UPDATE ON THE STATE OF EQUITY CROWDFUNDING
We’re often asked by clients about “crowdfunding” and whether there is a way to raise capital via crowdfunding. Below is a summary of the current state of equity crowdfunding.
What is “crowdfunding”?
The term “crowdfunding” is used in many contexts and has many meanings depending on the source. For example, many companies have raised money through crowdfunding sites like Kickstarter and Indiegogo. This type of crowdfunding has been described as “cash for love” and the contributor typically receives something tangible in return for the donation. Earlier this year Pebble raised $20.3 million from 78,471 backers for its new smart watch and in 2014 the Coolest Cooler raised a total of $13.2 million from 62,642 backers for its high tech cooler.[ii] No equity or securities are issued to backers in this type of crowdfunding and such campaigns are generally not subject to federal and state securities laws.
However, companies that raise money from investors in exchange for equity, securities or debt are subject to federal and state securities laws. Historically these laws have prohibited the type of activities that constitute equity crowdfunding.
Didn’t Congress pass a crowdfunding law permitting equity crowdfunding?
To permit equity crowdfunding, Congress passed the CROWDFUND Act back in April, 2012.[iii] The Act was designed to enable start-up companies to raise capital in small amounts from numerous investors through an online platform.
The Act wasn’t effective immediately and directed the SEC to adopt regulations implementing the Act within 270 days. In October 2013, the SEC finally adopted proposed regulations implementing the Act – 15 months after the Act was passed by Congress. However, despite significant publicity and comments, the proposed regulations have never been modified or finalized. Therefore, more than three years after Congress passed the CROWDFUND Act, the federal equity crowdfunding rules still cannot be utilized to raise capital.
What about state laws permitting crowdfunding?
Many states have enacted crowdfunding rules similar to the federal CROWDFUND Act. For example, Virginia’s Intrastate Crowdfunding Exemption – which was authorized in 2015 - permits Virginia companies to raise up to $1 million in equity funding from investors each year (or $2 million if the company has audited financial statements).[iv] Investors cannot invest more than $10,000 in the offering unless the investor is “accredited.” Companies must satisfy many other conditions and must complete and file a “notice filing” called Form ICE with the Virginia State Corporation Commission. The “notice filing” is 13 pages long and requires a significant amount of factual disclosure.
The biggest disadvantage to state crowdfunding exemptions – including Virginia’s – is that the offering must occur entirely within Virginia to satisfy the federal intrastate offering exemption. This means that the company must limit its offers and sales to individuals who have their principal residence in Virginia. Because crowdfunding works best via an online platform where a company can reach investors anywhere in the US, such a limitation destroys the most important benefit of crowdfunding. Accordingly, we believe that few companies will utilize state crowdfunding exemptions.
What other options are available?
Until the SEC finalizes the federal crowdfunding regulations, we continue to believe that most companies seeking equity capital will be best service by utilizing the exemption provided by Rule 506 of Regulation D. Under this rule, companies can raise funds from an unlimited number of accredited investors and up to 35 non-accredited investors. This rule also provides an important exemption from state securities registration requirements.
Under Rule 506(b), which has been used for decades, companies may not use advertising or general solicitation to seek investors. This means that an unrestricted website open to the public cannot be used to solicit investors. Recently, however, the SEC recognized an exception to this rule for online platforms that prequalify potential investors and limit offers and sales to investors who meet the accredited investor requirements and other suitability requirements.[v] This exception could provide opportunities to companies who desire to seek investors online but who don’t wish to comply with the verification requirements described below.
If a company is willing to restrict all of its sales to accredited investors and is willing to comply with the requirements of new Rule 506(c) regarding the verification of each investor’s status as an accredited investor, the company can utilize advertising and general solicitation – including unrestricted, open offerings online.[vi] Responding to this change, a number of online platforms have sprung up to assist companies in raising capital online (again, as long as all investors are accredited). More information regarding the Rule 506(c) requirements can be found in our article describing Rule 506(c).
In summary, crowdfunding has evolved over the past five years and we expect continued change for years to come – especially when the SEC finalizes the equity crowdfunding regulations. Please contact us if you are considering an equity offering for your company.
[iii] See www.gpo.gov/fdsys/pkg/BILLS-112hr3606enr/pdf/BILLS-112hr3606enr.pdf. As is customary, Congress came up with a tortured acronym for the Act: “Capital Raising Online While Deterring Fraud and Unethical Non-Disclosure Act of 2012.”
[v] See CitizenVC No Action Letter, August 2015, https://www.sec.gov/divisions/corpfin/cf-noaction/2015/citizen-vc-inc-080615-502.htm
[vi] Of course, companies must be careful when advertising or publishing content online regarding offerings under Rule 506(c) to ensure that the content contains no misstatements, omissions or other information that could lead to a claim under the anti-fraud provisions of federal and state securities laws. Companies that utilize a broker-dealer must also comply with applicable FINRA advertising guidelines.