Historically, there have been two categories of individual investors: accredited investors – deep pocket individuals, with significant income or assets – who had entrée to investments in technology start-ups and emerging companies; and John and Jane Q. Public, who for the most part stood by and watched, because they didn’t meet the minimum financial requirements for eligibility. The theory of crowd funding, authorized under the Jumpstart Our Business Startups Act (JOBS Act of 2012), is to find a way for the man and woman in the street to participate in these opportunities. While it was at it, Congress also made it easier for those emerging companies to reach the accredited investor community with public advertising. This article discusses how the JOBS Act addresses those issues.
Accredited Investors: In broadest terms, an accredited investor is one who has a net worth that exceeds a certain minimum level, or alternatively has met certain income levels in the past and appears likely to continue to do so in the year he makes an investment. Specifically, an individual is an accredited investor (a) if she alone or with her spouse has a net worth in excess of $1,000,000 exclusive of the value of their personal residence; or (b) in the two most recent years has had income of at least $200,000 (or jointly with her spouse of $300,000) and has a reasonable expectation of meeting those minimums in the current year. This classification as an accredited investor presupposes that possessing a certain level of wealth or income is an indicator that the investor is capable of looking after his own interests with less legal protection. Sales of securities solely to these investors are not tantamount to a ‘public offering’ of securities, and therefore federal and state securities laws allow these transactions to proceed without compliance with many of the more complex laws and regulations that ordinarily govern the sale of securities.
Restrictions on General Solicitation: What are the restrictions on offering and issuing stock only to accredited investors? (These offerings are referred to generically as ‘Rule 506 offerings’.) The rules have been quite relaxed about how much or how little information these investors are to receive from the issuing company, on the theory that those investors could take care of themselves, so long as the company filed a few forms with the federal and state governments and complied with anti-fraud measures like SEC Rule 10b-5. However, the problem is that up until now, it hasn’t been easy for small start-ups to reach accredited investors, in large part because there was a prohibition against general advertising about the investment.
In some (but not a majority) of the cases, accredited investors found out about a company on their own, and because they liked its product or technology, they made overtures to invest in it. A small cottage industry grew up over ‘finding’ money for these companies, but the company itself could not advertise that it was looking to sell shares to anyone who was accredited. Some of the money finders operated on the fringes of the existing law, and that created issues when the lawyers entered the deal and began pointing out these problems.
The JOBS Act removed that prohibition against general solicitations for investments solely from accredited investors. There hasn’t been a great deal of resistance to this change, and it simply liberalizes an existing practice, where lawyers and others had a clear understanding of what to do and how to do it. The Act gave the SEC 90 days to come up with ground rules for verifying that each investor is in fact accredited.
The SEC, however, has yet to issue the necessary rules to elaborate on how advertising is to be permitted and limited. Indications are that companies will have to conduct a much more searching investigation of prospective investors financial condition than historically has been the case. Simply asking the investor to sign a certification that she is ‘accredited’ will not be sufficient. There have been suggestions that issuers may need to review tax returns and other private financial information of the investor, or at least obtain a certification from someone who has done so like the investor’s accountant. Any company that engages in a general solicitation before the final rules are promulgated is exposing itself to legal risk that the process it adopts will not comply with the final rules.
It is important to remember that the JOBS Act relaxes the ability to advertise to the accredited investor community generally but it does not relax the far-reaching prohibitions on securities fraud that are contained in federal and state securities laws. Whatever form of advertising is ultimately permitted cannot contain any statements about the company or what it is selling that are knowingly false, incomplete or misleading.
Crowd Funding: Allowing a general solicitation to accredited investors doesn’t really solve the problem for those companies with less sex appeal. Accredited investors most commonly are looking for liquidity within 5 to 7 years. They are not permanent investors; instead, they have definite time lines for getting their money back, and if the projected revenues or cash flows are insufficient to meet their estimated payouts, they will insist on a forced sale or an initial public offering by the company to provide liquidity for their investment. Many companies simply can’t support the target rate of return, or are too small or plain-vanilla to warrant the commitment of expense, time and effort by the accredited investors, and those investors will move on to deals that can.
That’s where crowd funding comes in. The following is a brief history of crowd-funding, the previous rules governing this process and a summary of the JOBS Act’s rules and provisions:
- In plain English, crowd-funding is a company’s Web-based general solicitation of investments in smaller amounts from ‘crowds’ of unaffiliated investors, many or all of whom will not qualify as accredited investors.
- The crowd funding concept has been around for a while in different forms: Bulletin boards, etc. but selling an interest in a company (or loaning it money) most often involves selling a ‘security,’ and that process is highly regulated by federal and state securities laws.
- Under these securities laws, compliance becomes quite complex when a company is seeking investments from prospective investors who don’t meet the net worth or income standards for accredited investors.
- Consequently, there have been substantial legal impediments when a company solicits funding from a broad spectrum of investors, some of whom have modest resources.
- Recently, there have been assertions that it’s one thing to tightly regulate major syndications, and another thing to unfairly burden start-ups and early stage entrepreneurial companies badly in need of funding. There is also a professed concern that potential investors with modest resources were barred from ‘getting in on the ground floor’ of investments that eventually proved lucrative. Some of the dialogue was driven by a desire to cut back investor protections that had been in place since early in the New Deal. This led to the enactment of the JOBS Act of 2012.
- The JOBS Act addresses several quite different issues:
- As discussed above, it relaxes the rules for a general solicitation of accredited investors.
- It relaxes disclosure requirements for so-called ‘emerging companies’ during their post-commercialization growth period. That’s outside the scope of this article.
- It also lays down ground rules for companies that want to engage in crowd funding.
- The original House bill was very permissive, and it was denounced by federal and state securities regulators.
- In the Senate, last minute changes tightened the bill up significantly, and gave the SEC broad authority to make rules that may complicate the process. This rule-making process has lagged badly.
- Here’s how crowd funding will work under the JOBS Act as finally enacted:
- Crowd funding sales by a company are limited to $1,000,000 during any rolling 12 month period.
- Crowd funding purchases by investors are limited on a rolling, 12 month basis. The limits vary, depending on the annual income of the investor.
- Sales have to be effected either through a registered broker-dealer or through a so-called ‘portal’ that registers with the SEC. More on that below.
- Portal Obligations: Any broker or funding portal intermediary has to take steps to make sure an investor fully understands the risk of loss, and receives appropriate investor education material.
- The SEC will adopt a rule that requires the portal to implement anti-fraud measures, including background checks on the client company’s directors, officers and 20% or greater equity holders.
- The portal is responsible for filing the information about company financial condition and affairs that the company provides for investors with the SEC. This information must be filed at least 21 days before a sale to the investor, presumably to allow the SEC sufficient time to review it.
- The portal is also responsible for ensuring that no investor exceeds her allowable investment maximum.
- The portal may not pay fees to any finders who steer investors to it.
- No officer, director or partner in the portal may invest in an issuer that uses its services.
- The portal has to ensure that the company establishes a funding threshold or minimum and the target date by which funding will be completed. Prior to the time at which the threshold has been reached, funding will be placed in an escrow account and won’t be released until that funding threshold has been reached. Companies can’t begin to use investment dollars as soon as they come in the door. In this interim period, any investor who decides to back out can get her money back. If the funding threshold isn’t met within the time deadline set by the company, all funds in the escrow account must be returned to the investors.
- Company Obligations: The company must file with the SEC (and provide to the portal and the investor) information concerning its officers, directors and 20% shareholders, and information concerning its financial condition and its business plans.
- The type of financial information that is required varies depending on the size of the offering. For offerings of $100,000 or less within any 12 month period, the company must provide its income tax return and any existing financial statements, certified by its CEO. For offerings in the $100,000 to $500,000 range, the company must provide reviewed financial statements prepared by an independent accountant in accordance with standards to be promulgated by the SEC. Offerings in excess of $500,000 will be governed by rules to be promulgated by the SEC. As is with the case of other rules, this process has not yet been completed but we can assume that it will emphasize substantial disclosure.
- The company must provide the SEC and potential investors with detailed information about its capital structure, its current owners and their equity ownership and participation rights. The company must also provide information concerning (a) the use of proceeds; (b) what the minimum offering size will be, with updates on how it is progressing in meeting its goal; (c) how it arrived at a value for the shares being sold, and a complete description of its capital structure. The SEC is apt to pay particularly close attention to the process for valuing equity interests in the company. The SEC has many tools for drawing out the review process if it deems the valuation to be unrealistic or overly optimistic.
- Unlike the case where it is selling solely to accredited investors, the issuer cannot directly solicit or effect sales from investors, except for notices directing the investor to the portal. In fact, the JOBS Act limitations may make it impossible for a company to simultaneously both engage in crowd funding and to advertise a Rule 506 offering to accredited investors. The company has to choose one or the other.
- The company cannot pay fees to anyone who identifies investors or guides them to the portal unless it fully discloses any compensation.
- The SEC is given broad rule-making authority in other areas that are not already addressed by the Act.
- The SEC also has to determine how it can track investors to ensure that no person invests more than she is allowed to invest under the annual investment ceiling.
- If somehow the company can make its way through this Victorian maze, it’s free to sell to any investor, without restricting the offering to accredited investors. However, the investor then has a holding period of 1 year, in which she is restricted from reselling the shares to anyone other than (a) the company; (b) an accredited investor; (c) a family member; or (d) in connection with death or divorce.
- The SEC will also provide guidelines concerning who is and who isn’t qualified to act as a portal or participate as a seller in these transactions. The guidelines will look to the disciplinary record before the SEC; the prior conviction of a felony; and a multitude of other factors. These qualifications will extend to any officer, director or general partner of the issuer or the portal, and to any person holding 10% or more of any class of its securities.
- An eligible crowd-funding company is exempted from several other securities laws. Most importantly, it is also exempted from the scrutiny of state regulators insofar as registration requirements are concerned. However, it is not exempted from any other state law or regulation that governs the purchase or sale of securities, and it is not exempted from federal and state anti-fraud regulations. The state where the company’s principal office is located, and the state where the buyers of 50% or more of the offering reside, may require submission of notice filings and the payment of normal filing fees. All other states are barred from imposing filing or fee requirements.
- State regulators and the SEC have been the most vigorous skeptics about crowd funding in its original form. It is quite possible that they will claim the right to examine any prospective crowd-funding scheme to ensure that it meets all of these requirements. As of April 1, 2013, they continue to manifest a high level of concern:http://www.nasaa.org/13676/small-business-advisory-crowdfunding/
More Questions than Answers? Finally, these thoughts. Crowd funding by its nature is intended to attract large numbers of less sophisticated shareholders with modest resources. At some point, this kind of ownership structure becomes unwieldy for a small company. How will a company handle shareholder communications? Will compliance with normal corporate governance requirements — conducting an annual shareholder meeting, for example — become burdensome? Will casual investors assume that they have operational or management rights? Who will remain in control of the company? Will non-accredited investors share the goals and timelines of the founders, or will they begin pushing for a short term sale, or a change in basic operations? When the company starts looking for venture capital, or is preparing to be sold, will the presence of a large number of shareholders dampen its prospects or complicate the process? Companies that are attractive enough to draw traditional angel/accredited investors through newly-expanded general solicitation may be unwilling to go through the complicated process of crowd funding simply to provide an investment opportunity to non-accredited investments. Will this inevitably lead to the use of crowd funding by sketchy speculators and low growth companies with modest prospects that can’t attract angels and have no other practical alternative? The need for freely-available capital may obscure these considerations but they won’t make them disappear. See, http://tinyurl.com/clf3mhl
- Post-script, June 10, 2013: The SEC has yet to issue definitive regulations, as required by the JOBS Act. Its new Commissioner, Mary Jo White, has stated that it is a priority to do so. While some portals have apparently begun operations without waiting for SEC rule-making, their activities have drawn SEC scrutiny:http://tinyurl.com/bphfk3s.