On May 16, 2016, the much-anticipated SEC rule commonly known as “Regulation Crowdfunding” went into effect, providing you with a potential new source of capital in a time where it is harder to find. The law creates a framework for equity crowdfunding, which is a method by which a private company sells equity to the general public through the Internet. Generally speaking, this has been either illegal or impossible for growing businesses until now. With this practice now legal, you should be aware of the potential costs and benefits to your business in determining if it is the right way for you to raise money.
Prior to 2012, crowdfunding was solely done on a donation basis because the Depression-era legal framework prevented the sale of private equity in such a manner. However, the rapid growth of donation crowdfunding prompted Congress to address equity crowdfunding, resulting in the 2012 passage of the JOBS Act (Jumpstart Our Business Startups Act).
That Act created three avenues of crowdfunding: Regulation A, Rule 506(c), and Regulation Crowdfunding. Regulation A is a vastly complicated and expensive process with caps on money that can be raised, so it is only recommended for established companies. Rule 506(c) allows for the public solicitation of “accredited investors,” or investors that make over $200,000 per year, and has no cap on the amount that can be raised. This is highly advantageous for a business. However, companies are pre-screened by crowdfunding websites and only a select few get access to investors. In practice, Rule 506(c) does not really solve the access problem for businesses: only the strongest or best connected will get an audience with the accredited investors.
Regulation Crowdfunding changes that by allowing you to generally solicit up to $1 million annual investment from the general public, so long as it is done through a licensed crowdfunding website. This allows all investors and all businesses to get into the game. However, there are legal issues to be wary of. You must make significant disclosures, including the identities of the owners/directors, financial statements that have been reviewed or audited depending on the size of the offering, business and shareholder risks, and anything else that an investor would need to know. This reporting requirement is ongoing – you must file documents with the SEC and post them publicly annually. Next, the owner, officers, and directors could all potentially be personally liable for misinformation or omissions. Finally, you must be careful not to advertise the sale until it begins on the crowdfunding website, and any advertisements thereafter should be limited to the terms of the offer and the website address (no marketing fluff). The following are some key factors to inform your cost benefit analysis:
- Easier access to capital
- Public exposure for the business
- Ability to dictate the terms of the sale without negotiation
- Public disclosures of financial information and ownership identifying information to public
- Ongoing reporting to SEC
- Large amount of shareholders to manage
- Structural mistake that makes the business unattractive to later investors
- Disclosure of business model and intellectual property to public
- Personal liability
In making the requisite disclosures prior to the transaction, you must be careful not to disclose potential trade secrets or patentable information, so as to ensure that you can protect your intellectual property at a later date. This can be difficult, since investors will be more likely to invest in businesses that can display a strong intellectual property portfolio. Moreover, you and your key associates must be very thorough in making disclosures so as to not trigger the personal liability.
You also must also take affirmative steps to protect your capital structure by ensuring that your relationship with new shareholders does not become burdensome to operations, or make the business unattractive to subsequent investors who likely will not invest on the same playing field as the general public.
These issues can be complex, but the benefits to your business are enormous, particularly as a tool for seed or bridge financing. If you decide that crowdfunding would benefit your business, you should consult with an attorney that is knowledgeable in both the relevant crowdfunding laws and general corporate law.