstrate that they understand the risks of private equity investments. They can do that by studying the educational content on the portal (or other educational resource) and filling out a questionnaire.
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 or to an accredited investor, or transfer securities to a family-member or beneficiary in the event of death or divorce).
Investors in crowdfunded securities may file a lawsuit against an issuer for rescission of funds if the issuer is liable for material misstatements or omissions in connection with the offering.
Companies cannot directly offer crowdfunding investments to the public. All Title III offerings must be funneled through an intermediary, which can be either a funding portal or a broker-dealer platform. In addition:
Title III portals and platforms must register with the SEC and also with a self-regulatory organization (SRO). Currently FINRA is only SRO in the field of private securities. The registration process begins at the end of January 2016, although Title III portals cannot launch and begin taking commitments from investors until May 2016.
Funding portals that are not broker-dealers may not offer investment advice or make recommendations to, or solicit investments from, individual investors. In this way, these portals are purely conduits between issuers and “the crowd,” with some educational content added (see next item).
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 before they invest, by filling out a questionnaire or survey.
Funding portals and broker-dealer platforms can use both objective criteria (e.g., industry, geographic location, or number of employees) and subjective criteria (e.g., experience of management team, chances for success) in deciding which offerings list on their platforms. When issuers submit applications to an intermediary, the latter can “curate” offerings, i.e., determine which to accept and reject, based on whatever criteria they choose. The intermediary must not claim that its selection criteria make its offerings better or safer than any other’s. Nor can an intermediary use its selection criteria as a way of giving investment advice to its registered investors.
In deciding which offerings to “highlight” at any time, portals must use only subjective criteria designed to display a broad selection of issuers. They may not highlight offerings based on their judgment about the relative suitability or advisability of investing in them. Objective criteria may include, in addition to those listed in the previous item, the number of committed investors so far and the number days left in the funding period, for example.
Intermediaries may provide search functions, allowing investors to find offerings based solely on objective criteria.
Intermediaries must provide communication channels, such as forums and discussion groups, for investors to discuss offerings and collaborate on due diligence. Such channels are to be accessible and “transparent” to all individuals who register and establish accounts on the portals. Operators of funding portals may not participate in those discussions among investors, other than to establish guidelines for discussions and remove abusive or fraudulent participants.
If issuers or their representatives are allowed to participate in discussions (for the purpose of responding to investors’ questions), they must at all times identify themselves as issuers or engaging in discussion on behalf of issuers.
Intermediaries may decide whether investors who participate in discussions must do under their registered (real) names or may do so under aliases. We recommend that if you rely on communications and collaborations with other investors, you should use portals that require real names in discussions, so you can assess the reliability of participants. The ability to use aliases might encourage inaccurate posts.
An intermediary may not pool investors’ funds into a single investing entity (as MicroVentures does for Regulation D investments). In other words, each individual investor will invest directly in the company that offers shares.
In order to reduce the occurrence of fraud, intermediaries must conduct background checks on officers, directors, and 20 percent equity holders of each issuer, and must disqualify an issuer if one of its officers, directors, or “participants” (such as promoters) in the offering is a bad actor.
Intermediaries must have a “reasonable basis for believing” that the issuers listed on their portals have complied with their disclosure and registration requirements, and have established accurate record-keeping systems to keep track of their investors the securities purchased by investors.
Intermediaries must also assess each offering for the risk of fraud, and refuse to accept an offering if they have a reasonable basis to believe that it presents the potential for fraud. If an intermediary becomes aware of fraudulent intent after accepting and listing an offering on its portal, it must cancel that offering.
Depending on the facts and circumstances, an intermediary may potentially be liable in an offering where there is a fraudulent or intentionally misleading statement made by an issuer.
Funding portals are permitted to advise issuers about the content of their offerings, types of securities, and deal terms; and may (but are not required to) provide pre-drafted templates or standardized forms that issuers can use to prepare various offering documents.
Intermediaries must disclose to investors how they will be compensated by issuers in connection with offerings and sales made on their portals. They may accept a range of compensation, including flat fees, commission, and equity interest. Intermediaries should not receive any fees or compensation directly from investors.
Intermediaries may accept equity in an issuer only as compensation for listing and other services that portals normally provide to issuers. Intermediaries may not take a financial interest (i.e., may not purchase equity) in addition to such compensation. If they take equity as compensation, it must be at the same price and under the same terms as offered to individual investors in the same offering. Individual directors, officers, or partners of a funding portal may not, however, have a financial interest in any issuers using the portal’s services—only the portal itself may.
Intermediaries may not compensate any third parties (including promoters, finders, or lead generators) for identifying potential investors.
An intermediary may not accept any investment commitment from an investor until the investor registers and opens an account on the portal.
An intermediary may rely on investors’ representations regarding their compliance with annual investment limits, based on income and net worth.
Funding portals may not receive, manage, or hold investor funds, but must use a third-party escrow service for that purpose and release the funds to the issuer only when the offering is successful. The money is returned to investors from escrow if a campaign is not fully funded.
If an issuer makes a significant change to the terms of an offering, the intermediary must within five days contact all investors who have made commitments to invest in that offering, and request that those investors re-commit or cancel in light of the new information.
Intermediaries must make reasonable efforts to ensure that (1) issuers comply with offering limits and do not receive funds from investors until their target offering amount is achieved, (2) the personal information collected from investors is kept private and secure, and (3) investors do not exceed their limits based on income and/or net worth. SEC commissioner Luis A. Aguilar referred to this as the intermediaries’ “gatekeeping role.”
Intermediaries may compensate a third party for referring investors to the portal, as long as the referral does not include personally identifiable information about individual investors. Compensation for referrals must not be based on the ultimate purchase of securities unless the third party is a registered broker-dealer.
Funding portals may advertise their own existence in public media, including social media. They may identify specific issuers and/or offerings in their ads as long as (1) they use objective criteria for deciding which issuers or offerings to advertise, (2) those criteria result in a varied selection of issuers or offerings, and (3) the ads do not implicitly endorse one issuer or offering over others. Portals are prohibited from receiving special or additional compensation for identifying or highlighting particular issues or offerings in their ads.
Some equity crowdfunding professionals and their advisers believe equity crowdfunding will get off to a slow start, and it may take another act of Congress it gains traction. “I am 99 percent certain that there will be a JOBS Act 2.0,” says Kim Wales, CEO of Wales Capital in New York City and an executive board member of the CrowdFund Intermediary Regulatory Advocates (its acronym CFIRA is pronounced “Siffra”). Wales predicts that Congress will, among other revisions, increase the maximum amount that can be raised via crowdfunding from $1 million to possibly $5 million, which will attract more established companies (thus, less risky offerings) as well as more “smart money.” If that happens, Wales says, “there will be a pivot point in the marketplace in five years, with major changes in the private equity financing system. Venture capital and private equity will evolve along with the maturing crowdfunding industry.”
On March 23, 2016, Rep. Patrick McHenry (NC) introduced H.R. 4855, the “Fix Crowdfunding Act,” in the Financial Services Committee of the House of Representatives. It would increase the 12-month raise limit from $1 million to $5 million, reduce the liability of funding portals for inaccuracies and omissions by issuers, and allow intermediaries to aggregate investors into “single-purpose funds,” among other changes. We will post summaries and updates as the proposed legislation moves forward.
David M. Freedman has worked as a financial and legal journalist since 1978. He has served on the editorial staffs of business, trade and professional journals, most recently as senior editor of The Value Examiner (National Association of Certified Valuators and Analysts). He is coauthor of Equity Crowdfunding for Investors, published in June 2015 by…
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