On November 2nd, 2020 the SEC voted 3-2 to approve long-awaited rule changes to the exempt offering framework in the securities regulations. This includes significant changes to Regulation Crowdfunding designed to make online crowdfunding more attractive to both investors and issuers.
Most Notable Changes:
● You can raise more money through regulation Crowdfunding than you could previously.
● You are now allowed to gauge interest before setting up an offering by “testing the
waters.”
● Investors are allowed to invest more money each year.
Here is the backstory:
● When someone is offering people the opportunity to invest in their business, they are selling a security. They are called an issuer.
● Under the securities laws, issuers must either register these securities on a stock exchange (i.e. an IPO) or find an exemption from registration. Otherwise, they are breaking the law. You should not send someone a budget and pitch deck or business plan and ask them to invest, you may be breaking the law without realizing it.
● There are several exemptions to the securities laws, however, potential issuers are
discouraged by complexity, costs, or the lack of a network (many exemptions effectively require a “pre-existing relationship” with wealthy individuals).
● This traditional exemption framework resulted in over 90% of small businesses being self-funded on the personal credit of the entrepreneur (i.e. second mortgage, credit card, etc.). However, for many entrepreneurs this is not an option.
● Recognizing that these legal barriers reduced access to capital for many entrepreneurs, especially those without wealthy friends, Congress passed the JOBS Act of 2013. This led the SEC to adopt Rule 506(c) and Regulation Crowdfunding, which allowed issuers to legally sell securities to strangers online, as long as they followed certain rules.
● In March of 2020, the SEC released proposed changes to further improve the accessibility and functionality of exempt offerings, while still offering sufficient investor protection. On November 2nd 2020, the SEC officially voted to adopt Final Rules to accomplish that goal, referred to below as the new rules.
While these final rules changed several exempt offering types, this blog post will focus exclusively on the changes to Regulation Crowdfunding. Regulation Crowdfunding allows anyone, no matter their income or net worth, to invest in offerings through a registered Funding Portal, like Common Owner CF LLC.
The most substantial changes to Regulation Crowdfunding are to the offering and investment limits.
Offering Limits
From its adoption in 2015 until now (i.e. under the old rules), issuers were limited to raising $1 million per year (adjusted to $1.07 million for inflation) in Regulation Crowdfunding offerings per year. The amendments adopted in November 2020 raise the maximum offering amount per issuer (including affiliates) from $1.07 million per year to $5 million per year.
Investment Limits
Under the old rules, investors who had an annual income or net worth of less than $107,000 in Regulation Crowdfunding offerings were limited to investing either a $2,200 floor or 5% of the lesser of their income or net worth (whichever was greater). For example, an investor with a net worth of negative $50,000 (due to liabilities like student loans) and annual income of $70,000 would be limited to a negative amount, but could still invest the $2,200 under the old rules. If they had a net worth of positive $50,000 and an annual income of $80,000 they would be limited to $2,500 (5% of $50,000).
Under the old rules for those with an income or net worth of greater than $107,000, they could invest 10% of the lesser of their income or net worth. For example, someone with an annual income of $150,000 and a net worth of $200,000 could invest $15,000 per year. This limitation included accredited investors, which for individuals means over $200,000 in single income, or $300,000 in joint married income or $1 million net worth.
The new rules significantly change these limits and requirements.
First, accredited investors can now invest unlimited amounts in Regulation Crowdfunding offerings (as they can in most other offerings). Non-accredited investors can now invest the greater of the applicable percentage (5% or 10%) of their income or net worth, rather than the lesser of their income or net worth.
In the first example above, with the negative $50,000 net worth and $70,000 annual income, that person could now invest $3,500 per year instead of the $2,200 floor. In the second example, that person could now invest $20,000 rather than $15,000.
Unlike certain other exempt offerings, Issuers in Regulation Crowdfunding offerings are not required to verify that investors are accredited unless the issuer has a reason to believe the investor’s representation that they are accredited is false.
Eligibility for Regulation Crowdfunding
While many companies can be Regulation Crowdfunding issuers, under the old rules investment companies were prohibited from conducting Regulation Crowdfunding offerings. This means an entity created to invest in one or more other underlying or portfolio companies could not conduct a Regulation Crowdfunding offering. This has caused issues for many entrepreneurs, where having a large number of investors directly in an “operating company” can create administrative and financing challenges.
In response to this issue the amendments adopted by the SEC will allow for the creation of “Crowdfunding Vehicles,” through a new rule under the Investment Company Act.
A Crowdfunding Vehicle is a company that acts exclusively as an investment conduit for an underlying crowdfunding issuer. A crowdfunding vehicle is very limited in its permitted activities (acquiring, holding, and disposing of crowdfunding issuer securities) and the type of compensation it can receive. The crowdfunding vehicle and crowdfunding issuer are technically “co-issuers” under Regulation Crowdfunding and they will jointly file a Form C with the SEC. If there is a liquidity event (i.e. a sale) of the crowdfunding issuer, it is required to redeem or offer to repurchase the securities owned by the crowdfunding vehicle. The crowdfunding issuer must bear the costs of the crowdfunding vehicle. The crowdfunding vehicle can engage a third party (such as a funding portal) to handle the burden of communicating with investors regarding votes and for other administrative matters.
Financial Statements
In response to COVID-19, the SEC adopted temporary amendments to the Financial Statement requirements for issuers in Regulation Crowdfunding Offerings, which among other changes, exempted issuers raising up to $250,000 from the requirement for reviewed financial statements. Reviewed financial statements can be a significant additional expense for small businesses.
The new rules extend the temporary rule an additional 18 months so they apply to offerings initiated prior to August 29, 2022. Such issuers will still need to provide financial statements and certain tax return information, but this information will not need to be reviewed by an independent CPA.
Notably, if the issuer has reviewed or audited financial statements (for other
reasons) they must be provided and issuers taking advantage of this extended provision must include a prominent disclosure notifying investors that the financials were not reviewed by an independent CPA.
Offerings between $535,000 up to $5 million will continue to require audited financial statements.
Test the Waters
Under the old rules, issuers conducting Regulation Crowdfunding Offerings were not allowed to discuss the offering with potential investors prior to its commencement. The new rules include a “testing the waters” provision, which allows issuers to discuss their regulation Crowdfunding offering before it is open for investment, however these communications must state:
- No money or other consideration is being solicited, and if sent, will not be accepted;
- No offer to buy the securities can be accepted and no part of the purchase price can be received until the offering statement is filed and only through an intermediary’s platform; and
- a prospective purchaser’s indication of interest is non-binding.
Further, these materials are subject to the anti-fraud provisions of the securities laws. Issuers must include these “testing the waters” materials with the Form C filed with the SEC (which remain publicly available). Once the Form C is filed and the offering commences, all offering communications must comply with Regulation Crowdfunding (including Rule 204 advertising restrictions). The SEC believes these changes will allow investors “to have input into the structuring of the offering and convey to the issuer the types of information about which they are most interested.”
Effectively, this will help early-stage issuers value their companies so they do not give away too much equity or fail to have a successful raise because they were too aggressive.
Regulation Crowdfunding Communications
Under the old rules (which are notably still in effect until around year end), issuers relying on Regulation Crowdfunding were not allowed to orally discuss the offering with prospective investors, as all communications were required to go through the crowdfunding platform.
The new rules will allow issuers to orally discuss the offerings, as long as the advertising requirements of Rule 204 (which specifically sets forth what issuers are allowed to communicate about the offering) are met, except for the need to provide a link to the platform (which is excluded).
Additionally, the Issuer now may provide (1) A brief description of the planned use of
proceeds of the offering; and (2) Information on the issuer’s progress toward meeting its funding goals. Lastly, if the Regulation Crowdfunding Issuer is conducting a ‘concurrent offering’ under another exemption (like Rule 506(c)), the Issuer can provide information about the Regulation Crowdfunding offering in the offering documents for that concurrent offering (however, a link to the Regulation Crowdfunding offering must be provided).
It is impossible to know what kind of impact the new rules will ultimately have on the utilization of Regulation Crowdfunding, which has lagged behind other types of exempt offerings to this point. However, the amendments are carefully crafted to address certain pain points that have emerged in the equity crowdfunding space in recent years.
For example, many issuers were conducting “concurrent” Regulation Crowdfunding and Rule 506(c) offerings so that accredited investors could invest more than the $107,000 maximum. The elimination of limits on accredited investors in Regulation Crowdfunding offerings significantly reduces this need. Similarly, many potential issuers were deterred by the administrative complexity and perceived financial
challenges from having a large number of crowdfunded investors through two simultaneous offerings. The crowdfunding vehicle amendment is designed to address these challenges, while maintaining protections for investors.
The thoughtful and careful amendments should increase the issuance of equity offerings available to non-accredited investors, democratizing the ownership of small businesses and real estate. Hopefully this will lead to a broader understanding and acceptance of the equity crowdfunding space, resulting in more successful offerings. Crucially, the SEC has managed to do this while maintaining a high degree of investor protections.
If you have any questions about equity (or debt) crowdfunding, feel free to reach out to us at [email protected] or (716) 249-4223.