Initially implemented in early 2012, the Jumpstart our Business Startups Act (JOBS Act) eased the process of capital formation for small and mid-sized businesses and legitimized pooled investor platforms. Equity crowdfunding emerged and quickly became one of the biggest buzzwords in the startup and business communities. As discussed in a recent installment of the P2Bi Small Business Bootcamp webinar series that took place just a week before final Regulation CF was announced, there was initially a great deal of hope about crowdfunding under the JOBS Act. However, the Securities and Exchange Commission (SEC) stalled on delivering actionable, final crowdfunding rules that would allow for the kind of meaningful change many believed possible through the passage of the JOBS Act.
Finally, after a long three and a half years, the SEC finalized Regulation Crowdfunding (Regulation CF) rules under Title III of the JOBS Act for equity-based crowdfunding as of October 30, 2015. Regulation CF rules become effective in mid-2016, at which point companies will be allowed to raise a maximum aggregate amount of $1 million through registered crowdfunding platforms within any 12-month period.
For businesses and investors alike, the announcement is a breath of fresh air that brings a degree of validation to equity crowdfunding, but what, exactly, does the final Regulation CF mean for businesses and investors?
Costs of Equity Crowdfunding
One of the biggest hurdles for businesses seeking to raise capital under Title III of the JOBS Act was the sheer cost associated with adhering to the Regulation CF guidelines initially proposed by the SEC. The original proposed rules included stringent, cost-prohibitive requirements for businesses: audited financials, extensive disclosures, and ongoing financial reporting. As a result, equity-based crowdfunding was off the table for many small companies, especially those with smaller funding needs. Under the SEC’s final rules, however, companies will be able to raise money through crowdfunding in a slightly more cost-effective manner.
While certain disclosures are still required of businesses, the requirements under Regulation CF are somewhat less prohibitive than originally proposed. Companies will be required to provide and periodically update detailed information to their crowdfunding portal and investors as well as file those materials with the SEC on the new Form C. Companies that use Form C will be required to file annual reports with the SEC. In addition to details about the company and its securities, information provided to portals, investors, and the SEC will have to include specific financial information. Fortunately, the requirement for audited financials for offerings of over $500,000 was relaxed for first-time issuers in the final version of Regulation CF—representing substantial potential savings.
Under the final rules, for businesses raising up to $100,000, only an internal financial statement review must be conducted and provided to the crowdfunding platform and investors. Those raising between $100,000 and $500,000 must have CPA-reviewed financial statements. And, generally, companies raising between $500,000 and $1 million must have third-party audited financial statements in order to be in compliance with the final rules. However, companies that are first-time crowdfunders raising more than $500,000 are exempt from the requirement to provide audited financial statements and, instead, can submit CPA-reviewed financials to investors and the intermediary assisting with the raise.
Expanded Pool of Investors
One of the SEC’s most pressing concerns as a government regulatory agency is the need to protect the investing public from fraudulent or exceptionally risky equity crowdfunding offers. To this end, under the exemptions available prior to Regulation CF, companies offering securities through crowdfunding platforms were not allowed to solicit the general public during a raise and could only sell securities to individuals who fell into the category of either “accredited” or “sophisticated” investors. These restrictions severely limited the pool of investors from which small companies could solicit funds. Under the final Regulation CF rules, the SEC has removed these restrictions—allowing companies to solicit investment by the general public and allowing non-accredited investors to participate in equity crowdfunding up to certain limits.
Now, an individual investor (accredited or nonaccredited) has the opportunity to invest an aggregate of up to $100,000 across all crowdfunding platforms in any given 12-month period. However, investors’ individual limits may be lower depending on their annual income or net worth. Investors with an annual income or net worth of less than $100,000 are limited to the greater of $2,000 or 5% of their annual income or net worth (whichever is less). Investors who have an annual income or net worth of more than $100,000 are permitted to invest up to 10% of either their annual income or their net worth (whichever is less). Together with the disclosure requirements, these investment limitations are meant to protect the general public from a substantial financial loss from equity crowdfunding investments that carry significant risk while still allowing small companies to access the investment potential of the general public.
New “Funding Portals”
The SEC also laid out guidelines for crowdfunding platforms under Regulation CF. First, companies may only conduct crowdfunding offerings through a registered broker-dealer or “funding portal” as intermediary between the company and the public, and they may only use one crowdfunding portal at a time. Any organization acting as an intermediary for crowdfunding offerings under Regulation CF is required to register as a “funding portal” with the SEC and to become a member of the Financial Industry Regulatory Authority (FINRA), which is the official national securities association.
Together with the registration and membership requirement, crowdfunding platforms face a heavy burden when it comes to investor disclosures. They face an independent requirement to take measures to reduce fraud and ensure companies provide investors with educational materials that present a clear explanation of the process for investing, the types of securities offered, any limitations on resale of those securities, and total investment limits. Intermediaries are also subject to a laundry list of rules that govern the provision of access to their crowdfunding portals, intermediary conduct, and compensation to their promoters. Additionally, platforms must provide effective communication channels that allow for discussion about the securities being offered, as well as compliance with confirmation, completion and cancellation of securities offerings requirements. It remains to be seen how intermediaries with incorporate the costs associated with requirements and risk exposure into their pricing and operational models.
What Does the Future Hold?
While the final rules laid out by the SEC in Regulation CF are a step in the right direction for some companies, there are still a myriad of issues yet to be addressed. Will Regulation CF be an effective game-changer in capital formation, or will it flounder due to still-too-burdensome requirements on issuers or questions about the proper execution of its many provisions? Will nonaccredited investors jump on the opportunity to participate in equity-based crowdfunding, or will the risks associated with investing in small business, like fraud or high rates of failure, be an overwhelming deterrent? Some argue that these concerns—as well as costs to issuers and risks to investor— were not appropriately or adequately addressed in the SEC’s final version of Regulation CF. Others feel optimistic about what equity crowdfunding can bring to small businesses with capital needs. The first securities offered under Regulation CF may quickly reveal the fate of the new rules as transactions begin to take place next year, and we can all hope that equity crowdfunding shifts away from its buzzword status and begins to take shape as a viable funding alternative.
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