Over the past four years, since the enactment of the JOBS Act in April 2012, entrepreneurs and investors, particularly in the startup community, have been abuzz about crowdfunding, the process by which a company raises a large amount of money by selling securities in small amounts to a large number of investors. After the runaway success of non-equity crowdfunding, where products and services are exchanged for cash, it is understandable why many have placed great hope in the promise of crowdfunding. In this setting, it is also understandable why many have criticized the regulatory regime that will govern crowdfunding.
On May 16, 2016, the SEC rules governing crowdfunding, termed Regulation Crowdfunding, became effective. The lengthy SEC rulemaking process resulted from the SEC staff’s concerns regarding the risks that crowdfunding will pose to retail investors. To address such risks, Regulation Crowdfunding imposes a host of requirements on companies, investors and other market participants.
In a crowdfunding offering, an eligible company, which excludes non-US and other “disqualified” companies, may raise, during any 12-month period, a maximum of $1,000,000. Investors are also subject to investment limitations.
- For investors with annual income or net worth less than $100,000, the limit is the greater of $2,000, or 5% of the lesser of their annual income and net worth.
- For investors with annual income and net worth greater than $100,000, the limit is 10% of the lesser of their annual income or net worth, capped at $100,000.
A company must also comply with disclosure obligations prescribed by Regulation Crowdfunding. Pursuant to a new Form C, which must be filed with the SEC via EDGAR, a company must disclose information with respect to, among other things, its capital structure, management, business operations, and financial condition as well as information about the offering. The disclosure also includes GAAP financial statements: audited financial statements for offerings in excess of $500,000 and unaudited financial statements for offerings between $100,000 and $500,000. Continuing disclosure obligations may apply too, depending on the circumstances. A crowdfunding offering also must be conducted through the Internet via a single “funding portal”, which is a type of newly-created SEC registered intermediary. Like companies engaging in crowdfunding offerings, Regulation Crowdfunding subjects funding portals to numerous requirements, including FINRA registration.
After the runaway success of non-equity crowdfunding, where products and services are exchanged for cash, it is understandable why many have placed great hope in the promise of crowdfunding.
Notwithstanding the many requirements, crowdfunding offers a distinct advantage over the traditional capital raising processes, in which access to capital is driven by proximity. Through crowdfunding, an entrepreneur or company, regardless of location, will have exposure to vast pool of potential investors. In addition to geographic proximity, commentators have posited that crowdfunding will improve minority and women entrepreneurs’ access to capital. In other words, crowdfunding can alleviate the constraints of “cultural proximity.” Crowdfunding also has the potential to benefit retail investors, who will now have the ability invest in companies to which they otherwise would have no access.
Despite the potential advantages of crowdfunding, doubts persist. In addition to the investor protection concerns, which are real and substantial, crowdfunding places significant requirements on companies and funding portals. The compliance burden, in terms of both time and cost, may, in the end, discourage companies and funding portals from participating in crowdfunding offerings. Many have also argued that the investment limitations imposed by Regulation Crowdfunding are too stringent in order to cultivate material capital formation. On top of all of this, companies that are successful in crowdfunding will have to navigate the operational and legal compliance obligations incumbent upon a company with a large equityholder base.
Putting these debates aside, crowdfunding must win over the hearts and minds of a wide variety of stakeholders to take hold. Early mishaps – fraudulent offerings, technological failures, etc. – have the potential to stop crowdfunding in its tracks. One such group of stakeholders, the legal community, has, on the whole, been dismissive of crowdfunding’s ability to make inroads into the world of traditional capital raising. This sentiment, while perhaps accurate, misses the larger point. The beauty of crowdfunding is not its potential to replace traditional fundraising. Rather, it is the potential, as an alternative capital source, to increase the overall pool of capital available to entrepreneurs.
Even if crowdfunding is not an instant (or subsequent) success, the arrival of crowdfunding is a positive step towards the promotion of entrepreneurship and capital raising in the US. And it hopefully is a sign that the US government and other market participants have the appetite to continue to take action in furtherance of these goals.
Alex Tablin-Wolf is an associate at Blank Rome, where he concentrates his practice in Mergers & Acquisitions, Venture Capital, Securities, and Corporate Governance. Alex graduated cum laude from Temple Law in 2010.