Crowdfunding Promises New Opportunities for Entrepreneurs and Emerging Companies

Congress is currently considering bills that will allow issuers to raise capital through crowdfunding, which is also known as crowd-sourced capital, or crowd financing.  Crowdfunding is the sale of equity to a relatively large number of investors in small increments.  This is an exciting development for emerging companies, as it would offer a new, inexpensive method to raise start-up or early capital from individuals without many of the onerous limitations on general solicitation, number of investors, and investor accreditation imposed by current law.  It also may result in the creation of a new, and potentially profitable, business of crowdfunding intermediaries.

On November 3, 2011, the House of Representatives passed the Entrepreneur Access to Capital Act (the "House Bill") by an overwhelming margin.  Similar bills, the Democratizing Access to Capital Act (the "Brown Senate Bill") and the Capital Raising Online While Deterring Fraud and Unethical Non-Disclosure Act of 2011 (the "CROWDFUND Senate Bill"), are currently pending in the Senate.  These bills are generally referred to as "crowdfunding" bills and, depending upon who you ask, they either represent a compelling revolution in the funding of emerging and start-up companies or a doorway to potentially catastrophic financial harm.  Regardless, if any of these bills, or a compromise between them, becomes law, there will be significant new opportunities for issuers, investors, and crowdfunding intermediaries.

Entrepreneur Access to Capital Act

New Offering Exemption

The House Bill provides for a new, non-exclusive exemption under Section 4 of the Securities Act of 1933 from the registration requirements of Section 5 of the Securities Act for transactions involving the offer or sale of securities, provided that

• The aggregate amount sold in reliance on the exemption within a 12-month period is (a) $1 million or less or (b) $2 million or less, if the issuer provides audited financial statements; and
• The aggregate amount sold to any investor in reliance on the exemption within a 12-month period does not exceed the lesser of (a) $10,000 and (b) 10 percent of such investor's annual income.

Transaction Requirements

The House Bill also provides for a new Section 4A of the Securities Act, which sets forth additional requirements for a transaction to qualify for the exemption.  Which requirements apply, and to whom, depends upon whether a crowdfunding "intermediary" is engaged in the transaction.  An example of a potential intermediary could be a company that makes available Section 4(6) exempt offerings through a website that functions much like www.kickstarter.com but for investments in for-profit enterprises.  Instead of contributing funding towards a project, individuals would be purchasing securities from an issuer.  Although the crowdfunding intermediary cannot offer investment advice, it may accept compensation for its services in a crowdfunding offering.  Of particular note is that a crowdfunding intermediary will not be considered to be functioning as a broker or dealer under the Securities Exchange Act of 1934 in connection with a transaction exempt under Section 4(6). 

Although the specific transaction requirements under Section 4A vary depending on whether an intermediary is engaged, generally the issuer or crowdfunding intermediary must:

• Warn investors of the speculative nature of the investment, including risks in the secondary market related to illiquidity;
• Warn investors that they are subject to re-sale restrictions;
• Take reasonable measures to reduce the risk of fraud;
• Provide the SEC with information about the intermediary;
• Provide the SEC with continuous investor-level access to the intermediary's website;
• Require each potential investor to answer questions demonstrating understanding of the investment risks;
• Require the issuer to state a target offering amount and a deadline to reach the target offering amount and ensure a third party custodian withholds offering proceeds until aggregate capital raised from investors other than the issuer is at least 60 percent of the target offering amount;
• Carry out a background check on the issuer's principals;
• Provide the SEC and potential investors with notice of the offering and its completion;
• Outsource cash-management functions to a qualified third-party custodian;
• Maintain such books and records as the SEC determines is appropriate;
• Make available on the intermediary's website a method of communication that permits the issuer and investors to communicate with one another;
• Provide the SEC with a notice upon completion of the offering, which includes the aggregate offering amount and the number of purchasers; and
• Not offer investment advice.

Restriction on Resale

The House Bill restricts the resale of securities acquired under this new exemption.  Purchasers of such securities may not transfer them for a period of one year unless they are transferred to the issuer or an accredited investor.

Exchange Act Registration

The House Bill provides that securities acquired pursuant to Section 4(6) are not considered to be "held of record," which prevents them from potentially triggering the registration requirements of Section 12(g) of the Exchange Act.

Democratizing Access to Capital Act

The provisions of the Brown Senate Bill are more restrictive than the House Bill, potentially as a result of criticisms levied against the House Bill by organizations such as the North American Securities Administrators Association. The key differences in the Brown Senate Bill from the House Bill are as follows:

• The aggregate amount that may be sold in reliance on the exemption within a 12-month period is limited to $1,000,000, regardless of whether audited financial statements are provided;
• The aggregate amount that may be sold to any investor in reliance on the exemption within a 12-month period may not exceed $1,000;
• The transaction criteria are more generalized, requiring the issuer to disclose "all rights of investors, including complete information about the risks, obligations, benefits, history, and costs of offering" and to be an incorporated entity formed under, and subject to, the law of a state;
• Issuers must use a crowdfunding intermediary; and
• Crowdfunding intermediaries must meet specific requirements in order to be exempted from the definition of a broker.

Capital Raising Online While Deterring Fraud and Unethical Non-Disclosure Act of 2011

The CROWDFUND Senate Bill is even more restrictive than the Brown Senate Bill.  It provides:

• The aggregate amount that may be sold in reliance on the exemption within a 12-month period is limited to $1,000,000, but it requires delivery of audited financial statements if the company seeks to raise more than $500,000;
• Securities must be sold through a registered broker-dealer or "funding portal," which is an individual or entity engaged in the business of effecting securities transactions that does not offer advice or recommendations or solicit sales;
• The aggregate amount that may be sold to any investor in reliance on the exemption within a 12-month period may not exceed the greater of (a) $500 and (b) 1 percent or 2 percent of the investor's annual income depending on the amount of such income;
• Each investor is limited to an aggregate annual cap on the amount of all crowdfunding investments of  (a) $2,000 or (b) 4 percent of the investor's annual income if such income is above $50,000 but less than $100,000 or (c) 8 percent of the investor's annual income if such income is above $100,000; and 
•  A new cause of action is available for investors against corporate officers and directors in the event of fraud.

The Obama Administration supports the House Bill.  However, it is unclear if either Senate bill will move forward.

What This Means for Emerging Companies and Crowdfunding Intermediaries

If Congress passes crowdfunding laws in the form of the House Bill, Brown Senate Bill, CROWDFUND Senate Bill, or something similar thereto, there will be opportunities for emerging companies and crowdfunding intermediaries.  Of course, there will also be risks and responsibilities. 

Emerging Companies

• Opportunities may include:
  • Relatively quick funding;
  • Word-of-mouth marketing among hundreds to thousands of investors that exceeds the marketing capacities of many traditional start-ups;
  • Offering terms that may be more issuer-friendly than venture capital investments;
  • An ability to target local investors who are not accredited; and
  • A potential financing method of last resort when traditional methods are not available.

• Risks and responsibilities may include:
  • Investor relations issues due to unsophisticated investors;
  • A risk of shareholder lawsuits resulting from a larger shareholder base and newly-created causes of action; 
  • Minority stockholder rights under state law and company organizational documents, including voting and inspection rights;
  • Administrative complications and increased costs from a large number of small investors;
  • Decreased venture capital funding from other, more traditional sources based on numerous stockholders; and
  • Future regulatory changes and requirements.

Crowdfunding Intermediaries

• Opportunities may include:
  • Creating a new business segment within the securities industry;
  • Assisting in the development of emerging companies through introduction to potential investors;
  • Developing a new, and potentially large, investor base; and
  • Receiving compensation for assistance in the sale of securities via the new Section 4(6) exemption potentially without having to register as a broker-dealer.
    
• Risks and responsibilities may include:
  • Establishing a due-diligence and background-check process for vetting issuers and their officers and directors;
  • Creating a process to comply with record-keeping requirements;
  • Creating and monitoring compliance procedures to ensure no investment advice is given by intermediary employees or the website;
  • Developing more general compliance and monitoring procedures to ensure transaction requirements are met;
  • Making contacts and forming relationships with third parties, such as qualified custodians;
  • Potential securities fraud lawsuits; and
  • Future regulatory changes and requirements.

It is important to note that no crowdfunding law has yet been enacted by Congress, and any law that may be enacted will be subject to rulemaking by the SEC.  Final rules and requirements for crowdfunding, if any, could differ significantly from those discussed here.  Please register for our legal updates or check our website for future updates.

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