Crowdfunding has become a popular way of raising financing. It generally involves using the internet to ask a large number of people to each contribute a small amount of money to support a cause or a project. In some cases, people give money as a donation because they believe in the particular cause or project. In other cases, people are offered a reward, such as a t-shirt, tickets to an event, acknowledgement on an album cover, and the like, in return for their contribution.
Until recently, legal restrictions have prohibited equity crowdfunding, in which people could receive equity interests such as shares of stock in a corporation or a partnership interest in a business venture, in return for their contribution or investment. However, the Jumpstarting Our Business Startup Act (JOBS Act), signed into law in April, 2012, removed some of the legal restrictions which previously made equity crowdfunding illegal. This new law has the potential to transform the way in which start-up ventures, real estate syndicators, and established business enterprises raise money because it permits them to use the internet, social media and other forms of general solicitation and general advertisement to find potential investors.
General Crowdfunding
By creating an exemption from the registration provisions of the federal securities laws, Title III of the JOBS Act authorized the creation of a procedure through which startups and small businesses will be able to raise capital through securities offerings on the internet. This portion of the JOBS Act is still in the implementation stage and is not currently available for use. But, when it does become available, it will authorize equity offerings which meet certain requirements, including, but not limited to, the following:
- The amount raised may not exceed $1 million in a 12-month period;
- The amount an individual investor may invest in any 12-month period will be limited based on that persons income or net worth. For an individual with annual income or net worth of more than $100,000, the maximum investment amount will be 10% of income or net worth up to a maximum amount of $100,000. For investors with income and net worth below $100,000, the maximum investment per year will be the greater of $5,000 or 5% of income or net worth;
- The offering must be made through an intermediary which is either a securities dealer or a new; and
- The issuer will be required to provide potential investors with certain specified business and financial disclosures prior to their investment and with certain ongoing reports.
Rule 506(c) Offerings (Accredited Investor Crowdfunding)
A general principal of securities law is that any offering of securities to investors must be registered with federal and/or state securities regulators, unless an exemption from registration is available. Because registration is an expensive and time consuming process, it is often not a viable option. As a result, the majority of all securities offerings are made in reliance upon an available exemption from registration, the most common of which is a private offering or private placement exemption from registration.
A basic requirement of qualification for a private placement exemption has always been a prohibition on general advertising and general solicitation. Without the ability to advertise and to freely solicit potential investors, the pool of potential investors for a private placement offering has essentially been limited to family, friends and persons with whom the issuer, or someone acting on its behalf, had a substantive pre-existing relationship. This has sometimes made it difficult for newly formed issuers or those without an established network of potential investors to successfully raise money through a private offering.
One of the provisions of the JOBS Act (referred to as Rule 506(c)), eliminates the prohibition on general advertising and general solicitation for private placement offerings in which all investors qualify as “accredited investors” under Securities and Exchange Commission Rules. Although this portion of the JOBS Act is not technically referred to as crowdfunding, it does essentially create a special type of crowdfunding which is limited to accredited investors. Offerings made in reliance on Rule 506(c) will still be considered to be private offerings, but they will no longer need to be limited to family, friends and persons with whom the issuer has a pre-existing relationship. Instead, they will now be able to be made to a large group of potential investors through the internet, social media, or other types of public advertisement, and will still qualify for the private placement exemption from registration.
Accredited Investor Qualification. Individuals qualify as accredited investors if they have (i) a personal net worth, or a joint net worth with their spouse, of $1,000,000 exclusive of the net equity in their personal residence, or (ii) an individual annual income in excess of $200,000 for each of the past two years, or a joint annual income with their spouse in excess of $300,000 in each of those years as well as a reasonable expectation of an income in excess of those levels for the current year. Issuers making offerings in reliance on Rule 506(c) will be required to take reasonable steps to verify that all investors qualify as accredited investors, and will not be permitted to rely upon representations of eligibility made by such investors.
Benefits of Rule 506(c) Offering. There are many potential advantages which may cause Rule 506(c) offerings to become the most popular method of raising capital for small and midsize companies and for real estate syndicators without an existing track record and an established pool of potential investors. These potential benefits include:
- No restrictions on general solicitation and advertisement. Historically, one of the most significant disadvantages of raising capital through a private offering was difficulty in finding investors. Such offerings were limited to persons with which the issuer or its intermediaries (such as broker dealers or placement agents engaged by the issuer) had a substantive pre-existing relationship. Under 506(c), issuers may now use all types of general solicitation and advertisement to attract investors including radio, television and newspaper advertisements as well as internet and social media solicitations.
- No SEC review of offering documents. Unlike a public offering, there is no requirement for the offering documents to be reviewed and approved by the SEC or by state regulators. As a result, such offerings may be commenced much more quickly and inexpensively than a registered or public offering.
- No limit on the amount of money to be raised. There is no dollar limit on the amount of money which may be raised.
- No limit on number of offerees or purchasers. There is no limit on the number of potential investors to whom an offer to purchase securities may be made and, although all investors must be accredited investors, there is no limit on the total number of purchasers.
- No state regulation of offering. Federal law preempts state regulation of offerings made in reliance on Rule 506(c). As a result, although states may require the filing of a notice of sale and may charge a filing fee, they do not otherwise have the authority to review and approve offering documents or to impose restrictions or limitations on the offering terms.
- Limitation of Liability. A US Supreme Court decision has held that federal law claims for negligent misrepresentation (lack of due care or due diligence) do not apply to private sales such as 506(c) offerings. As a result, there are limitations on the ability of investors to make future claims against the issuer which are based on assertions that there were there unintentional errors or omissions in private offering documents.
- The Issuer does not become a public company. Although securities sold in a public offering are generally more attractive to prospective investors because they may be resold freely, there are also disadvantages to sale of securities in a public offering. The registration process is expensive and time consuming, following completion of the offering there are significant costs associated with SEC periodic report filing requirements, and there are significant corporate governance and compliance considerations applicable to public companies. Raising capital through a 506(c) offering instead of a public offering, allows an issuer to avoid, or at least postpone, dealing with the cost and compliance issues applicable to public companies.
