SeedInvest is thrilled by the SEC’s proposal on equity crowdfunding. The proposed rules are balanced, well thought-out and clearly indicate an intent to make crowdfunding offerings a viable financing path for startups. We thank the SEC for referencing our letters (including CFIRA’s) 60 times, for sticking to the original intention of the JOBS Act and for submitting a very workable proposal. There is a lot of work to be done but today was a big step in the right direction.
1) Investor Self-certification. The proposed rules allow individuals to self–certify their income and net worth and the amount of their other crowdfunding investments for purposes of the individual investor limits. This is in contrast to the high verification requirements for Rule 506(c) of Regulation D and is consistent with how accredited investor checks have been done in the past (prior to Sept 23). Placing the burden on platforms instead of individuals themselves to police this would have been overly onerous. Title II advocates are certainly scratching their heads right now.
2) Offering Amount Flexibility. There was concern that a company could only raise the amount they offer initially and not a dollar more. The commission has provided for a target amount (ie. $250k) and a separate maximum amount (ie. 750k). This is the way the real world works and they got this one right.
3) Advertising. The proposed rules allow companies a much broader ability to advertise than expected. Issuers can push out notices about the offering through all channels, including social media, internet, newspaper, television, etc. so long as the notice is limited to factual information about the company and the offering (and can include details about (1) the amount of securities offered; (2) the nature of the securities; (3) the price of the securities; and (4) the closing date of the offering period). This will allow companies to do kickstarter style campaigns using social media, television and otherwise.
4) Simultaneous Reg D and Crowdfunding Offerings Allowed. The proposed rules will allow companies to conduct a typical Reg D offering (both 506(b) or 506(c) with general solicitation) simultaneously with a crowdfunding offering. There was concern that Reg D offerings would count toward the $1M limit. This means that, if you comply with the rules of both offerings, you could raise from a venture capitalist or angels and simultaneously make a crowdfunding offering using a platform. Amounts raised under Reg D would not count towards the $1M crowdfunding limit. The investor limits will still apply to accredited investors and foreign investors for purposes of the crowdfunding offering.
5) Education Requirements. As the Chair of the Education Committee at the Crowdfunding Professional Association, we are very pro investor and entrepreneur education. The Commission did a good job of requiring proper delivery of educational materials without overburdening users. One important nit – we did not see any requirement that investors understand the importance of diversification. It is critical that crowdfund investors receive this message and not expect their single investment to be the next Instagram.
1) Prohibition on Investment Advice. Sure, we expected this but that doesn’t mean it’s a good idea. Funding portals are not able to subjectively filter out any companies looking to raise capital on a given platform. Based on our recent conversations with the SEC, we think there is room to work on this. It is no secret that the vast majority of startups looking to raise capital are either not ready to raise capital or are simply not fundable. SeedInvest for instance currently filters out over 98% of company applicants. Why not allow a portal such as SeedInvest, which employs former professional investors, to filter out the noise for the benefit of its investor base? Why not allow an additional layer of fraud protection on behalf of investors?
2) Audited Financials. Again not surprising but disappointing nonetheless. Companies raising $500k – $1mm are required to file audited financial statements. As discussed multiple times with the Commission, we are still not sure what there is to audit for a fresh start-up with no revenue. Costly burdens such as this will make startups strongly consider whether to raise capital via crowdfunding and, if so, whether its worth it to raise $500k or more.
3) Filing Requirements. The rules impose a slew of filing requirements with the SEC on new Form C including:
- Filing of offering materials, including financial statements
- Filing of updates on offering status (i.e. when you hit 50% threshold, 100% threshold and maximum targets)
- Filing of any material changes to the offering
- Annual filing of an financial statements and financial condition
- Failure to make annual filings will result in a ban from crowdfunding offerings for 2 years
While these requirements seem burdensome, it’s likely that platforms like SeedInvest will build in a mechanism to automatically make some or all of these flings.
4) Foreign Portals Are Allowed. The proposed rules contemplate that foreign portals may be allowed to conduct offerings subject to compliance with several requirements. The intent is to increase access to foreign investors. This seems dangerous, however, as these foreign portals may be beyond the reach of US regulators and US investors will not have the ability to interact and vet these portals. A better approach may be to require foreign portals to partner with U.S. based portals to reach more foreign investors.
5) LLC & Record Keeping. The proposed rules prohibit crowdfunding an investment company or any company that is exempt from the investment company act under Rule 3(c)(1) or 3(c)(7). This means that you will not be able to pool crowdfunders into a single purpose LLC and therefore will have a large number of investors directly on the cap table. The proposed rules also put additional requirements in place on issuers to keep track of their shareholders. A transfer agent type structure may be required. Unique legal structures will need to be developed to manage the cap table of these crowdfunded companies.
Liability. The rules do not address the liability concerns raised by the JOBS Act. According to the statute, an issuer has the burden of proof of proving that that their statements were not materially misleading, which could lead to rampant lawsuits against Issuers and intermediaries. We hope to see additional clarification from the SEC under this regime.
Top Five Storylines
1) The income/net worth verification method is much less stringent than Title II/Reg D Offerings. Will angel investors who do not want to provide financial information use crowdfunding to make their investments in order to avoid these requirements?
2) The possibility of doing a simultaneous 506(c) offering and crowdfunding offering opens up a huge potential for offerings. Imagine a startup like Birchbox with hundreds of thousands of subscribers closes a $25 million Series C financing round. It then allows each of its customers the opportunity to participate in a $1M crowdfunding follow-on round on the same economic terms. Their current customers would be thrilled to have the opportunity to participate in the upside of the Company and, with skin in the game, would be more likely to recommend the product to their friends, give feedback, and help the company. More people would want to become customers in order to be part of the “club.” Also, because this would be a follow-on to a venture backed investment, many of the concerns about fraud are minimized.
3) The audited financial requirement for financials between $500k – $1M may push companies to limit their offerings to $499,999 to avoid incurring this cost. There is some question about how burdensome audited financials statement would be to a very early stage company. Perhaps some firms will start offering a streamlined audit process for early stage companies with limited prior operations?
4) How will people deal with having hundreds or thousands of investors on their cap table? Some suggest holder shares via a broker in street name and others have suggested non-voting stock. New legal structures will surely emerge on this front (and SeedInvest has some ideas also)
5) Will all of the regulatory hoops, requirements and liability concerns make this type of offering unworkable? Technology can solve a lot of these problems, including automating filings and facilitating disclosure and standard docs. The liability concerns may be a bit of wild card.
This post was written by James Han on September 6, 2016
Equity Crowdfunding Rules: The Good, The Bad & The Ugly