On April 5, 2012, President Obama signed into law the Jumpstart Our Business Startups Act (the “JOBS Act”).2 The primary intent of the JOBS Act is to drive job creation by making a number of significant changes to federal securities laws which shall facilitate startups and other emerging growth companies raising capital.3 In addition to changes which ease restrictions placed on private placement offerings and Securities Exchange Commission (“SEC”) shareholder registrations, the most highly anticipated provisions of the JOBS Act is the enablement of “crowdfunding,” or the ability to sell securities in small amounts to a large number of investors. The changes brought by the JOBS Act will likely have a significant impact on how startups raise capital.
Crowdfunding is a financing concept that enables individuals and organizations to pool together resources to fundraise or source capital to fund efforts initiated by other people or organizations.4 Prior to the JOBS Act, crowdfunding made it easier for individuals and organizations to raise money in limited areas, including charitable purposes and artistic works. For example, Kickstarter has operated as a portal for emerging artists and developers to raise funds through the public for a tangible product.5 However, the concept of crowdfunding a startup’s securities prior to the JOBS Act was limited by two significant legal obstacles: first, the sale of securities triggered expensive SEC registration requirements; and secondly, third-party facilitators for the sale of securities raised via crowdfunding would subject such third-parties to broker-dealer regulations.6 As a result of the legal obstacles, current crowdfunding platforms have developed business models to avoid the characterization of crowdfunding as the sale of securities.
Title III of the JOBS Act, more specifically titled the “Capital Raising Online While Deterring Fraud and Unethical Non-Disclosure Act of 2012” or the “CROWDFUND Act,” lifts the legal obstacles and permits startups to raise capital through qualifying crowdfunding transactions.7 The exemption created by the JOBS Act, embedded as new § 4(6) of the Securities Act of 1933 (the “Securities Act”), permits an issuer to raise up to $1 million over a 12-month period from a large number of investors that do not meet the SEC’s standards of an accredited investor.8 Offerings which meet the requirements of the crowdfunding exemption will be exempt from state blue sky laws, which are intended to reduce the regulatory burden in these transactions.9
The gross aggregate amount an issuer can sell to an individual investor in any 12-month period is limited to the maximum of: (i) the greater of $2,000 or 5% of the annual income or net worth of an investor, if either the investor’s net worth or annual income is less than $100,000; or (ii) 10%, not to exceed $100,000, of annual income or net worth of an investor, if either the investor’s annual income or net worth is equal to or greater than $100,000.10 Additionally, an investor holding securities sold pursuant to the crowdfunding provisions are not transferable by the investor for 1-year from the date of purchase, unless the securities are transferred to the issuer, an accredited investor, in a registered public offering, or to family of the purchaser, in addition to other transfer restrictions to be imposed during SEC rulemaking.11
A crowdfunding offering involving the sale of securities must be conducted through a broker or “funding portal” that meets the qualifications to be established under new SEC rules.12 A funding portal must first register a crowdfunding offering with the SEC, and make available to prospective investors information regarding an offering provided by the issuer 21 days before the first day on which the securities are sold.13 The funding portal must also make certain disclosures to investors, such as investment risks and investor education materials, and establish measures to reduce the risk of fraud, such as background and regulatory checks on directors, officers and significant equity holders.14 Lastly, the funding portal must ensure that no investor in any 12-month period exceeds the applicable investment limits in the aggregate for all investments made by the investor.15
It is also important to note that funding portals are subject to strict regulations with respect to its permitted activities. A funding portal intermediary is not permitted to: (i) offer investment advice or recommendations; (ii) solicit purchase, sales or offers to buy the securities listed on such funding portal’s website; compensate persons for such solicitation based on the sale of securities referenced on its website; (iii) compensate employees, agents or other persons for such solicitation or based on the sale of securities displayed or referenced on its website or portal (iv) hold, manage, possess, or otherwise handle investor funds or securities; or (v) engage in other activities that the SEC determines.16 While noting that a funding portal will be subject to SEC rules and registration, the JOBS Act specifically exempts a funding portal from registering as a broker-dealer.17
Issuers engaged in crowdfunding must also meet a number of disclosure and filing requirements, both to the SEC and investors. An issuer’s disclosure obligations vary on the size of the offering.18 Accordingly, the JOBS Act provides a tiered disclosure regime based upon the size of the offering. For issuers conducting a crowdfunding offering less than $100,000, the issuer is required to produce income tax returns for the most recently completed year and certified financial statements certified.19 Issuers raising between $100,000 and $500,000 in a crowdfunding offering are required to provide financial statements reviewed by an independent public accountant.20 Issuers raising in excess of $500,000 must provide audited financial statements.21 In addition to the foregoing financial information required in connection with a crowdfunding offering, issuers will also be required to make annual filings with the SEC regarding the issuer's results of operations and financial condition.22
As noted earlier, an issuer must also file with the SEC, and must make available to its investors and funding portal the basic information about such issuer. The basic information of an issuer includes basic corporate information, names of officers and directors, major equity holders, description of the business, the stated purpose and use of the proceeds of the offering, the target offering amount and deadline, as well as the price of the securities, and other information as required by the SEC.23
Additional Capital Raising Initiatives under the JOBS Act
The JOBS Act also amends the Securities Act to provide additional capital raising opportunities for startups which had previously been limited. Specifically, a key element of the JOBS Acts eliminates the prohibition on solicitations and general advertising in connection with a private offering.24
Most securities offerings by startups are conducted under Rule 506 of the Securities Act. Currently, the ban on general solicitation and general advertising have limited startups to raise capital from existing investors, or from potential investors with whom they or finders have preexisting relationships.25 Under the JOBS Act, the elimination of the general solicitation and general advertising eliminates the prohibitions on general solicitation and general advertising in connection with a private offering conducted under Rule 506, provided that all investors acquiring securities in the offering are accredited investors.26 An issuer seeking to take advantage of general solicitation will be required to take reasonable steps to verify that each investor in the offering is accredited, using methods to be determined by the SEC.27
Impact of Crowdfunding and the JOBS Act on Startups
The enactment of the JOBS Act is intended to assist entrepreneurs and startups to obtain capital and financing outside of the traditional and conventional sources of funding. As indicated above, the JOBS Acts enablement of crowdfunding, as well as loosening certain Securities Act regulations, expands financing options available to startups. However, and most importantly, despite the enablement of crowdfunding, startup companies should not attempt to utilize crowdfunding or any other provision under the JOBS Act until the SEC finalizes its rulemaking regarding the specific provisions of the JOBS Act.28
When SEC rulemaking becomes finalized, an important element to raising a successful crowdfunding offering is the involvement of corporate counsel. When a startup begins to look to crowdfunding to address capital needs, it must ensure that attorneys are engaged and involved at an early stage to ensure that it is compliant with all applicable laws related to an offering.
Prior to any crowdfunding offering, a startup must first ensure that it is compliant with all applicable laws. A key legal item a startup must ensure is in order prior to an offering is that its corporate house is in order. For example, a startup must verify that it has authorized the appropriate number and type of shares to be sold in connection with its crowdfunding offering. Further, a startup must ensure that it is compliant with all SEC filings required under the JOBS Act. Although the filing requirements for startups will generally be less burdensome in traditional public offerings, missteps in filings may result in director or officer liability.29 Other additional items a startup will need to consider is whether new shareholders resulting from a crowdfunding offering should enter into agreements imposing restrictions on share transfers, such as a company right of first refusal or a market stand-off provision.
Despite creating an alluring alternative capital raising opportunity, it is important to consider many practical points prior to a crowdfunding offering. In many instances, early-stage startup companies may have formed recently and have not yet filed tax returns, and therefore preclude the startup from utilizing the Securities Act exemption. Even if startups have filed tax returns, many may not have complied with all financial reporting requirements by the time the startup decides to undertake a crowdfunding offering. Most importantly, startups must also weigh the consequences of disclosing its operations results and financial information to the SEC as a result of a crowdfunding offering, and whether it is more important to protect such information. The foregoing considerations may ultimately result in a startup being disinclined from utilizing a crowdfunding offering.
Lastly, while crowdfunding may only create a narrow exemption to the public sale of securities to unaccredited investors, the removal of advertising and solicitation restrictions under Rule 506 will likely have a significant impact on the capital-raising methods used by startups. As a result of the lifting of the ban, startups will be permitted to approach a wider investor pool and audience when conducting a capital fundraising campaign. Moreover, startups will be able to advertise or provide notice of any proposed offering over the Internet, in newspapers or other marketing channels, so long as the investors remain accredited investors.
The JOBS Act is an important legislative act which is ultimately intended to create jobs through innovating new ways to provide capital to startup companies. Although the new rules will allow startups to access a wider variety of investment and capital raising channels than previously permitted, it has yet to be determined whether this will result in a change of traditional venture capital offerings. As early-stage investors generally require a fair amount of personal interaction and evaluation over an extended period of time, a crowdfunding exemption may not result in any difference to the venture capital market. However, as the SEC rulemakings are finalized, and the markets begin to adapt, startups should carefully evaluate whether crowdfunding will be a right capital raising opportunity.
2 Jumpstart Our Business Startups (JOBS) Act, Pub. L. No. 112-106, 126 Stat. 306 (2012).
3 The JOBS Act was specifically created “[t]o increase American job creation and economic growth by improving access to the public capital markets for emerging growth companies.”
4 Wikipedia, Crowdfunding, http://en.wikipedia.org/wiki/Crowd_funding (Oct. 7, 2012).
5 See www.kickstarter.com
6 See generally § 4(6), Securities Act of 1933 § 77d
7 § 301, JOBS Act.
8 § 302(a)(6)(A), JOBS Act. Amendments to § 4(6), Securities Act of 1933 § 77d.
9 § 302(a)(6)(B), JOBS Act. Amendments to § 4(6), Securities Act of 1933 § 77d.
12 § 302(b), JOBS Act. Amendment to § 4(6), Securities Act of 1933 § 77a. Issuers are subject to stringent issuer regulations, including, without limitation, the provisioning of financial information and other offering related information.
14 Per § 302(b). JOBS Act. Amendment to § 4(6), Securities Act of 1933 § 77a. A major equity holders are individuals or entities who own more than 20% of the shares of issuer.
15 § 302(b), JOBS Act. Amendment to § 4(6), Securities Act of 1933 § 77a. Crowdfunding portals are required to ensure that investments facilitated through such intermediary are compliant with investor regulations.
16 § 304, JOBS Act. Amendment to Securities Exchange Act of 1934 § 78c.
17 § 302(b), JOBS Act. Amendment to § 4(6), Securities Act of 1933 § 77a. A funding portal
18 § 302(b), JOBS Act. Amendment to § 4(6), Securities Act of 1933 § 77a.
19 § 302(b), JOBS Act. Amendment to § 4(6), Securities Act of 1933 § 77a. Setting forth the tiered disclosure regime.
23 § 302(b), JOBS Act. Amendment to § 4(6), Securities Act of 1933 § 77a. Setting forth the SEC disclosure requirements of an issuer.
24 Under Title II of the JOBS Act, Access to Capital for Job Creators, § 201 JOBS Act, the general ban on advertising and solicitation is lifted specifically for capital raising efforts to accredited investors.
25 Regulation D, Rule 506, 17 C.F.R. § 230.506.
26 § 201, JOBS Act. Amendment to Regulation D, Rule 506, 17 C.F.R. § 230.506.
28 The full text of the SEC warning is available on the SEC’s website at http://www.sec.gov/spotlight/jobsact/crowdfundingexemption.htm. Conducting a crowdfunding offering to unaccredited investors would violate the Securities Act as it currently exists, and may result in the SEC’s determination that an issuer is a “bad actor” under the JOBS Act. Such designation may preclude a company from subsequently utilizing crowdfunding to raise capital.
29 Since crowdfunding offerings will be open to a large public audience, the shareholder composition after an offering may result in a large number of shareholders. Accordingly, it may be wise for startups to review its director and officer indemnification provisions under its certificate or articles of incorporation, or bylaws, and consider obtaining director’s and officer’s liability insurance.
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