The SEC has adopted final rules permitting equity crowdfunding under Title III of the Jumpstart Our Business Startups (JOBS) Act of 2012. The new rules allow certain nonpublic companies to raise up to $1 million during any 12-month period — from all types of investors — through Internet-based crowdfunding offerings.
Many growing companies view crowdfunding as an alternative to an initial public offering (IPO): It allows them to expand the pool of potential investors beyond that of traditional private placements, without the complexity and expense of an IPO. But the new rules impose significant restrictions and disclosure requirements, which should be considered carefully before choosing this strategy over an IPO. Given the limitations of crowdfunding, it’s uncertain whether it will live up to the hype.
Beginning on May 16, 2016, crowdfunding will be available to most U.S. companies that are not reporting companies under the Securities Exchange Act of 1934 — in other words, private companies. It won’t be available to foreign issuers, certain investment companies and companies that have been disqualified as “bad actors.” In addition, companies that take advantage of crowdfunding but fail to comply with annual reporting requirements will be disqualified from additional crowdfunding offerings for two years.
Also ineligible are companies that lack a specific business plan or have indicated that their business plan is to engage in a merger or acquisition with an unidentified company or companies.
Advantages and disadvantages
The primary advantage of crowdfunding is that it allows private companies to solicit all types of equity investors without registering the offering with the SEC or under state “Blue Sky” laws. Unlike other types of private placements, an issuer doesn’t have to restrict its offering to accredited investors who meet certain net worth or income requirements (subject to investment limits).
The ability to sell securities to anyone over the Internet is a big benefit, but crowdfunding also has several disadvantages, including:
Investment limits. The amount a company can raise through crowdfunding is limited to an aggregate of $1 million in any 12-month period, far less than other options. For example, companies can raise up to $50 million in a “mini-IPO” under Regulation A, or an unlimited amount from accredited investors in a placement under Rule 506 of Regulation D.
In addition, to protect unsophisticated investors, the crowdfunding regulations limit the amount an individual can invest. (See “Crowdfunding investment limits.”)
Reporting and disclosure requirements. A company must file:
- A detailed offering statement with the SEC providing information about the company, offering and planned use of the proceeds,
- Financial statements (although audited statements aren’t required for certain small or first-time offerings), Amendments in the event of material changes,
- Progress updates, and
- Annual reports that must also be posted to the company’s website.
These filings are required until the company goes public or certain other terminating events occur. In contrast, private placements involve little or no ongoing reporting. They also avoid the need to publish annual reports.
Intermediary required. Crowdfunding offerings must be conducted exclusively through an Internet-based platform managed by a single, SEC-registered intermediary — either a broker-dealer or “funding portal” — that meets certain requirements.
Limited advertising. A company isn’t permitted to advertise the terms of a crowdfunding offering, with the exception of “tombstone ads” that direct investors to the broker-dealer or funding portal.
Restricted stock. Securities purchased in a crowdfunding transaction can’t be resold for one year. (Similar restrictions apply to private placements but not to mini-IPOs.)
Cancellation. If the target offering amount isn’t met by the deadline set in the offering statement, the offering must be canceled and the funds returned to investors. Also, investors have the unconditional right to cancel their commitments up until 48 hours before the offering deadline.
Weighing the options
Crowdfunding allows a company to reach a wide audience of small investors, but this flexibility comes at a steep cost. Although the disclosure and reporting requirements are less stringent than those associated with IPOs, for many growing companies the $1 million fundraising limit may not justify the expense and lack of privacy.
Other private placement options allow companies to raise more capital without the need for reviewed or audited financial statements, publicly disclosed annual reports or ongoing reporting obligations. And for companies that are comfortable with a greater level of public disclosure, it makes more sense to conduct a mini-IPO or a full-fledged IPO.
Crowdfunding investment limits
Companies that use crowdfunding to raise capital may sell their securities to any type of investor. There’s no requirement to ensure that investors are accredited or financially sophisticated. To protect investors, crowdfunding regulations limit the aggregate amount an individual can invest in crowdfunding offerings (across all issuers) as follows:
|Type of investor
||Investment limit over a 12-month period
|Annual income or net worth (excluding primary residence) is less than $100,000.
||The greater of 1) $2,000 or 2) 5% of the lesser of annual income or net worth.
|Annual income or net worth (excluding primary residence) is $100,000 or more.
||10% of the lesser of annual income or net worth, up to a maximum of $100,000.