Crowdfunding Under the JOBS Act: What Investors Need to Know

Introduction

In April 2012, Congress enacted the “Jumpstart Our Business Startups Act”—or JOBS Act—as part of the federal government’s ongoing efforts to stimulate the economy. The Act was intended to spur small business growth by loosening decades-old rules prohibiting the solicitation and sale of private placement investments to the general public. Through the new “crowdfunding exemption” to the registration requirements of the Securities Act of 1933, Title III of the JOBS Act gives startup companies the go-ahead to raise up to $1 million in investment capital per 12 month period from everyday (e.g., non-accredited) investors. 

While there is no question crowdfunding will allow businesses easier access to startup capital, crowdfunding investors will not have the benefit of reviewing all the financial and other company information they otherwise would have in a traditional investment scenario. And given the fact securities crowdfunding–which the SEC considers amongst the riskiest investments available–will take place almost exclusively through the internet, investors may be more vulnerable to fraud or other misconduct.

The regulation of crowdfunding under the JOBS Act is a new and fluid area of the law. In fact, the Securities and Exchange Commission (SEC) only released its proposed crowdfunding regulations in late October of this year. Until those regulations are formally adopted–which is expected to take place shortly after the SEC’s comment period expires in January 2014–crowdfunding in the securities context will remain illegal.³ When crowdfunding becomes legal, however, investors should have a clear understanding of the rules and limitations governing crowdfunding before considering these inherently risky investments.

Crowdfunding Defined

In the securities context, crowdfunding involves the solicitation of small capital investments from a large number of investors to finance a new or expanding business venture. In return, those investors receive a small stake in the company (usually shares of stock, but sometimes debt securities) and expect to earn a profit on their investment if the company succeeds. Absent an exemption from SEC registration under the Securities Act, this type of investment generally was illegal before the JOBS Act.

The concept of “crowdfunding”–pooling small contributions from a large number of people to promote a common goal–is far from novel. Charities, social groups, churches and other non-profit organizations have raised funds using similar methods for hundreds of years. Where these organizations once held fundraisers or passed around the collection basket, websites like Kickstarter and Indiegogo brought crowdfunding to the internet by allowing startup companies and entrepreneurs to accept monetary “donations” from project “backers.”⁴ The difference between these crowdfunding platforms and crowdfunding under the JOBS Act, however, is that investors soon will be able to purchase a security interest in the company in which they are investing. The process thus falls squarely within the regulatory framework of the Securities Act.

General Limitations and Rules Governing Crowdfunding

The “crowdfunding exemption” is simply an exception to the formal registration and reporting requirements of the Securities Act. The exception will allow current nonpublic/ non-SEC reporting companies (referred to as “issuers”) to sell securities legally without meeting all of the stringent financial disclosure and reporting guidelines applicable to traditional public companies.

Under the SEC’s proposed crowdfunding regulations, there are limitations on the amount of money individual investors may invest each year. Issuers, moreover, cannot raise more than $1 million in capital during a 12-month period through crowdfunding and must comply with the various rules governing the exemption. Finally, all crowdfunding transactions must be conducted through a qualified intermediary–e.g., a traditional broker-dealer firm or “funding portal” that is registered with and subject to the oversight of the Financial Industry Regulatory Authority (FINRA).

Limitations on the Amount Individuals May Invest

First, the JOBS Act limits the amount of money an investor may invest through crowdfunding in any 12-month period. Investors with an annual income or net worth of less than $100,000 may invest up to the greater of $2,000 or 5% of their annual income or net worth. The limitation includes all crowdfunding activities, and is not calculated on a company-by-company basis. By way of example, if investor “A” earned $50,000 per year, he would be eligible to invest a total of $2,500 (5% of $50,000.00) per year through crowdfunding. He could purchase $100 worth of securities in 25 different companies or invest the full $2,500 in one company–the same dollar limitation would apply.

Investors with equal to or more than $100,000 in annual income or net worth may invest up to 10% of their annual income or net worth, not to exceed a maximum of $100,000 each 12-month period. Using a similar example, if investor “B” earned $120,000 per year, she could invest up to $12,000 through crowdfunding every 12 months. Under the proposed regulations, issuers may rely on intermediaries–e.g., the broker-dealer or “funding portal” processing the investments–to track the amount each individual has invested through crowdfunding.

Aside from these minimal restrictions, any member of the general public will be eligible to invest through crowdfunding. In fact, the SEC believes most investors who participate in crowdfunding offerings will be unsophisticated retail investors who do not have access to investment opportunities in early-stage ventures, either because they lack the necessary accreditation or because they do not have sufficient funds to participate as an angel investor.

Rules Applicable to Issuers

Most U.S.-based corporations, limited liability companies and some partnerships will be eligible to issue securities under the crowdfunding exemption, provided they comply with the many regulations applicable to issuers. Foreign entities, current public/SEC-reporting companies, investment companies and companies lacking a formal business plan, meanwhile, are prohibited from raising capital through crowdfunding. The SEC anticipates that most issuers will be startups or small corporations that are close to the “idea” stage of their business venture but lack the profit potential or business model to attract venture capitalists or angel investors. Thus, crowdfunding investments may rank amongst the riskiest of early-stage investment opportunities.

The most significant limitation applicable to issuers is the amount of capital they may raise through crowdfunding. Under the current proposed regulation, issuers may not raise more than $1,000,000 in any given 12-month period through crowdfunding activities. This limitation, however, is subject to SEC adjustment every five years. The SEC has not yet determined whether the $1,000,000 amount should be a total gross limitation or net of fees charged by funding portals or broker-dealers in connection with the offering.

To qualify for the exemption, all issuers must file a Form “C” with the SEC containing basic disclosures about the entity. Issuers must update their filings on at least an annual basis and provide copies of their disclosures to prospective investors, generally though their intermediary. The information required to be disclosed includes:

• the name, legal status, physical address and website address of the issuer;
• the names of the directors and officers (or anyone performing similar duties) and each person holding more than 20% of the issuer’s shares;
• a description of the business of the issuer and the anticipated business plan of the company;
• a description of the financial condition of the issuer;
• a description of the stated purpose and intended use of the crowdfunding proceeds;
• the target offering amount, deadline to reach the target offering amount and regular updates regarding the progress of the issuer in meeting the target;
• the price to the public of the securities or the method of determining the price; and
• a description of the ownership and capital structure of the issuer. Traditional SEC filings (e.g., Forms S-1, 10-K, 10-Q etc.) are not required. Aside from a “description of the financial condition of the issuer”, conspicuously absent from the required disclosures is the type of detailed financial information usually provided to investors in the traditional investment scenario. Moreover, aside from requiring the disclosures to be written in English, the SEC’s proposed regulations do not designate any particular format for the disclosures. This inevitably will result in a large variance in the reporting formats used by various issuers, which will make it difficult for prospective investors to compare “apples to apples” when evaluating a potential investment. In short, the disclosures provided by crowdfunding issuers will be much less inclusive than those normally provided by public, SEC-reporting companies.⁵

The proposed regulations also limit the advertisement and solicitation of crowdfunding investments.6 Issuers may, however, publish “notices” listing the terms of their offering, provided the notice directs the investor to the issuer’s chosen intermediary (where, presumably, the investor would have access to the issuer’s disclosures). These “notices” may only include: (1) a statement that the issuer is conducting an offering; (2) the name of the issuer’s intermediary; (3) the terms of the offering (e.g., share price and number of shares); and (4) factual information about the legal identity and business location of the issuer.⁷

The SEC declined to set limitations on how the issuer may distribute its notices. Thus, issuers may publish notices on their own websites, on social media sites and in traditional media such as newspapers, magazines and mailers. Given the limitations on advertising, however, investors should exercise caution if a company’s “notice” describes specific products and services or makes statements about the company’s prospective growth.

The Requirement of an Intermediary

All crowdfunding investments must be made through a third-party intermediary–e.g., a FINRA-registered broker-dealer or “funding portal,” which essentially will act as an online storefront for crowdfunding transactions.8 A telltale sign of fraud, therefore, may be where a company or individual solicits or accepts crowdfunding investments directly from an investor without the use of an intermediary. And because all transactions will be required to take place online, investors should be wary of fraudsters who may attempt to solicit crowdfunding investments in person or over the telephone.

Companies will be prohibited from using more than one intermediary at a time to accept crowdfunding investments. The SEC believes this will help foster the “crowd-like” environment which will allow investors to share company information with one another. Allowing issuers to use more than one intermediary also would make it difficult to track whether the issuer has exceeded the $1 million annual offering limitation.

In addition to tracking issuers’ annual offerings, funding portals will be required to comply with a slew of recordkeeping and compliance regulations. They also will have an affirmative obligation to take measures to reduce fraud (e.g., performing background checks on the issuer’s officers and directors) and must have a reasonable basis for believing that an issuer seeking to offer and sell securities under the crowdfunding exemption has, in fact, complied with the requirements of the statute. In exchange, intermediaries generally will be compensated by the issuer, either as a sliding scale percentage of the total offering or on a fixed fee basis. The SEC’s proposed regulations require intermediaries to clearly disclose the manner in which they are compensated in connection with the offering when an investor opens his or her account.

Takeaway Tips for Investors

Crowdfunding will make it very easy for unsophisticated investors to invest in risky startup business ventures over the internet. At the same time, those businesses will be excused from the stringent reporting requirements typically imposed on publicly-traded companies. The potential for fraud by unscrupulous issuers (or even intermediaries) is obvious. As a result, before considering a crowdfunding investment, investors should do their due diligence; learn as much about the startup venture as possible and understand the inherently risky and illiquid nature of the investment they are considering.

The North American Securities Administration Association (NASAA) has urged prospective investors to be extremely cautious about crowdfunding investments.9 According to NASAA, investments in small businesses are among the riskiest investments available, as approximately 50 percent of small businesses fail within the first five years in operation. Moreover, investors may have little to no ability to recover losses from an issuer if they are defrauded or if the investment fails to perform as represented. Finally, crowdfunding investments are extremely illiquid, as the proposed regulations do not allow intermediaries to act as secondary market makers (e.g., allowing person-to-person transfers of crowdfunding investments). Thus, even if the startup venture succeeds, investors may be left holding their investment indefinitely.

Conclusion

Through its proposed regulations, the SEC has attempted to strike a balance between protecting investors and affecting the intent of the JOBS Act by allowing startup companies quicker and easier access to capital. Prospective issuers have criticized the proposed rules as being overly complex, particularly for nascent companies seeking to raise small amounts of capital through crowdfunding. Some state regulators and securities industry groups, meanwhile, claim the rules do not go far enough to protect investors in what may become an area rife with fraud. Only time will tell how the regulations will work once the crowdfunding floodgates open.

Mr. Miller is an associate based in the firm’s San Diego office. His practice focuses on securities arbitrations, business and corporate litigation, employment and contractual disputes, expungement issues and judgment enforcement proceedings.

See H.R. 3606. http://www.gpo.gov/fdsys/pkg/BILLS-112hr3606enr/pdf/BILLS-112hr3606enr.pdf; see also Securities Act of 1933, codified at 15 U.S.C. §77d.

See http://www.sec.gov/rules/proposed/2013/33-9470.pdf.

Both Kickstarter and Indiegogo prohibit the sale or solicitation of securities or any ownership interest in the companies or ideas promoted through their sites. Seehttp://www.kickstarter.com/hello?ref=nav; http://www.indiegogo.com/about/terms. Thus, while investors sometimes are promised rewards in exchange for their contributions (e.g., being the first person to have an opportunity to purchase a new product, or getting the product at a discount, for free etc.), most investors contribute simply because they want to see the product or idea come to fruition.

The SEC’s proposed regulations require prospective issuers to provide different types of financial information depending on the total amount they seek to raise through crowdfunding. Issuers seeking to raise $100,000 or less, for example, need only provide income tax returns for the most recent year along with financial statements certified by the issuer to be true and complete. Issuers seeking to raise more than $500,000 through crowdfunding must provide independently audited financial statements much like traditional public companies.

Section 4(A)(b)(2) of the Securities Act prohibits issuers from advertising the terms of the offering, except through “notices” which direct investors to the funding portal or broker.

See proposed Rule 204(b) of Regulation Crowdfunding. In short, issuers cannot advertise using puffery or catchy descriptions of the issuer’s products or services. Instead, issuers must direct investors to their chosen intermediary, where investors will have access to their SEC disclosures.

All funding portals must be organized under the laws of the U.S. and registered with FINRA. While the SEC has not proposed any licensing requirements for persons associated with a funding portal, FINRA could propose such a requirement in the future.

See http://www.nasaa.org/12842/informed-investor-advisory-crowdfunding/

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