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The Entrepreneurial Spirit ® Newsletter
Special 2016 New Year Edition - Crowdfunding

Getting ready for the new year?  We can help, so let's get right to it.  In this special edition of the The Entrepreneurial Spirit ®, we address the new way to raise money for your venture: Crowdfunding: A Game Changer.  Our legal assessment report is produced separately; this short article is intended to warm you up for the new way to raise money—coming in 2016—for inventors, artists, at-home parents, innovators, high-tech companies, publishers, medical products, real estate syndicates, film-makers, as well as everyone else.  Please keep in mind that Crowdfunding is a complex area of law and you need to consult with an experienced lawyer regarding implementation of your strategies and goals.

Crowdfunding: A Game Changer
Coming May 16, 2016.

On April 5, 2012, the Federal Government enacted the "Jumpstart Our Business Startups" Act, better known as the JOBS Act.  On October 30, 2015, the Securities and Exchange Commission (SEC) issued the Final Rules, which become effective on May 16, 2016.  You can review the regulations from our law firm's statute repository Get ready for May, 2016.  Crowdfunding is a game-changer. 

What is Crowdfunding?  Crowdfunding is to fund something by placing it before a "crowd" for consideration, pooling money via the Internet, to support a mission, idea or business plan.  The possibilities are endless.

Why is this a big deal?  You've heard of the Stock Market Crash of 1929.  Among other things, the perceived causes of the '29 Crash included a lack of governmental control over the securities (raising money) markets, along with a significant amount of fraud.  To rectify the problem, the U.S. Congress enacted the Securities Act of 1933 and the Securities Act of 1934.  With these investor protections came a myriad of complex limitations on the ability of entrepreneurs to raise capital.

Complex securities laws have made raising money difficult: one problem solved, another problem created.  When business has a difficult time raising money, innovation is stifled, because opportunities can't get financially leveraged to the marketplace.  It has been, and it remains, a contention in the industry to find the balance between investor protection and raising capital flexibility.

Laws v. Regulations?  "Acts" are laws enacted by the legislative bodies of government, such as Congress.  "Regulations" are issued by the administrative agency that has been created to oversee the details of the administration of the law.  So, technically, we have "laws" and we have "regulations"; sometimes both are referred to as "laws" generically, because both have the practical effect of law.  For example, Congress enacted the Tax Act, and the administrative agency, the IRS, issues the tax regulations; similarly, Congress enacted the JOBS Act, and the administrative agency, the SEC, issues the regulations.  Any disputes are ultimately resolved in court.  Crowdfunding, although enacted in 2012, needed to await the writing and effectiveness of the SEC regulations, coming in May, 2016.

Ambiguous Term, "Crowdfunding."  Be careful, there are two types of “crowdfunding.” If you google the term, you will find articles claiming that crowfunding is already legal and other articles saying that crowfunding is not yet legal.  Which is it?

1.  Non-Equity.  One type of crowdfunding (also sometimes called "crowdsourcing") that has already been implemented is to fund a product by pre-sales. www.Kickstarter.com is a site that has implemented this model.  That is, to make a conditional product available.  This is the "If you fund it, we will build it" model.  If enough pre-sales are achieved, the product is produced. This is (probably) not a securities issuance model because it is not equity-based.  Fraud potential still applies.  This is the only model available for non-profits, because non-profits do not have equity-based opportunities.  Non-equity crowdfunding is, of course, an important opportunity for both non-profits and for-profits.

2. Equity.  The other type of crowdfunding is a securities, or equity-based, issuance model. That is, to sell equity interests in an enterprise. This is the heart of the securities paradigm revolution, and the subject of the new regulations.  The equity-based crowdfunding model effectively pits small companies to compete for pooled public investment funds with a "best deal wins" capitalism paradigm.  It also permits small investors to get into the game. 

Equity-based crowdfunding is coming in 2016.  Private companies will now have the ability to raise money in capital markets by selling equity shares via the Internet, legally!   It is still a complex area of law, but it is a significant revolutionary paradigm shift.

Golden Rule of Securities Law.  All offers and sales of securities (e.g., raising money by selling equity) must be registered with the applicable securities agencies, unless an exemption from registration exists Yes, be careful, securities laws apply to the sale of a few shares of your equity to kindly Aunt Flo, and other "family and friends."

Registration v. Exemptions.  You've probably heard of companies like FACEBOOK "going public."  This is a public offering registered with the SEC; it is a complex and expensive set of transactions for SEC registration and getting listed on a public trading exchange.  You probably also know (or least you intuit) that many sales of equity interests in companies occur without securities registration.  (Ala, the sale of equity stock to Aunt Flo, and family and friends.)  The reason is because those unregistered sales of private equity, assuming performed in legal compliance (sometimes accidentally by the unknowing), were pursuant to exemptions from registration with the SEC.  Basically, there are a number of exemptions from registration for "small" offerings and "private" sales of equity.  Some of the exemptions from registration are "self-executing exemptions—meaning you automatically have the exemption available to you; other exemptions from registration are available only if you file a document to claim it, called "non-self-executing exemptions."  For non-self-executing exemptions, filing a document to claim the exemption can be complex, but it is still not a registration.  Then, additionally, there is the Federal system, as well as the dual applicability of every state's ("Blue Sky") laws that are affected by the equity transaction.  And, apart from the concept of registrations and exemptions, you still need to ensure that there is a proper disclosure of information to educate the prospective purchaser regarding the nature of the investment.

Try saying the Golden Rule to yourself, now slightly augmented: "Every sale of securities must be registered, unless an exemption from registration exists, and I know that there are a lot of exemptions from registration, but I need to confirm that federal and state exemptions are actually available for  my intended transaction, and, irrespective of registrations and exemptions, I must provide disclosure documentation."  If you disregard the Golden Rule, you are simply "flying blind."  And, getting lucky is not good strategy.

But, what is a "small" or "private" offering?   Regarding exemptions from registration, what exactly are "small" and "private" offerings?  If I sell to 5 people is that private?  If I put an advertisement in a small newspaper, is that private?  If I say on my webpage that I am offering shares, is that private?  If I am only raising $10K, is that private?   That very question has caused significant litigation, but, to help everyone out, sort of, the SEC has issued regulations to define what is a small and/or private offering; that is, an acceptable context to permit catch-all legal "safe harbor" exemptions from registration.  This is where SEC REGULATION D, or "REG D" comes in to play.  There are three primary Reg D references: 504, 505 and 506, each supplying context and conditions that permit raising capital without registration.  However, each has it benefits and detriments.  Unlike Reg. D 504 and 505, if an issuer meets the conditions, Reg D 506—called a "506 Offering" or "506 Private Placement"—allows raising an unlimited amount of capital, and with "minimal" state law involvement.  Reg. D 506 preempts state securities laws, which is a very big deal, because federal law prevents the investment terms of a 506 Offerings from being reviewed by the applicable states.  States can have administrative filings, some of which are now unified by the North American Securities Administrators Association (NASAA).

The JOBS Acts Modifications.   Generally, the JOBS Act creates a new registration exemption that permits certain issuers to raise up to $1M within any twelve month period.  However, the maximum investment by any investor in such a transaction must be limited to:

1. If either the investor's annual income or net worth is less than $100K then: the greater of $2,000 or 5% of the investor's annual income or net worth within any twelve month period; or

2. Otherwise, if either the investor's annual income or net worth is at least $100K then: 10% of the investor's annual income or net worth, not to exceed $100K.

With this new opportunity for the private sale of equity, significant investor protections in connection with crowdfunding were put into place:

1.  A “funding portal” is an intermediary in a securities offering that satisfies certain requirements, including not offering investment advice or recommendations, not soliciting purchases, sales or offers to buy securities, and not compensating employees or others based on the sale of securities;

2.  Ban on advertising the terms of the offering;

3.  Restricting the transfer of securities sold under the exemption for one year;

4.  Imposing personal civil liability onto the principals for material misstatements or omissions in connection with the offering;

5.  Requiring the issuer to file with the SEC (and to provide to investors and financial intermediaries) certain information about the issuer and its business, anticipated business plan, financial condition, and details of the proposed crowd funding transaction; and

6.  Depending on the size of the offering, the issuer would be required to provide different levels of financial information: a) income tax returns and financial statements certified by the principal executive officer of the issuer for offerings of less than $100,000; b) reviewed financial statements by a certified public accountant for offerings of more than $100,000, but not more than $500,000; and c) audited financial statements for offerings of more than $500,000.  

The key to the entire crowdfunding paradigm is the "Funding Portal," because the Funding Portals provide the center-point for the offer and investment transaction management.  How Funding Portals will actually roll out in the marketplace, comply with the standards, compete with each other, and add value, will be nothing less than fascinating. 

Funding Portals effectively act as a broker or funding intermediary.  The broker or funding portal must register with the SEC and any applicable self-regulatory organization as a broker or funding portal.  It must provide certain disclosures to potential investors relating to risks, with other investor education materials and ensuring that potential investors review and acknowledge these disclosures.  Funding Portals must reduce the risk of fraud by issuers, including conducting back-ground checks on issuer principals, as well as make available to the SEC and potential investors any information that the issuer provides to investors and intermediaries.  Moreover, Funding Portals must confirm compliance by issuers with the limitations on investment amounts for crowd funding transactions set forth above.

Conclusion.   The new crowdfunding exemption from registration is a paradigm shift for raising capital in a now pseudo-private market, brought to everyone by embracement of the new online technologies.  The law limits the amount that an issuer can offer, and limits the amount that an investor can invest.  In this way, the new law attempts to strike a new balance between keeping the opportunities small and private, with continued investor protections for the context.  The regulations are complex, because there are a number of technical issues, such as integration of different offering exemptions, measurement of the limitations, etc. 

 

Crowdfunding gives every idea and innovation a new hope of becoming a reality.  Every Amelia Earhart, Thomas Edison or Henry Ford of our generation has a new hope of disrupting the course of things by taking his or her idea directly to the public.  Crowdfunding embraces the American Entrepreneurial Spirit. 

 — Gregg Zegarelli

 

 

  

 

 

  

 

 

 

 

     
 

 

Technology & Entrepreneurial Ventures Law Group, PC

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