The concept of “crowdfunding” offers a new option to startups and small businesses for raising capital, although it is a greatly misunderstood and misused term. It refers to the pooling of money from a crowd for the funding of a project or venture, whether utilizing a donation model, reward model, royalty model, debt model or equity model. Securities laws apply when equity or debt securities are offered.
Title III of the JOBS Act added a new Section 4(a)(6) to the Securities Act, which provides an exemption from the registration of such securities provided the issuer complies with certain rules and restrictions. To implement this amendment, federal crowdfunding rules were enacted by the SEC on October 30, 2015 as Regulation Crowdfunding. The rules are expected to become effective on May 16, 2016.
The federal rules, which apply when securities are sold in interstate transactions, provide that (i) the offering must be an “all-or-none” offering (meaning that the entire amount offered must be raised or else the raise “fails” and all subscriptions must be returned to investors), (ii) the aggregate amount sold by an issuer to all investors in any 12-month period may not exceed $1,000,000, (iii) offering activities must occur through a registered broker-dealer or a new type of platform that must also be registered with the SEC and known as a “funding portal”, and (iv) issuers may only communicate with investors through communication channels provided by the funding portal or a broker-dealer. Investors in the offering do not have to be accredited investors; however, the maximum amount any one investor can invest in crowdfunding offerings in any 12-month period cannot exceed the following:
- the greater of $2,000 or 5% of the lesser of the annual income or net worth of the investor, if either the annual income or the net worth of such investor is less than $100,000;
- 10% of the lesser of the annual income or net worth of the investor, but not to exceed $100,000, if both the annual income and net worth of the investor is equal to or greater than $100,000.
Additionally, there are specific requirements with respect to the financial statements for an issuer choosing to sell its securities pursuant to Regulation Crowdfunding, including that all financial statements must be prepared in accordance with generally accepted accounting principles (“GAAP”).
There are also restrictions on the resale of securities sold via crowdfunding. They cannot be transferred by an investor for one year from the date of purchase, except for transfers to the issuer of the securities, an accredited investor, a family member of the investor or in estate type transfers, and third parties in a registered offering.
The rules also provide for ongoing reporting obligations for issuers, including filing with the SEC and providing to investors certain annual and periodic reports, progress updates on the offering and a notice of termination of the offering.
Intrastate crowdfunding, which is raising money through crowdfunding solely within one state, is governed by the crowdfunding rules of the state in which the securities are sold. The Securities Act permits offerings of securities that are not registered with the SEC so long as the securities are only offered to the residents of a single state by an issuer that is registered and doing business in that state. All intrastate offerings must comply with the applicable state registration and offering requirements, which vary from state to state.
Crowdfunding, whether interstate or intrastate, may work for smaller operating companies and startups, but may not be ideal for many issuers involved in real estate acquisition and development. The $1,000,000 cap (which cap is $2,000,000 in some states for intrastate offerings, including Virginia) significantly limits the real estate assets that an issuer can acquire utilizing equity raised through crowdfunding unless utilized simultaneously with some other offering vehicle pursuant to a permitted exemption. Any use of concurrent offerings would need to first be fully assessed to determine that there are no issues with integration of the concurrent offerings causing them to run afoul of securities laws.
Additionally, although the pool of potential investors may be greater since the offering is not limited to accredited investors (or a limited number of unaccredited investors) as required by private offering exemptions, the amount each investor can invest in the offering is capped, meaning that the issuer will need to reach a larger number of investors and process a greater number of subscriptions potentially resulting in increased marketing and administrative costs for the issuer.