What is Crowdfunding?
Crowdfunding is a term used to describe an evolving method of raising money through the internet. For several years, this funding method has been used to generate financial support for such things as artistic endeavors like films and music recordings, typically through small individual contributors from a large number of people.
While crowdfunding can be used to raise funds for many things, it generally has not been used as a means to offer and sell securities. The reason is due to the fact that offering a share of financial returns and/or profits from business activities can initiate the application of federal securities laws, and an offer or sale of securities must be registered with the Securities and Exchange Commission (SEC) unless an exemption is available.
The Jumpstart Our Business Startups Act (or “JOBS” Act) created by Congress in 2012 created an exemption to permit securities-based crowdfunding. Among other things, the JOBS Act was intended to help alleviate the funding gap and accompanying regulatory concerns faced by startups and small businesses in connection with raising capital in relatively low dollar amounts.
Title III of the JOBS Act established the foundation for a regulatory structure that would permit small businesses to use crowdfunding, and it directed the SEC to write rules implementing the exemption. It is important to note that Title III of the JOBS Act is still pending (which means it has not yet been passed into law). Title III also created a new entity – A Funding Portal – to allow internet-based platforms or intermediaries to facilitate the offer and sale of securities without having to register with the SEC as brokers. Together, these measures were intended to facilitate the raising of capital by small and start-up businesses while providing significant investor protection.
Proposed Rules of Title III (Crowdfunding)
Title III of the JOBS Act contains proposed rules that would, among other things, permit individuals to invest subject to certain thresholds, limit the amount of money a company can raise, require companies to disclose certain information about their offers, and create a regulatory framework for the intermediaries that would facilitate crowdfunding transactions.
The proposed rules of Title III include the following:
- A company would be able to raise a maximum aggregate amount of $1 million through crowdfunding offerings in a 12-month period.
- Investors, over the course of a 12-month period, would be able to invest up to: (a) $2,000 or 5% of their annual income or net worth, whichever is greater, if both their annual income and net worth are less than $100,000 or (b) 10% of their annual income or net worth, whichever is greater, if either their annual income or net worth is equal to or greater than $100,000.
Disclosure by Companies Seeking Capital through Crowdfunding:
Consistent with Title III of the JOBS Act, the proposed rules would require companies conducting a crowdfunding offering to file certain information with the SEC, provide it to investors and the relevant intermediary facilitating the crowdfunding offering, and make it available to potential investors.
In its offering documents, the company would be required to disclose the following information:
- Information about officers and directors as well as owners of 20% or more of the company
- A description of the company’s business and the use of proceeds from the offering
- The price to the public of the securities being offered, the target amount, the deadline to reach the target offering amount, and whether the company will accept investments in excess of the target offering amount
- Certain related-party transactions
- A description of the financial condition of the company
- Financial statements of the company that, depending on the amount offered and sold during a 12-month period, would have to be accompanied by a copy of the company’s tax returns or reviewed or audited by an independent public accountant/auditor
Companies relying on the crowdfunding exemption to offer and sell securities would be required to file an annual report with the SEC and provide it to investors.
One of the key investor protections Title III of the JOBS Act provides is the requirement that crowdfunding transactions take place through an SEC-registered intermediary, either a broker-dealer or a funding portal. Under the proposed rules, the offerings would be conducted exlusively online through a platform operated by a registered broker or a funding portal, which is a new type of SEC registrant (referring to funding portals; broker-dealers are already registered with the SEC).
The proposed rules would require these intermediaries to:
- Provide investors with educational materials
- Take measures to reduce the risk of fraud
- Make available information about the issuer and the offering
- Provide communication channels to permit discussions about offerings on the platform
- Facilitate the offer and sale of crowdfunded securities
The proposed rules would prohibit funding portals from:
- Offering investment advice or making recommendations
- Soliciting purchases, sales or offers to buy securities offered or displayed on its website
- Holding, possessing, or handling investor funds or securities
What’s Next for Crowdfunding?
The SEC will seek public comment on the proposed rules for 90 days, then review the comments and determine whether to adopt the proposed rules.