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Crowdfunding Signals a New Era in Equity Investment

Closely held companies have new opportunities to solicit investment from the general public, and individuals are finding it easier to pick companies in which they would like to invest.

Matt Winter  

Matt Winter

 

When President Obama signed into law the "JOBS Act" in April 2012, his signature set in motion an easing of regulatory restrictions on small businesses that need to attract investment capital. Almost two years later, rules are nearly in place that will finally free the new law to fulfill its intended purpose.

For business owners, the most interesting features of the JOBS Act included approval of (a) “crowdfunding” and (b) public marketing of Rule 506 (accredited investor) offerings. Predictably, much of the publicity has focused on crowdfunding, which is also the focus of this article. Crowdfunding is an increasingly popular vehicle for raising capital that has been used outside of the securities arena to raise funds through the Internet for projects ranging from innovative product ideas to the production of movies and music.

The crowdfunding provisions of the JOBS Act are intended to (a) let business startups solicit investment from the general public, something that until now has been prohibited, and (b) make it easier for individuals to identify growing companies in which they might wish to invest.

General Solicitation

For the past 80 years, startups and growing companies that wanted to raise money could not publicly advertise that they were seeking investment unless they first registered the securities offering with the SEC. For many of them, that restriction is going away.

The new rule allows private companies to publicly advertise that they are seeking investment, known as "general solicitation." The rule aims to make it easier for smaller companies to access new investors and raise capital — the biggest challenge facing many companies.

On July 10, 2013, the SEC approved the lifting of the general solicitation ban in traditional, non-registered (exempt) offerings, paving the way for the adoption of Title II. In December 2013, the Securities and Exchange Commission (SEC) announced that more than 300 companies had submitted filings and raised about $2.2 billion in capital via general solicitation.

As encouraging as that report was, the greater impact of the new law has been delayed while the SEC gathered public comment on proposed rules for Title III, which allows unaccredited investors to enter the market and to participate in crowdfunding. The 90-day comment period for the proposed rules ended February 3, after which crowdfunding activity is expected to accelerate.

Exemption Requirements and Crowdfunding

Under the Act, the offer and sale of securities through crowdfunding is generally exempt from SEC registration if it meets these basic requirements:

First, the issuer may not be a public company, investment company or foreign private issuer.

Also, there is a $1 million limit on the aggregate amount sold to all investors under the crowdfunding exemption in any 12-month period.

Third, the intermediary and issuer both must comply with SEC disclosure and reporting requirements.

Finally, the transaction must be conducted through a broker or a funding portal.

A “funding portal” acts as a crowdfunding intermediary and does not (a) offer investment advice, (b) solicit purchases of the securities displayed on its website or pay others to do that, or (c) handle investor funds or securities. After FINRA issues its rules that regulate funding portals, fully functioning portals will symbolize the power of new technologies and the Internet to automate processes such as submission of advertising and offerings and, consequently, reduce the costs of those activities.

Under the proposed rules, Title III of the JOBS Act will essentially create a new investor class by allowing non-accredited investors to participate in crowdfunding. In short, business investment will no longer be a game played only by the wealthy. Seeking to protect unsophisticated investors from plunging too deeply into their new opportunities, the SEC has imposed limits on individual investing:

  • An investor who has an annual income or net worth of less than $100,000 can invest (in a 12-month period) no more than the greater of (a) $2,000 or (b) 5% of his or her annual income or net worth.

  • An investor who has an annual income or net worth of $100,000 or more can invest (in a 12-month period) up to 10% of his or her annual income or net worth, with a cap of $100,000.

Taking Advantage of the JOBS Act

If the JOBS Act’s loosening of the reins for companies seeking investment capital could enhance the growth of your company, you should consider how to prepare to seize the new opportunities.

  • Beef up your management team and professional advisors, and highlight industry expertise and success stories that will impress potential investors.

  • Create and attractively package a business plan that will impress would-be investors. Investors are buying ownership of a piece of your business, and they will want to know that you have a plan in place to make the business work, make a profit, provide a return on investment and do it in a way that looks better than the other companies they are considering.

  • Get your financial house in order. If you are trying to raise under $100,000, you will need your company’s most recent income tax return and financial statements certified by your principal executive officer. If you are trying to raise between $100,000 and $500,000, you will need to have your company financials reviewed by a CPA. If you are shooting for between $500,000 and $1,000,000, that will require an audit by a CPA.

  • Clean up any messy, unprofessional, incorrect or incomplete company documents, such as operating agreements, by-laws, buy-sell agreements, etc. (Providing incorrect information or failing to disclose important information can lead to severe civil and even criminal repercussions.)

  • Protect your intellectual property. Before you go public with crowdfunding, you need to be sure your ideas, inventions and other intellectual property are all protected. Patents, trademarks and copyrights of your products, processes, names, logos, etc. need to be in place.

  • Get familiar with SEC Form C (not yet in final form) and start gathering everything you need to complete it.

  • Develop an online communication and marketing plan. When you launch your equity crowdfunding campaign, you will need to spread the word far and wide to be successful, perhaps meaning that, for the first time, you need to take seriously the world of social media (i.e., Facebook, Twitter, LinkedIn, Google Plus, etc.). That applies to your company, to you personally, and to all of your key people.

  • Recognize that raising money requires money. Showing some degree of initial capitalization, including cash on hand, sends a good message to potential investors. Also, you will need to be able to afford the costs of a crowdfunding campaign, such as broker-dealer or portal fees, due diligence expenses, legal and accounting fees, etc.

Not for Everyone

Keep in mind that the new opportunities for attracting investment capital are not for every business or business owner. Suddenly having a slew of fellow shareholders whom you probably do not know places new demands on “transparency” in your management style and sharing of information. Many entrepreneurs are not used to having people look over their shoulders and second-guessing their decisions, and that intrusion might outweigh the benefits of attracting new money to your company.

Also, be alert to the pitfalls of entering, perhaps for the first time, a regulatory environment. The federal government is not the only player; most states (including Arizona) have their own securities laws intended to protect their residents. The JOBS Act itself requires a lot of disclosures; the SEC incorporates them and complicates matters by adding even more disclosure requirements. You will have to give all of this information to the funding portal and to investors in some manner.

On a related note, taking on investors can raise your legal exposure to new heights. For example, the Act’s definition of "issuer" includes any person who offers or sells a security in a crowdfunding transaction; that definition could pose a significant expansion of personal liability for directors and officers if things go sour for a crowdfunded company.

Conclusion

In weighing the pros and cons of the JOBS Act and conducting your independent research into the opportunities it provides, include your legal, financial and tax advisors. With crowdfunding and the easing of general solicitation restraints still in their infancy, don't try to sort through the often confusing (and conflicting) information and sales pitches alone. Look to your professional team for input as you make perhaps one of the most important business decisions of your career.

Finally, you should be aware that some commentators have attributed the delay by the SEC in adopting the new rules regarding general solicitation and crowdfunding as an indication that the SEC was not in favor of these changes, and you should expect that the SEC will strictly scrutinize the use of general solicitation and crowdfunding and stringently enforce the new rules.