Originally published on WilmerHale by Glenn Luinenburg and Shahzia Rahman.
When Congress adopted the Jumpstart Our Business Starupts Act (JOBS Act) in January 2012, many budding entrepreneurs rejoiced at the prospect of easier and quicker access to capital to turn their ideas into money-making ventures.
These entrepreneurs envisioned joining their tech-savvy competitors and colleagues in the new world of “crowdfunding,” where startups vie for average investors’ dollars through website offerings unencumbered by the strict rules and regulations that govern other types of financings.
In an economic environment in which traditional paths to capital for entrepreneurs, such as small business loans, can be difficult to access, crowdfunding offers what look like an attractive funding alternative.
Despite its theoretical promise, when Congress adopted the JOBS Act, it let many of the details on the mechanics of crowdfunding to the Securities and Exchange Commission to determine—and the SEC has not yet completed its rulemkaing. Companies will not be able to rely on the JOBS Act exemption for crowdfunding until this rulemaking is completed. ) Although Congress initially set a deadline of Dec. 31, 2012, for the SEC’s rulemaking, as of the date of this article we have yet to see the final rules.)
Below is an overview of what we currently know about the JOBS Act’s crowdfunding rules:
The amount of money a qualified private company issuer can raise through crowdfunding in a 12-month period is limited to $1 million. This amount will likely be sufficient for many local businesses. However, emerging technology companies that would otherwise seek angel investor or venture capital funding frequently have needs that exceed this cap.
Investments must be made through “intermediaries.” Investments cannot be made directly between a company and an investor. (In fact, companies are prohibited from advertising the terms of an offering directly.) Instead, Congress requires investments to be made through an intermediary. In order to qualify as a crowdfunding intermediary, the intermediary must register with the SEC as either a broker or a “funding portal.” A “funding portal” is exempt from registration as a broker or dealer but is still subject to SEC authority. Intermediaries cannot offer investment advice or recommendations and are prohibited from soliciting purchased, sales or offers to buy the crowdfunded securities offered or displayed on their websites.
The amount of money a company can receive from any individual investor is also limited. Investors with a net worth of less than $100,000 can only invest the greater of (i) $2,000 or (ii) 5 percent of their annual income or net worth. Investors with an annual income or net worth exceeding $100,000 may invest 10 percent of their annual income or net worth, up to $100,000. Annual income and net worth will be calculated in the same manner for accredited investors under Regulation D, but the exemption will make the intermediary responsible for policing whether potential investors are adhering to these limitations in the context of a particular offering.
Companies must provide investors with information both before and after their investment. One issue that will broadly impact the feasibility and effectiveness of crowdfunding is what kind of information a company needs to provide to investors, both before and after the investment.
The JOBS Act currently requires companies to provide basic information, such as the name and address of the company, a description of the company’s business and anticipated business plan and the names of directors and officers and 20 percent or greater shareholders. In addition, companies must provide more detailed information, such as the intended use of proceeds, the risks associated with the investment, the price to the public of the crowdfunded securities (including the method of determining this price) and certain financial information.
The amount of financial information that must be provided varies depending on the size of the offering. Smaller offerings only require a description of the company’s financial condition, whereas offerings of more than $500,000 require audited financial statements. The expense and effort involved in providing audited financial statements will likely deter some companies from seeking funding under these rules.
In addition, once the investment is made, the JOBS Act would require companies to make annual filings with the SEC and provide reports to investors on their results of operations. The details of these reporting requirements have yet to be determined by the SEC.
Securities issued pursuant to the crowdfunding exemption are “covered securities” and will not be counted for shareholders limitations. Similar to Rule 506 offerings, crowdfunded securities will be “covered securities” exempt from state registration requirements (but not from enforcement of state anti-fraud laws).
In addition, the original holders of crowdfunded securities will not be counted toward the shareholder limits under Section 12(g) of the Securities Exchange Act, which can cause issuers to become reporting companies. As an example of the potential effects of SEC rulemaking, however, whether that exclusion will apply to subsequent holders (i.e. transferences) of crowdfunded securities is not yet clear.
Liability for “issuers” making an untrue statement of material fact or failing to state a material fact. Any person who purchases a crowdfunded security under the exemption may bring an action against an “issuer,” which is defined to include the issuing company and its directors, partners and principal executive, financial and accounting officer(s). Defining “issuer” in this way appears to be a significant expansion of personal liability to directors and officers, and it remains to be seen whether the uncertain scope of personal liability will inhibit fundraising under the new exemption.
With limited exceptions, securities purchased under the crowdfunding exemption will not be transferable for one year. Crowdfunded securities will not be transferred for one year unless the transfer is to the issuer, an accredited investor, as part of a registered offering, or to a member of the purchaser’s family.
In addition to the requirements above, entrepreneurs should be thoughtful about the ways in which crowdfunding can affect their prospects for future financings. A number of venture capital firms have expressed concerns about investing in startup companies that have a large number of unsophisticated early-stage equity investors. Managing a broad base of investors and a large capitalization table can be time consuming and complicated. The more investors in a company, the more burdensome it can be to provide information required by the SEC rules and the greater the chances that entrepreneurs will face a higher volume of inbound communication from shareholders. In addition, a dispersed investor base can make getting the votes required to approve certain corporate actions harder to obtain.
Whether crowdfunding can provide a viable alternative to more traditional venture capital and angel investment venture capital and angel investment financing routes remains to be seen. Crowdfunding proponents remain optimistic that the proposed rules will facilitate a responsible emerging industry that will provide entrepreneurs with the capital they need to turn their ideas into reality.
Glenn Luinenburg is a partner in WilmerHale’s Palo Alto office who has completed transactions for companies at all stages of development, from IPOs and acquisitions involving multibillion-dollar global enterprises to work for entrepreneurial technology startups and venture capital firms. He can be reached at (650)858-6075 or firstname.lastname@example.org
Shalzia Rahman is a senior associate in WilmerHale’s Palo Alto office and represents a number of public and private company clients on an on-going basis and in a variety of transactions, including mergers and acquisitions and IPSs. She focuses her practice on emerging growth companies and cross-border transactions and is a member of the firm’s Emerging Company, Life Sciences and International Transactions Groups. She can be reached at (650)858-6122 or email@example.com