Up until recently, the opportunity to invest in startups has been limited primarily to professional investors, venture capital firms and banks. This is because under securities regulations, companies are generally limited to accepting investment from “accredited investors” – i.e. individuals with income of more than $200,000 a year or, together with their spouse, $300,000 a year for the prior two years and the reasonable expectation to earn the same or higher in the current year, or a net worth of at least $1,000,000 not including their primary residence – and only a finite number of non-accredited investors (typically 35). Platforms like Kickstarter and IndieGogo, in fact, do not and cannot offer actual ownership or equity in the companies promoted on their platforms, but instead act as ways for companies to seek donations while promoting their products. In contrast to the ease with which one may make a donation on Kickstarter (about 90 seconds and a credit card is all that it is required), it can be complicated.
The Jumpstart Our Business Startups (JOBS) Act, passed in April 2012, contained a number of provisions aimed at stimulating growth of the American startup economy. The JOBS Act included modifications to existing securities regulations designed to pave the way for more Americans to make investments in startups. After due consideration, on October 30 of this year, the SEC finally adopted rules authorized under Title III of the JOBS Act to allow “crowdfunded” investments in startups, whereby an unlimited number of non-accredited investors can invest in any given startup. Despite the restrictive rules promulgated by the SEC under Title III of the JOBS Act, it is a certainty that within the first quarter of 2016 there will be multiple crowdfunding platforms approved under the SEC’s new regulations.
The SEC’s recommended rules under Title III of the JOBS act for companies seeking crowdsourced investment would:
– Permit a company to raise a maximum aggregate amount of $1 million through crowdfunding offerings in a 12-month period;
– Permit individual investors, over a 12-month period, to invest in the aggregate across all crowdfunding offerings up to:
– If either their annual income or net worth is less than $100,000, than the greater of $2,000 or 5 percent of the lesser of their annual income or net worth.
– If both the investor’s annual income and net worth are equal to or more than $100,000, 10 percent of the lesser of their annual income or net worth; and
– During the 12-month period, the aggregate amount of securities sold to an investor through all crowdfunding offerings may not exceed $100,000.
– Under the recommended rules, certain companies would not be eligible to use the exemption. Ineligible companies would include non-U.S. companies, Exchange Act reporting companies, certain investment companies, companies that are subject to disqualification under Regulation Crowdfunding, companies that have failed to comply with the annual reporting requirements under Regulation Crowdfunding during the two years immediately preceding the filing of the offering statement, and companies that have no specific business plan or have indicated that their business plan is to engage in a merger or acquisition with an unidentified company or companies.
– Securities purchased in a crowdfunding transaction generally could not be resold for one year. Holders of these securities would not count toward the threshold that requires a company to register its securities under Exchange Act Section 12(g) if the company is current in its annual reporting obligations, retains the services of a registered transfer agent and has less than $25 million in total assets as of the end of its most recently completed fiscal year.
– In addition, all transactions relying on the new rules would be required to take place through an SEC-registered intermediary, either a broker-dealer or a funding portal.
The biggest caveat to these non-accredited investments is that the SEC requires substantial disclosures be filed with the agency in order to qualify for taking on such funding. These filings include:
– The price to the public of the securities or the method for determining the price, the target offering amount, the deadline to reach the target offering amount, and whether the company will accept investments in excess of the target offering amount;
– A discussion of the company’s financial condition;
– Financial statements of the company that, depending on the amount offered and sold during a 12-month period, are accompanied by information from the company’s tax returns, reviewed by an independent public accountant, or audited by an independent auditor. A company offering more than $500,000 but not more than $1 million of securities relying on these rules for the first time would be permitted to provide reviewed rather than audited financial statements, unless financial statements of the company are available that have been audited by an independent auditor;
– A description of the business and the use of proceeds from the offering;
– Information about officers and directors as well as owners of 20 percent or more of the company; and
– Certain related-party transactions.
– In addition, companies relying on the crowdfunding exemption would be required to file an annual report with the Commission and provide it to investors.
What remains to be seen is how these new crowdfunding platforms will make their own money. According to the SEC press release, such platforms will be barred from:
– Providing access to their platforms to companies that they have a reasonable basis for believing have the potential for fraud or other investor protection concerns;
– Having a financial interest in a company that is offering or selling securities on its platform unless the intermediary receives the financial interest as compensation for the services, subject to certain conditions; and
– Compensating any person for providing the intermediary with personally identifiable information of any investor or potential investor.
As a result, the crowdfunding platforms themselves will likely be experimental startups in their own right, many of which may seek to make money by charging for value-added services or as loss-leaders to more traditional business offerings.
The new rules come into effect, on January 29, 2016, and we anticipate seeing the first crowdfunding platforms opening up for investment shortly thereafter. We will be monitoring the evolution of the crowdfunding ecosystem closely. For more information on Title III crowdfunding or other currently available methods for raising funds, please contact William A. Newman or Charles B. Hughes.