A Quick Primer on Title III Equity Crowdfunding: Starting-Up as a VC (Part 1 of 3)
In the same way technology empowered anyone to become an entrepreneur, so too will it enable anyone to step into the shoes of a venture capitalist. April 5 marked the 4th anniversary of the JOBS Act’s signing by President Obama, but the final rules which implement Title III, which pertains to equity crowdfunding, went into effect on May 16, 2016.
While the creation of a more legitimate crowdfunding industry can be seen as a major step in the democratization of capital markets, it’s not as if the barriers to entry are being completely leveled—entrepreneurs and investors alike will still have to be conscientious of the investment restrictions, disclosure requirements, and other limitations before determining whether equity crowdfunding is suited to finance their ventures.
In this first part of this three-part series, we clarify some terminology for those completely new to the concept of equity crowdfunding and give a quick overview of the regulations themselves. In Parts 2 and 3, we’ll help you use some of this information to determine whether crowdfunding is right for your business and some things to think about when you raise your first round.
If you’re confused by the foregoing because you’ve been funding new ventures through Kickstarter for years, don’t feel bad; people often speak of “crowdfunding” generally without distinguishing between equity crowdfunding and other types.
Crowdfunding simply refers to the practice of funding a project through a large number of donors. In the past, people have initiated crowdfunding campaigns through platforms like IndieGoGo and Kickstarter in which donors typically receive certain perks or rewards for early presales or donations.
Equity crowdfunding involves the offering of equity securities to investors online. Investors purchase an actual ownership stake in the business entity with an intent to share in its financial returns and profits. It’s a close cousin of debt crowdfunding or peer-to-peer lending, which involves the offering of debt securities to groups of lenders online. Debt crowdfunding sites like Lending Club and Upstart have already taken off.
In the U.S., the sale of securities implicates federal securities laws, as well as state “blue sky” laws. Issuers must either register their securities with the SEC or find an exemption (…or, face serious penalties). Until recently, startups nearly always structured early stage offerings to fall under Reg D, a set of three rules—504, 505, and 506—which carve out exemptions to the registration requirements of the Securities Act of 1933, which we described in great detail in an earlier post. Because Reg D fails to provide startups a way to reach larger pools of investors, the SEC created another avenue by amending Regulation A (now referred to as Reg A+), as described in our prior post. Reg A+ allows companies to file a single, less costly registration with the SEC as opposed to one under each state’s blue sky laws, but given the need for audited financials (and a track record of legal, audit, and underwriting fees sometimes exceeding $1M), Reg A+ is not always suited to early/seed stage companies.
Enter Regulation CF
To fill the vacuum of ways for startups to raise seed capital from a large number of investors, Title III added Section 4(a)(6) to the Securities Act to create an exemption from registration for certain crowdfunding transactions.
Section 4(a)(6) sets a hard cap of $1M per 12-month period for any entity raising funds. This may seem low, considering that the median convertible note round last year was $1M, on the rise from years prior. However, it’s possible that the sort of crowdfunding enabled by Reg CF will itself change the way startups raise money by eliminating the need to pull together a syndicate of interested accredited investors and gather funding in a single transaction.
The SEC doesn’t want you to get carried away as you start channeling your inner Mark Cuban. If you make less than $100,000, you can invest the greater of $2,000 or 5 percent of your annual income or net worth in a 12-month period. If you make over $100,000, you can invest up to 10% of your annual income or net worth (but in no cases greater than a total of $100,000) per 12-month period. Transactions must be done through an intermediary registered as a broker-dealer or a funding portal.
Entrepreneurs Who Can Stop Reading Now
Some companies aren’t eligible to use the Reg CF exemptions. These include:
- Non-U.S. companies
- Exchange Act reporting companies
- Certain investment companies
- Companies that are disqualified under Reg CF’s disqualification events (which include the conviction of crimes, court orders against engaging in the sale of securities, and other regulatory actions against the issuer)
- Companies that have failed to comply with the annual reporting requirements under Reg CF during the two years immediately preceding the filing of the offering statement, and
- Companies that have no specific business plan or have indicated their business plan is to engage in a merger or acquisition with an unidentified company or companies.
Securities purchased in a crowdfunding transaction generally cannot be resold for a period of one year. Investors should consider themselves in it for the long haul.
How will investors know what they’re investing in? Issuers are going to have to disclose in their offering documents information that includes:
- Information about officers, directors, and owners of 20 percent or more of the issuer
- A description of the issuer’s business and the use of proceeds from the offering
- The price to the public of the securities or the method for determining the price
- The target offering amount
- The deadline to reach the target offering amount
- Whether the issuer will accept investments in excess of the target offering amount
- Certain related-party transactions
- A discussion of the issuer’s financial condition
- Financial statements of the issuer that are accompanied by information from the issuer’s tax returns, reviewed by an independent public accountant, or audited by an independent auditor.
An issuer relying on these rules for the first time would be permitted to provide reviewed rather than audited financial statements, unless they’ve already had their financial statements audited. Issuers are also required to file an annual report with the SEC and provide it to investors.
Check out Part 2 of our series here.