It’s been five months or so since the SEC published its long awaited investment crowdfunding rules. Though Congress dictated that this task be completed by the end of 2012, the SEC missed the mark by nearly three years. Now, with rules in hand, and an anticipated launch date of May 16, 2016, the time is ripe to assess where are we are headed in the brave new world of equity crowdfunding.
Some Preliminary Observations
Given the magnitude of the task handed to the SEC, balancing the need to protect the most vulnerable group of investors in the riskiest area of investment, and the confines presented by Title III of the JOBS Act, the SEC did a pretty good job of listening to commenters and critics alike. Though the proposed rules were in many respects “sinful”, in most areas the Commission seemed to have struck the proper balance between investor protection, critical to establishing and maintaining the integrity of this new marketplace, and the need for the smallest, albeit riskiest, ventures to raise relatively small amounts of capital in a right-sized environment, in terms of both financial cost and complexity.
Audited Financial Statements – Though Congress left it to the SEC to decide if and when audited financial statements would not be required for raises over $500,000, something it was unwilling to do in its proposed rules, the SEC abandoned the requirement for audited financial statements in the final rules for first time crowdfunding companies. Except for the American Institute of Certified Public Accountants, this was a no brainer for most commenters – requiring audited financial startups added little incremental protection to investors and was a cost that most startups could simply not tolerate.
Non-Financial Disclosure – The SEC had very little leeway in dictating the type of non-financial disclosure required by a crowdfunding company – as the JOBS Act had explicit disclosure requirements. However, the SEC in the final rules heeded the call of two lonely commenters (yours truly and the SBA Office of Advocacy), who pleaded with the SEC to provide an alternate, more simplified Question and Answer disclosure format. This was not a novel idea. Indeed, this was one of the top recommendations of participants in the SEC’s 2012 Annual Government-Small Business Forum. Only this time, this “recommendation” was couched in terms of the obligation of the Commission to consider some type of simplified “form” disclosure under a federal statute intended to reduce burdensome requirements on small businesses in the federal rulemaking process – The Regulatory Flexibility Act of 1980. No wonder that this change in the final rules was one of two changes mentioned by Chair White in her opening remarks when the Commission considered and adopted the Title III Final Rules on October 30, 2015.
Compensation of Intermediaries – In the final rules the SEC backed off somewhat from its position in the proposed rules that no intermediary (portal), not even a licensed broker-dealer, could accept equity compensation. Under the final rules an intermediary can accept equity compensation, with two provisos: it must be the same type of equity as is received by the crowd, and the equity can only be given as compensation for the intermediary’s services. This was not a trivial issue. Absent equity compensation, in most instances broker-dealers would look to another form of financing which allowed equity compensation. For a funding portal, whose activities are limited to Title III crowdfunding raises, the inability to receiveequity compensation could be the difference between the portal turning a profit in the long term – or not. And for the crowdfunding company, the ability to pay some of the crowdfunding costs with equity instead of cash would be a useful option. Having said that, by limiting equity compensation to the same type of equity offered to investors, not required by the JOBS Act, this limited the economic value of equity compensation to an intermediary. And for a broker-dealer, this limitation makes Title III crowdfunding less attractive to it than other types of financings which do not contain these limitations – the most prominent being unregistered offerings limited to accredited investors allowed under Title II of the JOBS Act since 2013.
However, in my view it is too soon to be popping the champagne corks on the May 16 launch date. Many of the legislative proscriptions in the JOBS Act will make Title III crowdfunding a non-starter for most startups thirsty for capital. Apart from the relative cost and complexity of raising money through JOBS Act crowdfunding, Congress, in its wisdom, essentially took the crowd out of crowdfunding. How?
Title III crowdfunding is simply not your daughter’s Kickstarter campaign.
You see, under the JOBS Act crowdfunding companies are prohibited from engaging in advertising their offering, except under limited circumstances. Let’s take a closer look.
Of course, an issuer can promote their offering on an SEC and FINRA licensed portal. But not so fast. You cannot even begin your campaign on a licensed portal unless and until you file your offering materials with the SEC and make them available on the portal. So is this a big deal? If tried and true principles of rewards based crowdfunding carry over to equity crowdfunding, which I expect they will, a key metric to a successful Kickstarter campaign is how much traction your campaign generates on the opening days of a campaign. If you cannot generate interest in the offering among friends, family and fans before your campaign officially begin, the odds of a successful campaign plummet. And if you go out and spread the word before your campaign officially commences you will likely find yourself engaged in “general solicitation” of the offering, something that in most cases will invalidate the Title III crowdfunding exemption – a serious matter if the issuer and its principals are not prepared to refund backers’ money down the road (what the SEC calls an investor’s right of rescission).
Well, at least you can widely promote your company and its products, without mentioning its securities, before the commencement of the equity crowdfunding campaign. Right? Not necessarily. You see, according to the SEC (and buried in the SEC’s 685 page final rules release) is a cautionary statement. If you go out and start promoting your company and its products right before you start your Title III campaign, you may have already blown the Regulation Crowdfunding exemption before you even start – by engaging in general solicitation (advertising). If this sounds complicated – well, it is.
So How About Equity Crowdfunding under my State’s Law?
If you want to advertise your state crowdfunding raise under a crowdfunding exemption in your home state – now a possibility in a majority of states – think again. Most states which have enacted local crowdfunding legislation did so under a federal exemption, the intrastate offering exemption. A key requirement of the federal exemption, which states must follow, is the requirement that no offers or sales of securities be made to residents outside the state. And according to the Staff at the SEC, in two published rulings back in 2014 (and much to my chagrin), an issuer cannot use the Internet or other means of general solicitation or advertising in an intrastate offering. Period. Full Stop.
The bottom line? Most equity crowdfunding raises cannot effectively use the Internet or social media to promote their equity crowdfunding raise. Imagine: crowdfunding, Si – But Internet solicitation – well . . .
So unless you wanted to get busted by a regulator for “solicitation”, or be at risk of having to refund your investors’ money, you may want to carefully review your other fundraising options before diving into a Title III campaign, or even a local equity campaign. And yes, there are many good options, courtesy of the JOBS Act.
Title II crowdfunding is one option which has no restrictions on solicitation, but all of your investors must be “accredited” – as in rich. And then there is Title IV of the JOBS Act, dubbed Regulation A+. Again, you can solicit to your heart’s content, even before you make any expensive filings with the SEC. But Regulation A+ will not be a good fit for most startups, simply because in most cases it requires a company to provide a detailed disclosure document with audited financials, all of which must be reviewed and approved by the SEC before a company can begin accepting investor money – not to mention the ongoing public reports which a Regulation A+ must file with the SEC at least twice each year.
And if all else fails, there is the tried, true and relatively unregulated rewards based crowdfunding world. But, unfortunately, no profits can be left on the table for your loyal backers – something that the Oculus backers learned the hard way not too long ago – sold for a cool $2 Billion after running a successful rewards based campaign.
So What is the Solution to this Conundrum for Startups Who Need (and Deserve) Better Options?
Solutions are in the works in our Nation’s Capitol, both at the SEC and in Congress – much of which is behind closed doors. For a peak at what is hopefully around the corner for equity crowdfunders looking to raise money from the great unwashed masses – with a piece of the company thrown in – stay tuned for my next article; Part II – coming to you, of course, on Crowdfund Insider.
Author’s Note: For two other articles I wrote on this subject, addressing the risks of engaging in “off portal” publicity activities, and legislative solutions in the works, see http://corporatesecuritieslawyerblog.com/?p=707 and http://www.crowdfundinsider.com/2016/04/84175-busted-for-crowdfunding-its-rehab-time-on-capitol-hill-this-week/
Samuel S. Guzik, a Senior Contributor to Crowdfund Insider, is a corporate and securities attorney and business advisor with the law firm of Guzik & Associates, with more than 30 years of experience in private practice. Guzik is also former President and Board Chair of the Crowdfunding Professional Association (CFPA). A nationally recognized authority on the JOBS Act, including Regulation D private placements, investment crowdfunding and Regulation A+, he is and an advisor to legislators, researchers and private businesses, including crowdfunding issuers, service providers and platforms, on matters relating to the JOBS Act. As an advocate for small and medium sized business he has engaged with major stakeholders in the ongoing post-JOBS Act reform, including legislators, industry advocates and federal and state securities regulators. In 2014, some of his speaking engagements have included leading a Crowdfunding Roundtable in Washington, DC sponsored by the U.S. Small Business Administration Office of Advocacy, a panelist at the MIT Sloan School of Business 2014 Crowdfunding Roundtable, and a panelist at a national bar association event which included private practitioners, investor advocates and officials of NASAA. His articles on JOBS Act issues, including two published in the Harvard Law School Forum on Corporate Governance and Financial Regulation, have also served as a basis for post-JOBS Act proposed legislation.