Beginning May 16, 2016 Regulation Crowdfunding is the law of the land in the US. For the first time, US startups have a legal framework for seeking equity investment from the general public. It is surely historic, but unfortunately, it may not be time for startups to celebrate just yet.
Here's why: capital formation is just one of the SEC's two main responsibilities. The other is maintaining order and protecting investors. To achieve that latter objective, the new crowdfunding rules are packaged with significant restrictions covering three broad areas:
- Limitations placed on the amount of money investors can invest;
- Requirements placed on the form and mechanism for the transactions; and
- Offering limitations and disclosure obligations and placed on companies.
Here are the important details:
1. Investor Limitations
Investors relying on these rules are limited on how much they can invest. Investors with less than $100,000 in annual income or net worth may invest the greater of (a) $2000 or (b) 5% of the lesser of (i) their income or (ii) net worth per year in aggregate across all crowdfunding platforms. Investors with more than both (a) $100,000 in income and (b) $100,000 in net worth may invest 10% of the lesser of (i) their income or (ii) net worth per year across all crowdfunding platform. All investors are subject to a cap of $100,000 in total investments per year. Got that?
2. Transactional Requirements
All equity crowdfunding transactions must take place exclusively through an SEC-registered intermediary--either a traditional broker-dealer subject to SEC rules or a newly created entity called a "funding portal."
Companies are limited to working with a single portal for their offering. And at no time may an issuer discuss or advertise an active crowdfunding transaction off-platform in any substantive way. (A simple public notice that a transaction exists, directing interested parties to the intermediary is permitted.) The intermediaries' portals are intended to be the sole source of information regarding any offerings, and information is meant to be paired directly with appropriate disclosures. Most entrepreneurs and many portals seem not to fully grasp this--offerings cannot be discussed or generally solicited off platform. You can send a tweet saying "We have an offer on this portal" but that is about it. In practical terms this means it is not possible for issuers to generate off-platform buzz or momentum around an offering.
In addition, the rules require both types of intermediaries to:
- Provide investors with educational materials;
- Take measures to reduce the risk of fraud;
- Make available information about the issuer and the offering;
- Provide communication spaces to permit discussions about offerings on the platform; and
- Facilitate the offer and sale of crowdfunded securities.
The rules prohibit funding portals from:
- Offering investment advice or making recommendations;
- Soliciting purchases, sales or offers to buy securities offered or displayed on its platform;
- Compensating promoters and others for solicitations or based on the sale of securities; and
- Holding, possessing, or handling investor funds or securities.
The SEC very clearly views the funding portals as the choke point and responsible party for regulation and compliance. In addition to these obligations, the SEC is unambiguous that they expect portals to take steps to prevent fraud by scrutinizing companies, maintain investor accounts and keep scrupulous records, disclose fees and whether they are investing, confirm investors comply with limitations, keep detailed records of fund movements (but not handle funds or securities).
Interestingly, the rules provide no requirement for nor specific provision regarding due diligence other than allowing for deal discussion spaces on the forums.
3. Company Obligations
Despite being limited to raising a maximum of just $1M across all crowdfunding platforms in any given year, companies relying on the rules are subject to very hefty disclosure requirements, many of which involve competitively sensitive and/or confidential details. The offering disclosures must be made 21 days prior to any offering and then kept up until there are no remaining crowdfunding shareholders in the company. In other words, indefinitely, unless the shareholders are bought out or the company is acquired. Required disclosure areas include:
- The pre-money valuation, target size of the raise, the maximum size of the raise, and the target close date;
- Detailed financials which must be certified by the executives if the raise is less than $500K, and reviewed by an external auditor if raise is more than $500K;
- Management's discussion of financial condition of company;
- Management's discussion of the business, its plans, and the anticipated use of proceeds;
- Details on officers, directors and 20% shareholders; and
- Disclosure of related party transactions.
In addition, the company must use a professional third party registered stock transfer agent and maintain associated records. Most importantly, the company must continue to file annual reports and continuously update their crowdfunding disclosures for so long as any crowdfunding shareholders remain. Because this is a long-standing and blanket rule, as usual a company must become a "public" reporting company under the Securities Exchange Act of 1934 once they have 500 or more investors.
Understanding the Possible Implications
This is a big departure. No one knows for sure what impact these well-intentioned regulations will have. It can take years for markets to adjust and adapt to using new methods of fundraising (take Regulation A+, for example). However, given the requirements, it is already clear that money raised using the new crowdfunding regulations will be relatively high-cost capital, which, by the nature of its formation, brings relatively low-value, from anonymous investors who may be less sophisticated, more numerous, and have less skin in the game.
When compared to traditional, exempt, private placement deals from angels or VCs, the new crowdfunding offerings bring significantly higher direct expenses: drafting, filings, financials and portal fees, plus the cost of on-going compliance and disclosure, in addition to requiring advance disclosure of sensitive information. Plus, there are some less obvious costs. Use of crowdfunding may displace the tremendous strategic value a company receives as a result of building a tight coalition of sophisticated investors with specific industry knowledge and who have the wherewithal to add more financial capital to the company in future rounds.
Protecting an entirely new class of unaccredited early-stage investors is appropriate, given the SEC's responsibilities. However, the burdens with the framework for protection may have unintended consequences. Specifically, they may unleash a negative cycle: It's possible that sophisticated investors with enough deal flow to be in a position to choose, may choose non-crowdfunded deals. Traditional deals allow a small core of networked angels to work more closely with a company to manage their risk through in-person diligence and active deal leadership.
Similarly, it is not too great a leap to surmise that companies with the best teams, markets and overall prospects would choose traditional exempt private placements over crowdfunding. This unfortunate dynamic could steadily drain the crowdfunding market of the best companies and the best investors, leaving a self-reinforcing downward spiral.
The SEC has put a lot of work and thought into these rules and done its best to strike a balance between its dual responsibilities of capital formation and the protection of investors. But those are two priorities which don't play nicely when it comes to the SEC's newest customers: crowds consisting of members of the general public. It will be interesting to watch how these changes play out. I have a hunch we are looking at a fizzle not a bang.