If you follow financial or business news you might have heard a shout of excitement about the Securities and Exchange Commission (the SEC) finally releasing new crowdfunding rules under the 2012 JOBS Act. Although the Act passed into law years ago, its specific parts (“Titles”) aren’t be operative until the SEC issues the rules for how the new securities sale systems will work.
The recent news that the SEC issued rules about crowdfunding might have made people think that equity crowdfunding – selling shares in privately-held companies online to anyone – is finally a go. Well, not quite, but sort of. The SEC issued rules for Title IV of the JOBS Act in the last couple of weeks. Title IV is the revamp of an existing and previously little-used regulation known as Regulation A, now known as Reg A+. Reg A+ essentially allows smaller companies to have a “mini-IPO,” selling shares in the company to raise investment capital, without having to register the securities and the company with the SEC (which is an expensive and legally complicated process).
When the average person hears the word “equity crowdfunding,” however, he or she likely thinks of a truly public investment marketplace where individuals can make an equity investment in small companies and start-ups, buying a piece of the company which can ideally either then be sold to another investor or recouped in the form of dividends or equity buy-backs later. Title III’s proposed rules of the JOBS Act contain the provisions to set up the SEC- version of that kind of crowdfunding, and the proposed rules’ language indicates how the SEC-version of that system would work. However, the SEC has yet to issue operational rules for Title IV, and it’s unknown when it will do so.
But, SEC cliff-hangers aside, you’re probably reading this article because you’re interested in the funding part of crowdfunding and how the SEC’s newly- and yet-to-be-released rules might affect your ability and opportunity to raise investment capital for your business. Rather than talk about the rules (or the potential rules) in the abstract however, let’s apply them to a hypothetical. As usual, this is not legal advice; if you are a business seeking ways to raise investment capital, we recommend consulting a qualified attorney. Let’s go to the story:
Anna and Brad graduated from design school together and started their luxury artisanal handbag business, Case Studies. As is typical for most new business ventures, they weren’t able to secure a loan from a bank or other typical lender for their business’ start-up costs, because they had no assets or sales records to demonstrate that they would be a good credit risk. So like many small businesses, Case Studies’ very first production run was funded from Anna and Brad’s personal savings and credit, and through gifts and loans from family and close friends. They had their attorney draw up agreements with everyone who gave or loaned them money, laying out who was giving a gift with no expectation of return, and who was giving a loan to be repaid and on what terms. Anna and Brad sold their first production run door to door to local boutiques and at artisan craft shows. They tried out selling on a pre-order system, which funded a run of exactly as many bags had been pre-ordered and gave the brand wider exposure. They started an IndieGoGo campaign, raised some capital through donations, and built awareness of their brand and business a little more. These were fine as short term solutions to raise money for the next production run (and rent, electricity, and food), but Anna and Brad determined that these fundraising models weren’t going to be a sustainable long-term capital-raising solution for Case Studies or themselves. Anna and Brad wanted to grow the business to be able to increase production, expand the product line, and hire employees (after reading this post, of course). They hoped to have their own production shop one day, and be able to fill large orders from retail stores. In order to do all of that they knew the business would need a bigger influx of capital than just the profit margin on total sales or another IndieGoGo campaign. They considered asking their bank for a loan but worried that they still didn’t have enough of an established sales record or assets to be approved.
Anna and Brad heard about Title IV/Reg A+ along with everyone else, and wondered “Is this a fundraising option for us?” In a nutshell, Title IV creates a two-tier system to enable small companies (subject to eligibility, disclosure and reporting requirements) to raise up to either $20 million or $50 million dollars in a 12-month period from both accredited and unaccredited investors through SEC-regulated broker-buyer exchanges. The big change Reg A+ brings to the previous version of Regulation A and registration-exempt securities sales is an expanded definition of a “qualified investor” to include “unaccredited” investors. “Accredited” investors, as defined by the SEC, are individuals who make more than $200,000 a year or households that have a net worth of more than $1 million. “Unaccredited investors” are the rest of us. So Reg A+ expands who can be part of the “crowd” in this type of crowdfunding, although non-accredited investors’ investments are capped at a maximum 10% of their income or net worth per year, for fear they might otherwise “lose it all” on a single risky investment.
The differences between Tier I ($20 million) and Tier II ($50 million) offerings come down to a balance of fewer state regulations versus more filing and reporting requirements. There are additional filing and auditing requirements for Tier II, a limit on the percentage of unaccredited investors purchasing in a Tier II offering, as well as a limit on the percentage of total securities the company offers one investor can purchase. The upside of Tier II is that the securities sale would not be preempted by a state law regulating or banning Reg A+ types of sales. Tier I offerings do not have state pre-emption so would fall under state-related requirements and review in each state where the securities were sold. However, companies that raised securities investments under Tier I would not be required to perform formal audits and annual reporting as required under Tier II offerings. The costs of auditing and annual reporting to the SEC for Tier II securities investment fund raising are projected to be high, and are in addition to the initial costs of preparing the offering documents and having the SEC audit the company and its financial statements.
Case Studies would be eligible under the rules to make a Reg A+ offering because its principle place of business is in the US or Canada, Anna and Brad have a business plan (and it isn’t to just merge with another company), they aren’t in the business of mineral rights, and they haven’t been disqualified as a “bad actor” or failed to file required SEC paperwork. Anna and Brad took a breath after all that SEC regulation language about Reg A+. They thought about this as an option. Making an offering under Title IV would be making a “mini IPO,” with all the pros and cons of investing the time and resources to make an offering of equity in the company for sale. Selling shares in Case Studies would provide a potentially huge source of investment income, and create a base of investors beyond friends and family with an interest in the business’ success. On the other hand, Anna and Brad knew that regardless of which Tier they made an offering under, there would be upfront costs such as preparing and filing the offering paperwork and preparing Case Studies’ records, attorney’s fees to ensure those filings were correct, and ongoing auditing and reporting costs if they made an offering under Tier II.
Anna and Brad also wondered if they should wait for the SEC to release rules for Title III, the truly “crowdfunding” part of the JOBS Act. They met the eligibility requirements to make an offering under Title III, as they are (as proposed now) the same requirements as under Title IV. Under Title III, unaccredited investors in the US – aka, anyone – would be able to make investments and buy equity in US-based start-up companies through new SEC licensed and regulated “funding portals” or existing broker-dealers. Under the proposed rules, companies would be able to raise a maximum of $1,000,000 per year. Individual investments would be capped at either $2,000, or 5% of the investor’s income if his or her annual income is less than $100,000 or 10% of his or her income if it’s greater than $100,000, per investor, per annual offering. The caps on individual investment and total amount raised means it will likely be used mainly by smaller companies and seed-level start up as a viable investment funding option.
Anna and Brad read over the disclosure requirements for Title III crowdfunding. Some of the requirements reminded them of the information they had given for their IndieGoGo campaign: the proposed offering price, target goal, deadline, description of the company, business plan and anticipated use of the proceeds, and contact information and website. Unlike the plug-and-play nature of current online crowdfunding, however, Anna and Brad agreed that the SEC’s regulations would have made it difficult or even impossible for this to have been a viable fundraising option for Case Studies before their first production run and subsequent building up of the business as a recognizable going concern. If they wanted to pursue this route of capital fundraising they would have to disclose the company’s financial records, discuss the risks associated with the investment, the number of employees, any indebtedness of the company, how the business was structured and how it was owned. Anna and Brad had formed and run the company as an unregistered equal partnership so far, but the list of required disclosures prompted them to talk about registering Case Studies as a corporation or other type of legal entity, before offering to sell shares in a business that was currently just them, some fab handbags, and a small bur growing following of shoppers. In addition to the disclosure documents, under the proposed rules Anna and Brad would also have to file an annual report with the SEC updating the initial disclosure information and provide it to investors for as long as there were investors to update. Unlike the current online crowdfunding platforms where the relationship between donator and company didn’t necessarily continue beyond mailing out the incentives, selling shares of Case Studies would create an ongoing relationship with the investors as part owners.
Anna and Brad still haven’t decided what to do, whether to try for a Title IV “mini IPO,” wait for the SEC to issue rules for Title III, or go another way for fund-raising capital.
To discuss your options for funding with Law On The Runway, please email email@example.com.
This was a guest post written by Elif Sonmez. Elif is a San Francisco attorney. She is interested in civil litigation and helping artists run their businesses. Before she became an attorney, she worked nationally as the Head of Props and Wardrobe for the John F. Kennedy Center for the Performing Arts’ KCTYA On Tour program.