Hailed as the true democratizer of private investment, crowdfunding has been attracting both headlines and a fast-growing pile of cash. In May of 2016, rules from the Securities and Exchange Commission went into effect that will democratize the process even further.
These new rules will open the doors to more investors, but they also pose some significant challenges for entrepreneurs seeking to safely tap this expanded source of financing. That means startups need to do their homework to avoid potential problems that range from complicated filing requirements to future barriers to financing.
The genesis of these rules was the Jumpstart Our Business Startups Act of 2012, which was intended to help smaller companies raise capital. These new rules allow a company to raise debt or equity funding through the Internet and social media without registration, either under the Securities Act of 1933 or under state securities laws. Moreover, they eliminate limitations that other commonly used registration exemptions impose.
One of the most commonly used exemptions from registration is the safe harbor of Regulation D for private placements. When a company raises money using the Regulation D safe harbor, the company is supposed to have a “pre-existing relationship” with the investors it targets. Moreover, under Regulation D Rule 506, a company may sell securities to an unlimited number of very wealthy “accredited” investors, but only to up to 35 less well-heeled “unaccredited” investors.
And if the company sells to any unaccredited investors under Regulation D, it must comply with detailed disclosure requirements. For individuals, one is “accredited” if he or she has a net worth of at least $1 million, or an annual income of at least $200,000, or $300,000 with one’s spouse.
The new crowdfunding rules allow a company to bypass the “pre-existing relationship” and accredited investor limitations. The additional burdens imposed by the new rules, however, make the use of this exemption difficult and fraught with booby traps that can plague a startup for years to come and even in an exit event. These issues include strict rules on:
—Filing Requirements
The new rules require the company to file disclosure documents with the SEC at least 21 days prior to the initial closing of the offering. If there are any material changes after the initial filing, the company has to file an amendment with the SEC. The company must also file regular progress updates and annual reports with the SEC.
Regulation D does not require the filing of disclosure documents with the SEC.
—Intermediaries
The new rules require the company to conduct the offering online through a registered broker-dealer or funding portal. Broker-dealers and funding portals do not offer these services for free. Generally, the fees range from 3 percent to 10 percent of the offering amount. As such, a startup company raising $1 million might end up spending $100,000 on fees or commissions.
Regulation D does not require the use of a broker-dealer or funding portal.
—Limits on Investment Amounts
Under the new rules, a company can only raise a maximum of $1 million in any 12-month period.
Rule 506 of Regulation D has no dollar limitation.
—Limits on Investors
Under the new rules, an investor with an annual income or a net worth of less than $100,000 can annually invest no more than the greater of $2,000 and 5 percent of annual income or net worth, whichever is lower. If the investor has both an annual income and a net worth of at least $100,000, he or she can invest 10 percent of the lesser of his or her annual income or net worth. But in either case, the investment cannot exceed $100,000. There are similar rules for investors that are entities.
These limitations on individual investment mean that a company could end up with dozens or even hundreds of stakeholders, each owning a very small share of the company. This applies whether the issuer is a corporation or a limited liability company. A startup should seriously consider whether it wants such a large stakeholder base given the need to solicit stakeholder consents for a wide range of matters. These include such things as amending the stockholders’ agreement, investor rights agreement and operating agreement, or updating the Certificate of Incorporation to allow for another round of financing. Having a large stakeholder base makes the process more complex and more expensive. Regular stakeholder communications also become more burdensome and expensive as the number of stakeholders grows.
—Ongoing Complications and Exit Issues
Often a company with investors will provide its investors with “pre-emptive” rights, or the right to participate in future rounds of financing to maintain their pro rata ownership in the company. Having a multitude of unaccredited investors can severely restrict a company’s ability to make use of exemptions such as the safe harbor of Rule 506 of Regulation D for future financing rounds. As such, a company using the new crowdfunding rules to conduct its initial financing would be unwise to provide pre-emptive rights to all the investors. And that, in turn, could be a deal-breaker for many potential investors.
Having a stakeholder base full of unaccredited investors can also make exit transactions tricky. Let’s say an acquirer wants to buy the company for stock and cash. The acquirer would have to issue that stock to the stakeholders of the target company under an exemption or registration. If the stakeholders of the target company are largely unaccredited, there may be no available exemption. The acquirer would then need to register the stock to be used for the acquisition, and that process could take months and many thousands of dollars.
While the new crowdfunding rules are intended to ease capital raising for small businesses, it is likely many entrepreneurs will opt to proceed under Rule 506 of Regulation D. In doing so, they will make the initial offering simpler and more streamlined, while avoiding additional expenses and complications throughout the life of their business.