Expert Q&A on Equity Crowdfunding
The proliferation of social media and the liberalization of the securities laws have given rise to an increasing use of equity crowdfunding offerings to raise capital. These offerings are made over the internet to a large group of people, with each investor investing a relatively small amount. For a startup company, crowdfunding can provide additional capital to supplement what the company can raise from its network of friends and family and can also offer an alternative to working with professional investors.
Practical Law asked Sara Hanks of CrowdCheck, Inc. to weigh in on trends in equity crowdfunding and key issues for companies considering a crowdfunding offering.
Sara is the co-founder and Chief Executive Officer of CrowdCheck, Inc. and a corporate and securities attorney with over 30 years of experience. CrowdCheck offers due diligence and compliance services to intermediaries, entrepreneurs and investors in crowdfunding offerings. Sara previously practiced law at several international law firms, including for many years as a partner at Clifford Chance LLP. She is also a former SEC staff member and worked on Capitol Hill on bailout oversight issues during the financial crisis.
What are some common types of equity crowdfunding offerings, including the types of companies, types of investors and status under the federal securities laws?
There are quite a few different types of securities offerings being called crowdfunding. Since there is no real "legal" definition of crowdfunding, I personally define it as offering securities:
Over the internet.
In relatively small amounts.
To a large number of potential investors.
This was theoretically possible before the passage of the Jumpstart Our Business Startups Act (JOBS Act) in 2012, but only in circumstances where the platforms acting as intermediaries took steps to avoid "general solicitation," such as making offering information available only behind a password-protected firewall.
Since the passage of the JOBS Act, we are seeing:
"Accredited" crowdfunding on the unrestricted internet.
"True" crowdfunding, although this is not yet available at the federal level.
Accredited crowdfunding using general solicitation has been legal since September 2013, when amendments to Regulation D under the Securities Act of 1933 (Securities Act) mandated by the JOBS Act became effective. These offerings rely on Rule 506(c) of Regulation D, which permits Regulation D offerings sold only to accredited investors to use general solicitation, and therefore the unrestricted internet, to attract investors.
Currently, there are many online investment platforms available to issuers seeking to use general solicitation to offer securities to accredited investors under Rule 506(c). Some platforms specialize in offerings by early-stage companies, especially tech companies, and many platforms have sprung up to offer investments in real estate projects. Real estate crowdfunding is a separate asset class and appeals to a different type of investor. Potential returns from early-stage companies (at least those that survive) may be large but are typically realized only after a number of years, whereas real estate projects may achieve annual returns of 8% or more over a much shorter period.
Notably, some accredited crowdfunding offerings rely instead on Rule 506(b), the pre-JOBS Act private offering safe harbor that prohibits general solicitation. In Rule 506(b) accredited crowdfunding offerings, platforms make offering information available only behind a password-protected firewall and comply with other requirements. This is similar to how pre-JOBS Act online funding platforms operated.
For more information on Rule 506(c) and general solicitation under the securities laws, see Practice Note, General Solicitation and Startup Capital Raising: Guidance and Questions.
Amendments to Regulation A (often referred to as Regulation A+) under the Securities Act, also required by the JOBS Act, became effective in June 2015. Some offerings under amended Regulation A are referred to colloquially as registered crowdfunding, even though Regulation A, which requires offering documents to be reviewed and qualified by the SEC, is technically an exemption from full SEC registration. Additionally, Regulation A can be used for traditional capital raising that does not use the internet at all.
Offerings under Regulation A can be made to all investors, not just accredited investors. There are two tiers of Regulation A offerings:
Tier 1 permits offerings of up to $20 million and requires review by both the SEC and state securities regulators.
Tier 2 permits offerings of up to $50 million and requires SEC review only. However, unlike in Tier 1, Tier 2 issuers must make ongoing reports with the SEC and there are limits on the amount of money non-accredited investors may invest.
There have been some public filings under Regulation A, but many of those were immediately amended due to filing errors. It is still too early to predict what type of company will use amended Regulation A the most.
For more information on Regulation A, see Practice Note, Regulation "A+" Offerings under Amended Regulation A.
The JOBS Act mandated that the SEC implement regulations to permit crowdfunding offerings of up to $1 million under a new exemption from registration under the Securities Act, Section 4(a)(6). The SEC published its proposals for Regulation Crowdfunding (Regulation CF) in October 2014, but those proposals have not yet been adopted. It remains to be seen whether Regulation A might eventually prove more popular than Regulation CF.
In the meantime, many state securities regulators have taken advantage of the Securities Act Section 3(a)(11) exemption from registration at the federal level for intrastate offerings, and created their own state law versions of the federal crowdfunding exemption. The companies making intrastate crowdfunding offerings have tended to be "main street" businesses with a local focus.
For more information on Section 4(a)(6) and proposed Regulation CF, see Practice Note, Crowdfunding Offerings Under Section 4(a)(6).
What factors make equity crowdfunding a compelling option for a company, as opposed to more traditional ways to raise capital?
In short, the crowd. There are many companies out there that do not appeal to traditional venture capital(VC) or angel investors. Those investors are generally focused on investing in companies:
In a narrow range of industries (such as software-as-a-service, social media or life sciences).
In specific geographies (for example, no more than one hour's drive from Silicon Valley, Boston or New York City).
With the potential to scale massively and achieve a successful exit.
Some companies, such as personal services firms, cannot scale the way a software business can. And not every company wants to move to Palo Alto. But there may be some great investment opportunities among the 98% or so of companies that do not get VC or angel funding. Companies with a built-in fan base, such as devoted consumers of a retail product or enthusiastic players of a video game, should certainly consider equity crowdfunding.
It is also important not to regard this as an "either/or" decision, at least when Regulation D offerings are involved. It is quite possible, and increasingly popular, for a company that is raising funds from traditional sources to offer a portion of the offering to the accredited crowd. In some ways, an offering under Regulation A to individual retail investors (as opposed to an initial public offering to large institutions), is a return to the most traditional type of offering of securities.
What corporate housekeeping items should a startup think about before it launches a crowdfunding offering?
A startup should make sure that it has paid its franchise taxes and is still in good standing with its state of incorporation. It is surprising how many companies fail to do this. It should also make sure it has properly documented all its previous securities issuances. In other words, the company should be able to show that for every entry on its cap table, the corresponding issuance of securities was authorized, approved by the board and properly documented.
There is a lot of sloppy record-keeping by startups, which is understandable given the many demands on their resources. However, companies need to understand that selling securities to strangers over the internet (which is what crowdfunding is) is not the same as selling to friendly angel investors who are closely involved with the company and can help sort out the paperwork later if necessary. Startups need to have their paperwork in order before they start crowdfunding.
What role do crowdfunding platforms play in helping companies identify housekeeping priorities?
The role that platforms play tends to vary according to their regulatory status. Platforms that are broker-dealers or affiliated with broker-dealers have liabilities and due diligence obligations, and because of this they have compelling incentives to make sure that the startups they list have their paperwork in order. Some platforms do their own due diligence and some outsource the process to providers like CrowdCheck.
Some platforms that host Rule 506(c) offerings on their site are not broker-dealers, but instead are what the SEC refers to as "bulletin boards." They operate on more of a "buyer beware" principle and alert investors that they should do their own due diligence.
Generally speaking, what company disclosure is provided to investors in crowdfunding offerings?
It varies, especially in Rule 506 offerings. Regulation A and Regulation CF both mandate specific disclosure, and in Regulation A offerings the SEC (and in Tier 1 offerings, also state securities regulators) will review that disclosure. In Regulation A offerings at least, there will be consistent disclosure.
In Regulation D offerings, practice varies widely. Some platforms insist that companies they feature provide full private placement memoranda (PPMs), although the quality of those PPMs also varies widely, and many consist mainly of boilerplate. Some platforms require only a video and an investor slide deck. Some traditionally minded attorneys have denigrated that sort of information as "comic-book disclosure," although it could be argued that the best disclosure is disclosure that is read and understood. It does seem that scant attention is being given to financial statements and risk factors when that type of disclosure is used.
What role are attorneys playing in crowdfunding offerings?
This is another area where the answer varies depending on the type of offering. A company cannot conduct a Regulation A offering without an attorney (and an experienced securities attorney at that). The first batch of Form 1-A filings included several that were immediately amended because of obvious errors (such as checking the box indicating audited financial statements and attaching unaudited financial statements).
Not only is Regulation A fairly complex in itself, but there are certain other requirements that apply generally to SEC filings that are almost unwritten, in that they are published but you have to know where to find them. While these rules are second nature to experienced securities attorneys, they might not be apparent to other attorneys. For example, experienced securities attorneys know that the SEC staff will decline to review a filing made without complete financial statements and an auditor's consent, on the grounds the filing is not "substantially complete." And yet several recent Regulation A offering circulars were filed without financials.
In theory, companies should be able to make Regulation CF filings without attorneys. However, given the experience so far with Regulation A filings, the SEC may monitor these types of filings carefully.
Rule 506(c) offerings are frequently completed without attorneys, at least on the issuers' side. This sometimes leads to problems, and CrowdCheck has encountered a number of companies that are no longer in good standing, and in some cases that do not even technically validly exist as entities. Many companies come to us without board minutes, even when their by-laws say they must keep them. Some companies seem to think they have an attorney looking after their affairs, when in fact the attorney was only engaged for a specific task that is now complete.
It is clear that there are a lot of companies making offerings of securities to strangers over the internet without the assistance of counsel, which may lead to problems later.
What are some key legal issues for equity crowdfunding offerings involving overseas investors?
I have seen a lot of US startups looking to raise funds overseas and just assuming that whatever they do in the US will work overseas. That is not necessarily the case. Every offering, wherever it is made, has to be registered under the Securities Act or be eligible for an exemption from registration.
A startup could make Rule 506(c) offerings to overseas investors, if it can find a way of establishing their accredited status (and non-US investors are often leery of disclosing personal data). Some companies say they are relying on Regulation S under the Securities Act to make unregistered offerings outside the US, but Category 3 of Regulation S (the section of Regulation S that generally applies to US startups) imposes significant requirements on companies seeking to rely on it, including, in some cases, the adoption of changes to the company's by-laws. But companies are not doing that.
There is also the issue of broker-dealer or equivalent regulation in the investors' home country. If a foreign investor just happens to find a US startup and asks to invest, that is one thing. However, if the company or its agents are making offers into another country, they had better be doing so through an entity that is complying with local requirements as to the registration of financial intermediaries and the making of offers of securities.
In addition to CrowdCheck, what resources would you recommend to startups considering raising capital through crowdfunding?
Engage an accountant as early as the company can afford one. Even if it cannot pay for an audit, an accountant can help the company compile its financial statements in a way that looks professional and might help mitigate liability. If you are a founder of a startup you might not have any experience in, for example, how to recognize revenue. When you do eventually get your financials audited, early investors, if they have invested on the basis of inadequate financials, might get a nasty surprise.
QuickBooks, while used by many companies, is only a temporary solution and does not provide a good picture of how the company is doing. I spend hours at the close of each month taking CrowdCheck's QuickBooks accounts and manually transposing information into an Excel spreadsheet which more closely tracks US GAAP. Essentially, get a real accountant.