What You Should Know About the New Equity Crowdfunding Rules

equity crowdfundingFINALLY!!!  After years of waiting for equity-based crowdfunding rules (aka Reg CF) to be adopted and put into effect following legislative approval of the JOBS Act of 2012, it’s finally here (effective May 16, 2016).  So should you stand on top of your roof and heed the battle cry to all of your fellow entrepreneurs?  Well, not so fast.

I think you should “double click” on the final regulation to know what you would be advocating.  I’m not sure it’s for everyone and certainly it is not for every situation.  In this article I’ll attempt to demystify at least the basics.

Would you believe the final ruling by the US Securities and Exchange Commission (SEC) for this particular aspect of the JOBS act took 685 pages to communicate everything?  You can download it here but if much time has gone by since its original effective date (May 16, 2016), you should search the SEC website to see if there is a more recent version or additional clarifications – especially if you’re a startup destined for an equity crowdfunding campaign or an investor thinking about using this new instrument.

The document I’m referring to specifically relates to Title III of the JOBS Act and is more commonly referred to as Reg CF or “Regulation Crowdfunding“.  It is intended to support private, equity-based investments by non-accredited investors.  I mention this because previously the SEC ratified rules for other forms of equity-based crowdfunding.

Highlights

  • Issuing companies can raise up to $1M in a 12-month period through a crowdfunding style campaign.
  • Equity in the company can be sold, compared to other popular crowdfunding campaigns in which a physical product or service is essentially pre-sold.
  • Limits are placed on investors based on certain conditions (for more information see the section below titled “What Investors Should Know”).
  • Each offering must be exclusively conducted through an approved and registered online platform called an “intermediary” (you can find a list of approved broker-dealers here and a list of funding portals here).
  • Issuing companies are required to make quite a few disclosures and also have some on-going reporting requirements (for more information, see the section below titled “What Startups Should Know”).

What Startups Should Know

I’m happy to have an alternate source of seed funding for startups but have to say the Reg CF method is likely not ideal for many/most of them.  Make sure to educate yourself first and then, if still interested, consult with your attorney.  And make sure your attorney has also educated themselves on the regulation (even better if they’ve had clients go through the process).  Basically, I’m strongly suggesting that you not just talk to the sales rep for an equity crowdfunding portal and read their brochure as your only sources of information, even though I assume they are all reputable companies trying to serve a market.

Below are a handful of things that caught my attention:

  • Information about the company’s financial condition must be provided – specifically liquidity and capital resources.  (see p75 of the document)
  • Financial statements must be provided (see p91 of the document)
    • If the company is raising more than $100,000, the financial statements must be reviewed by an independent public accountant
    • If the company is raising more than $500,000 and previously raised money using Regulation Crowdfunding, the financial statements must be audited
    • In all cases, the financial statements must be prepared in accordance with US generally accepted accounting principles (GAAP)
  • Annual reports must be filed with the SEC and posted on the company’s website (see p119 of the document)
  • Cap table information must be provided – specifically, owners of 20% or more equity in the company  (see p46 of the document)
  • The company must disclose the current number of employees at the time of the issuance filing  (see p68 of the document)
  • From what I can tell, advertising the offering is very limited and specific.  In other words, I don’t see support for broad social media or email campaigns by the company but rather see very specific ways the company can direct interested investors to their chosen intermediary’s platform site.  (see p139 of the document)

I don’t know about you but this seems overly burdensome to me for most early stage company situations in which amounts like $100K, $500K or even $1M are to be raised.  Additionally, what about all of the public disclosures.  Do you want your employees, customers and competitors to have access to the type of information listed above?

What Investors Should Know

In general, I understand the desire to limit the downside financial risks for non-accredited investors.  I won’t describe all of the nuances related to how the SEC accomplishes this because they are well documented on the SEC website and elsewhere.  But in general, there are some situations in which an investor can only invest up to $2,000 and others that allow them to invest more.

Investors are generally required to hold their equity for at least one year.  But the truth is that at the time of this writing there are not many marketplaces for selling private equity anyway.  Surely this will evolve over time and is probably something you should investigate further.  It’s a real bummer to get stuck with an investment in a company that either isn’t successful enough or otherwise attractive enough to be acquired or complete a public offering (IPO).  Instead, they become what’s referred to as a “lifestyle business”, which might be great for the founders but not the investors that eventually want a return on their investment.

To my way of thinking, offerings put on equity crowdfunding portals are likely to be the ones that couldn’t otherwise secure seed stage funding from traditional professional channels like accredited angel investors, angel networks and syndicates, seed stage venture funds and even startup accelerators.  Just look at my list of warnings further above for the startups and ask why one would pursue it anyway if they had “traditional” methods of funding available.  Experienced investors in seed stage ventures already know those investments are in a category of extremely high risk with half or more assumed to go to zero (loss of everything).  I’m suggesting that these particular equity crowdfunding opportunities are even more risky.  So if you’re “swinging for the fence” and a home run, you’d better prepare to swing a lot of times (several/dozens of such investments).

Summary

For both entrepreneurs and investors, I recommend searching for updated versions of this regulation if much time has passed since it’s initial effective date (May 2016).  And if I update this article I will make sure to add a comment with time stamp information at the beginning so that you know.

In general, I like having numerous forms of financing for early stage business ventures.  And to that end, the JOBS act in its various forms attempts to do that.  I understand our legislators’ and government administrators’ desire to protect private investors that don’t have millions of dollars in net worth from the inherent super-high degree of risk with early-stage investments.  And to that end I am grateful for their service and don’t plan to put in the effort to give them a mountain of suggested improvements.

Like most things in business, I recommend keeping “eyes wide open”, educating yourself as much as possible, and relying on seasoned professionals for additional insights and guidance.  And that goes for both startups and investors alike.

Related Reading

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Author: Gordon Daugherty

Over the past 15 years Gordon has seen nearly 1,000 startup pitches, advised more than 200 entrepreneurs and been involved with raising over $45M in growth and venture capital. Throughout his 28 year career in high tech, serving twice as President and three times as CMO, Gordon has both an IPO and a $200M acquisition exit under his belt. Now his emphasis is purely focused on helping startups and early stage tech companies. Through his Shockwave Innovations advisory practice and as Managing Director for Austin’s Capital Factory startup accelerator, Gordon is an active angel investor, VC and startup advisor.