Share This

Crowdfunding Opportunities and Challenges

| James F. Verdonik James F. Verdonik

"Give me Technology or give me Death!"

Patrick Henry actually said "Give me Liberty or give me Death," but for twenty-first century entrepreneurs, the freedom to use technology tools to raise capital is literally often the difference between the life and death of their businesses.  For many people and businesses Descartes' "I think, therefore, I am" has changed to "I'm on the Internet and social media.  Therefore, I am."  That's because technology has changed many of the ways we do business and live our lives.  So, it's not surprising that technology is taking over how we raise capital and invest.

Now, after two decades of trying to pretend that the Internet and social media do not exist (or at least trying to keep businesses from selling securities using the Internet and social media,) the JOBS Act of 2012 is forcing the United States Securities and Exchange Commission ("SEC") to allow companies to raise capital the same way they conduct the rest of their business – by using twenty-first century communications tools. 

Although small businesses are attracted to what is now loosely called "crowdfunding," a method for raising capital through the Internet or social media, the vast opportunities crowdfunding offers are also attracting major Wall Street players like Goldman Sachs to launch crowdfunding platforms.  Initially, the biggest crowdfunding dollars are going into debt offerings as technology platforms compete with banks and other traditional lenders.  Equity crowdfunding has gotten a later start, but is becoming more commonplace.

So, how much money is flowing through crowdfunding technology platforms?  Here are some interesting crowdfunding facts and numbers from the first quarter of 2015 compiled by Crowdnetic® Corporation (www.Crowdnetic.com).

 

Period January 1, 2015 to March 31, 2015

$649 million

The amount of capital raised in crowdfunding offerings during the first quarter.

35%

Growth rate compared to $482 million raised during the last quarter of 2014.

25%

The average success rate of crowdfunding offerings.

$35 million

The biggest successful crowdfunding offering (used to finance building a 15 story office building).

Real estate and financial investments

The largest crowdfunding industry measured by amount of capital raised.

Technology

The industry with the largest number of offerings.

California

State with the most crowdfunding offerings.

New York

State with highest average amount raised per successful crowdfunding offering.

62%

Percentage of crowdfunding offerings that sold equity securities.

These facts show that the crowdfunding party is:

  • Big;
  • Growing exponentially bigger each quarter; and,
  • Open to all types of entrepreneurs and investors.

But you can't enjoy the party if you ignore it.  The statistics also show the Southeastern United States is lagging behind.  We in the Southeast have a lot of education to do before we can catch up.

Let's start moving up the learning curve now.

What is Crowdfunding?

In its broadest sense, crowdfunding is a way to use technology to raise funds for a business, a project, or a cause.  Instead of dealing with a financial institution or specific investors or donors, the company, non-profit organization, or individual tries to raise money from a worldwide "crowd."

Some crowdfunding campaigns sell securities.  Other crowdfunding campaigns solicit donations and pre-orders.  This article focuses on the rules that apply to crowdfunding campaigns that:

  • Limit issuers to offering and selling securities only in an offering registered with the SEC or in an offering that satisfies the requirements of an exemption from registration. 
  • Forbid issuers from misstating material facts or omitting material facts if the omission would make something else the issuer tells investors misleading to the investors.

For the most part, crowdfunding laws focus on the first principle.  These laws create new exemptions that allow issuers to make general solicitations without having to register the offering with the SEC.  Some crowdfunding exemptions permit issuers to sell securities to non-accredited investors, but other crowdfunding exemptions allow issuers to sell securities only to accredited investors.  "Accredited investors" include people who have a net worth of $1 million or more (not including their primary residence) or, generally, a $200,000 annual income (or, if married, a combined marital income of $300,000) for the last two years with a reasonable expectation of reaching the same income level in the then-current year. 

Much crowdfunding publicity has focused on non-accredited investors, but accredited investors usually supply the most capital simply because they have more money to invest.  So, choosing an exemption because it allows sales to non-accredited investors often does not substantially increase the amount of capital raised.  The primary exception would be if the offering is especially appealing to a demographic group that includes few accredited investors.

These new exemptions are important because they will democratize the capital-raising process by allowing more types of businesses to communicate with many more investors and different kinds of investors. 

While the crowdfunding laws have created changes related to the first principle of securities law, the second principle, requiring accurate disclosure, has always been the rule and has not changed.  Any crowdfunding offering will violate the second principle of the securities laws if the offering includes a misstatement of any material fact or if the offering omits any fact that will make any other disclosure to investors misleading.

Five Types of Crowdfunding under Securities Laws

There are five basic legal pathways that issuers can take to use crowdfunding to advertise and conduct general solicitations (or what may look like a general solicitation) to let the world know that the issuer is raising capital without  the very expensive and time-consuming process of registering the offering with the SEC and state securities regulators.  Some of these pathways are currently available.  Others are still under construction.  Here's a summary of their status:

  • SEC Rule 506(c) authorizes advertising and general solicitations to verified accredited investors only.  It became effective in 2013.  Rule 506(c) allows an unlimited amount of capital to be raised, affords great flexibility in how disclosures are made to investors, and does not require the filing of the disclosures with the SEC.  Rule 506(c) also pre-empts state securities registration laws and affords issuers the best liability protection.  For these reasons, most crowdfunding offerings use Rule 506(c).
  • SEC Rule 506(b) allows offerings to be conducted on the same technology platforms that also facilitate Rule 506(c) offerings.  If a broker-dealer who operates the platform has "pre-qualified" the accredited investors (who must have password restricted access to the part of the platform that facilitates the Rule 506(b) offering), a Rule 506(b) offering technically is not a general solicitation.  But to casual observers, it may look like any Rule 506(c) offerings made using the same platform.
  • SEC Regulation A+ allows up to $50 million per year to be raised using advertising and a general solicitation to both accredited and non-accredited investors if specified disclosure rules are followed and the offering documents are reviewed by the SEC.  Some Regulation A+ offerings also preempt state registration laws.  Regulation A+ became effective in June, 2015.
  • SEC crowdfunding rules authorized by Title III of the JOBS Act create a highly regulated and expensive offering environment for raising up to $1 million during any 12-month period with limits on how much each investor is allowed to invest.  The SEC's final rules become effective in May, 2016.
  • State crowdfunding laws that exempt offerings from state securities registration laws and allow general solicitations to be made within the state and sales to non-accredited investors.  The amount of capital that can be raised (usually $1 million to $2 million) and what has to be disclosed to investors varies from one state to another.  Compliance with any SEC rule that permits general solicitations and sales to non-accredited investors is also required.  Most state crowdfunding laws were written to be used with the federal exemption for intrastate offerings (including SEC Rule 147), although some states are writing laws that combine with the less restrictive SEC Rule 504.  On October 30, 2015, the SEC proposed amendments to both Rule 147 and Rule 504 that will make it easier for issuers to use both rules in conjunction with state crowdfunding laws.

The Arguments of Crowdfunding Critics and Supporters

Critics of crowdfunding often say that the general public is too inexperienced and naïve to understand investments, and that new businesses lack experience and resources to comply with securities law disclosure requirements.

Supporters of crowdfunding argue that it will enhance transparency by taking capital-raising out of the shadows and putting it on the Internet where everyone can see what businesses are telling investors, and that members of the crowd of investors will protect one another by openly sharing their views about offerings.  These members of the "crowd" who can openly comment will include experienced investors, inexperienced investors, Wall Street professional advisers, and securities regulators.

This difference of opinions about crowdfunding raises three basic questions about the many securities law changes created by the crowdfunding provisions of the JOBS Act of 2012:

  • Is crowdfunding the best thing to happen to young and growing businesses since the Internet was invented?  Some people think crowdfunding will change the world by opening capital-raising doors wide to many types of new businesses that were never able to raise capital before;
  • Is crowdfunding more like a hastily assembled firecracker that will blow up in the faces of both investors and businesses?  Some people think crowdfunding will open the doors to massive securities fraud;
  • If crowdfunding is both an opportunity and a challenge, how do you end up a winner instead of a loser? 

Different issuers and investors are likely to have vastly different experiences with crowdfunding.  At one end of the bell curve, some investors will lose money in fraudulent schemes.  Other offerings will include unintentional failures to make all the disclosures securities laws require.  The middle of the bell curve will be filled with issuers and investors who will make modest profits or lose money in offerings that do not violate securities laws in any way.

If business was easy, everyone would be rich.  There are no guaranteed safe investments in private businesses.  At the success end of the bell curve, some issuers and investors will become big winners.

The SEC's Opposition to Crowdfunding

To understand how the new crowdfunding rules work, it is helpful to understand one basic fact:  the SEC has steadfastly opposed crowdfunding.  The SEC is only issuing crowdfunding rules because the JOBS Act required it to do so.  When there is an unwilling regulator, implementation is delayed, the regulator often puts roadblocks in the way of people who want to use the new rules, and the regulator will be hyper-vigilant in pursuing any colorable violation to "prove" that it was correct in opposing the new program.

It's clear why the SEC has opposed crowdfunding.  Crowdfunding creates a new type of securities offering that can best be described as "Public Private Placements" because they undermine a fundamental principle of securities laws as administered by the SEC for the better part of a century – the wall between registered public offerings and private placements that are exempt from registration.  The JOBS Act was no mere tinkering on the edges of securities rules.  Its crowdfunding provisions were the equivalent of President Ronald Reagan standing in Berlin shouting:  "Mr. Gorbachev tear down that wall!"

Exploring the SEC's wall between registered public offerings and private placements will aid in an understanding of the new freedom created by tearing down the SEC's wall between registered public offerings and private placements.

Why Does the SEC Favor Registered Public Offerings?

The SEC favors registered public offerings over private placements because securities laws set specific standards for public offerings that do not apply to private placements and make it much easier for investors who sue an issuer to recover damages if the issuer fails to make all required disclosures.  For example:

  • In registered public offerings, investors who are not given the required disclosures in the registration statement can sue for violation of Section 11 of the Securities Act of 1933 which creates liability for any misstatement or misleading omission of material fact whether or not the misstatement was intentional or negligent.  However, the misstatement or misleading omission has to be in a registration statement and there is no registration statement in a private placement.
  • In exempt offerings other than those pursuant to Section 4(2) of the Securities Act or SEC Rule 506 (and if misstatements or misleading omissions occur outside the registration statement in a registered public offering), investors who are not given the required disclosures can only sue for violation of Section 12(a)(2) of the Securities Act of 1933 which creates liability only for negligent misstatements or misleading omissions of material facts.
  • In private placements exempt from registration by reason of Section 4(2) of the Securities Act or SEC Rule 506, investors who are not given the required disclosures can only sue for violation of Section 10 of the Securities Exchange Act of 1934 and SEC Rule 10b-5, both of which require either knowledge or recklessness by the issuer and not mere negligence to create liability.

While all three provisions prohibit issuers from misrepresenting material facts or failing to disclose material facts if the omission will cause other disclosed material statements to be misleading, they create very different burdens of proof and defenses.  Plaintiffs have a much easier case to prove if they are suing for a violation of Section 11 of the Securities Act than if they are suing for a violation of either Section 12 of the Securities Act or Section 10 (b) of the Securities Exchange Act of 1934, and the seemingly small distinctions create very big differences in liability risk and in what issuers must do to protect themselves when they sell securities. 

The Rule 506 crowdfunding exemption from registration will provide the lowest liability risks for issuers.  Since the Rule 506(c) crowdfunding provisions allow general solicitations to verified accredited investors, issuers are now allowed to conduct offerings that are similar to a registered public offering without the liability risk entailed in a registered public offering.  Since the liability risk is much lower, legal fees and other offering expenses will also be generally much lower for Rule 506(c) offerings.

Summary

Despite the open hostility of the SEC and its foot-dragging in writing rules and regulations, crowdfunding is becoming an ever more popular way for small and medium-sized businesses to fund operations.  Rule 506(c) offerings have become the most popular form of crowdfunding, because the Rule:

  • Allows issuers to conduct a general solicitation;
  • Allows issuers to use inexpensive Internet and social media communications tools;
  • Has lower liability risk, which usually results in lower legal fees; and,
  • Preempts state registration laws.

--
© 2016 Ward and Smith, P.A. For further information regarding the issues described above, please contact James F. Verdonik.

This article is not intended to give, and should not be relied upon for, legal advice in any particular circumstance or fact situation. No action should be taken in reliance upon the information contained in this article without obtaining the advice of an attorney.

We are your established legal network with offices in Asheville, Greenville, New Bern, Raleigh, and Wilmington, NC.