Equity Crowdfunding is a Reality

As those of you who follow my posts are aware, I have published several articles regarding the concept of “equity crowdfunding” from back in 2012 when equity crowdfunding was first mandated by the Jumpstart Our Business Startups Act (“JOBS Act”), then again in October 2013 when the US Securities and Exchange Commission (“SEC”) released its proposed crowdfunding regulations, and again in December, 2015 when the final Regulation Crowdfunding (“Regulation CF”) was adopted by the SEC, and finally when those crowdfunding regulations became effective on May 16, 2016.

We have already seen various donation-based crowdfunding sites (charitable) and product-based crowdfunding sites (you get a free product being developed or perhaps just a model of the product). In addition, some states have passed regulations allowing equity crowdfunding within their borders. However, as of May, 2016, we now have a national based SEC regulation in place.

In July, 2017 I was the luncheon speaker at the Sacramento County Bar Association’s Business Law Section in which I provided an update on equity crowdfunding and some other recent changes in federal securities laws.

Set forth below is a summary of how the new Regulation Crowdfunding is working as well as the other recent amendments to securities regulations.

Regulation Crowdfunding Offerings

In researching how equity crowdfunding was doing so far, I found the following interesting aspects.

Funding Portals

As you are aware, equity crowdfunding can only be conducted through “funding portals” which must register with the SEC pursuant to Subpart D of Regulation CF and are monitored by the Financial Industry Regulatory Authority (“FINRA”).

1. Currently 29 Funding Portals are registered with the SEC, the most popular being “Wefunder.com” which has hosted approx. a third of all crowdfunding offerings to date. The other registered portals at the present time, as published by FINRA, are:

2. A Funding Portal will charge between 4% – 10% of proceeds raised. Some will also charge the investor a small percentage, (typically less than 1%) for a processing fee

3. I often wondered what Funding Portal would want to be exposed to the “gatekeeper” liability, but the SEC has signaled that Funding Portals are only responsible for making sure issuers have filed their Form C and have prepared a document covering the Rule 201 disclosure items. These Portals are not required to determine whether such disclosure is true or false or even if the disclosure is full and fair.

4. Late last year FINRA brought its first enforcement action against a funding portal called uFunding Portal (“UFP”). FINRA found that UFP was not verifying that listed issuers were filing their Form C with the SEC or that listed issuers had prepared the required disclosure document pursuant to Rule 201.

Number and Type of Offerings

1. As of the end of 2016, approx. 152 issuers had filed Form C to commence a Crowdfunding Offering. Most common business type was 45 technology companies (27 of which were from Silicon Valley companies) followed by retail business (16), breweries, (my favorite) (13), and entertainment, real estate development, education, restaurants, and recreational industries rounding out the business types.
2. Issuers are very young companies with minimal assets. 60% of issuers were less than a year old and another 25% were less than 5 years in existence. 70% of the issuers had less than $100,000 in assets.
3. Most securities offered were either common stock or SAFE’s (Simple Agreement for Future Equity). {A SAFE is like a convertible note; investor gets future SAFE preferred stock (w/liquidation preference) but issuer doesn’t have to record the SAFE as debt.}
4. Most issuers are apparently using the “do-it-yourself” method of preparing documents for the Crowdfunding Offering. While I believed securities counsel and accountants would be invaluable to crowdfunding issuer’s, such is NOT the case with most issuer’s incurring minimal legal and accounting fees.
5. As of the end of 2016, just over one half of all crowdfunding offerings hit their funding goals.
6. While Funding Portals might have reduced liability, Officers and Directors of the Issuer have heighted liability under §4(A)(c) of the Securities Act of 1933. Unlike typical securities claims that require a plaintiff to establish scienter, causation and reliance, under §4(A)(c), a plaintiff need only allege materiality, privity and compliance with the statute of limitations in a lawsuit against an issuer after which the burden of proof shifts to the defendant to show an absence of scienter, causation and reliance.

Number and Types of Investors

1. Investors so far have been overwhelmingly from California and Texas.
2. The typical crowdfunding offering consisted of average individual investments of $833 raised from approx. 300 investors.
3. Average money raised is $226,000. On average it has taken 45 days for each successful offering to reach its minimum target amount with the total offering period averaging about 122 days.
4. Marketing of a company’s crowdfunding offering seems to be the major challenge as companies are expected to convert their existing customers and followers to investors by using their mailing lists and social media presence to get the word out.

Rule 147 and New Rule 147A

Rule 147 is the “safe harbor” rule for the Securities Act §3(a)(11) exemption for intrastate offerings. Effective April 20, 2017, the SEC has made changes to liberalize the intrastate exemption.

1. The “doing business within a State” requirement has been changed from having a company’s “principal office” within the State to having the company’s “principal place of business” within the State. “Principal place of business” is defined as: location where officers or managers primarily direct and control activities of the issuer.

2. Rule 147 also required:

• 80% of revenues from within the State;
• 80% of assets located within the State; and
• 80% of proceeds to be used within the State.

Revised Rule 147 only requires the issuer to meet one of the 80% tests.

3. Prior Rule 147 exemption was blown if even one investor was not a resident of the State, even if an investor lied about his/her residency. Revised Rule 147 now only requires the issuer to have a “reasonable belief” that each investor was a resident of the State. Presumably a proper Subscription Agreement and Investor Questionnaire would satisfy the “reasonable belief” standard.

4. Prior Rule 147 required that shares sold in an intrastate offering had to “come to rest” within the State with “coming to rest” defined as held by the investor for at least 9 months. Revised Rule 147 shortens the “coming to rest” period to 6 months.

5. Prior Rule 147 required the issuer to provide the resale limitations “in writing” to every offeree, which presented a potential problem with online or verbal offers. Revised Rule 147 only requires resale restrictions to be “disclosed” to offerees, with “written” limitations only required to be given to actual purchasers.

In addition, new Rule 147A has been adopted which pretty much makes Rule 147 superfluous. Rule 147A was adopted under the SEC’s general exemptive powers under §28 of the Securities Act. Rule 147A not only includes all the revisions to Rule 147 listed above but adds:

1. The issuer no longer needs to be incorporated or formed in the State; and
2. Rule 147 required the issuer to “limit” its offers to within the State. Rule 147A allows offers to be made outside the State so long has purchasers are only residents of the State.
3. I think the SEC kept Rule 147 simply to provide a safe harbor for §3(a)(11) of the Securities Act, elsewise there would no longer be a way to effectuate the long standing §3(a)(11) exemption.

Further Changes to Regulation D

1. Effective as of January 20, 2017, the maximum offering limit for Rule 504 offerings was raised from $1mil to $5mil.
2. Effective as of May 22, 2017, Rule 505 was removed from Regulation D.

Final Thoughts

Seems to me that between the US Congress and the SEC itself, the jurisdiction of the SEC over securities offerings is receding, leaving the States and aggrieved investors to fend for themselves.

The explicit intent of Congress with the JOBS Act was to give all businesses, particularly small businesses, easier access to investor capital (ie more exempt offerings) and rely on Federal and State anti-fraud provisions when it turns out an issuer lied to or cheated investors. The reasoning here should come as no surprise because small companies represent the vast majority of new and existing jobs in the US. Hence, helping the creation and financing of new businesses with the expectation that new jobs will be created is the driving force in these congressionally mandated changes.

Feel free to give us a call to discuss equity crowdfunding as this new, innovative funding opportunity is built specifically for new and start-up companies.

Article by Roger D. Linn © Barnett & Linn