February 19, 2016
Regulation Crowdfunding: 10 factors to consider
before joining the crowd
By Deborah McLean, Daniel McAvoy, Richa Naujoks and Brian Becker
Crowdfunding research firm MASSolutions reported that the global crowdfunding industry more
than doubled in size in 2015, accounting for a projected $34.4 billion in funding for startups, social
initiatives and other ventures. Only a year prior, crowdfunding platforms accounted for $16.2
billion in funding—a 167 percent increase over 2013. While the crowdfunding industry has
consistently grown at a high rate since raising $880 million in 2010, the impact of a new era of
securities-based crowdfunding in the United States will soon be seen.
While currently crowdfunding in the United States has been limited to reward- or donation-based
crowdfunding or peer-to-peer lending, starting on May 16, 2016, startups and small businesses will
be permitted to issue securities to non-accredited investors through online intermediaries, also
referred to as “funding portals”, without Securities and Exchange Commission (“SEC”) registration
pursuant to new Section 4(a)(6) of the Securities Act of 1933, as amended (the “Securities Act”). To
participate in these securities-based crowdfunding offerings, however, the issuer must comply with
the final rules of the SEC contained in Regulation Crowdfunding, also referred to as Regulation CF.
Some of the commentators following the crowdfunding industry have concluded that the
requirements under Regulation CF are too onerous to become widely used. Others argue that
changes to the general solicitation rules under Regulation D have done more to allow early-stage
companies to access a broader base of potential investors than will be achieved by Regulation CF.
An issuer conducting an offering pursuant to Regulation D is largely limited to issuing its securities
to accredited investors; however, the relaxation of the restrictions on general solicitation
potentially permits an issuer to use online platforms and even social media to broadly advertise its
offering. On the other hand, while an issuer relying on Regulation CF is not limited to accredited
investors, the final rules contain a whole host of other restrictions, which are an attempt on the
part of the SEC to balance ease of capital-raising with investor protections. Finally, some states
have issued state crowdfunding rules that can be used in the narrow instance where a
predominantly in-state business is offering securities only to residents of that state.
While the list below is not exhaustive, the following are some major considerations before offering,
selling, purchasing, or facilitating the sale of securities pursuant to the federal crowdfunding
regulations under Section 4(a)(6) and Regulation Crowdfunding. If an issuer, or its registered
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broker or funding portal, does not substantially comply with the requirements, the issuer may be in
violation of Section 5 of the Securities Act as well as various state securities laws.
1. Limit on offerings: Over a 12-month period, an issuer is permitted to raise a maximum
aggregate amount of $1 million in reliance on Regulation CF. Capital raised through other
available exemptions from registration, such as Regulation D, will not count toward the
$1 million limit. That said, marketing restrictions can make it tricky to concurrently hold a
Regulation Crowdfunding offering and an offering involving another exemption from
registration.
2. Limit on investments: Over any 12-month period, an individual investor is permitted to
invest in the aggregate across all crowdfunding offerings:
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if the investor’s annual income or net worth is less than $100,000, the greater of
$2,000 or 5% of the lesser of annual income or net worth; or
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if the investor’s annual income and net worth are both $100,000 or more, 10% of
the lesser of annual income or net worth, but not more than $100,000.
No investor may invest more than $100,000 in crowdfunding offerings over any 12-month
period. For these purposes, net worth is determined in the same way as it is for purposes of
the accredited investor definition, i.e., without including the value of the investor’s
principal residence and without deducting any mortgage on that residence except to the
extent the mortgage is in excess of the fair market value of the residence or has been
increased during the 60 days prior to the investment.
3. Online intermediaries: Crowdfunding offerings may only take place through an
intermediary registered with the SEC. The intermediary may be either a broker-dealer or a
funding portal—a new type of SEC registrant. Funding portals must follow certain rules
and registration requirements that differ from those for registered broker-dealers due to
the narrower scope of activities in which funding portals may engage (see 7 below). To
encourage the formation of a “crowd”, the issuer may conduct a crowdfunding offering
using only one intermediary at a time.
4. Issuer disclosure requirements: Issuers are required to file with the SEC and provide to
the intermediary and investors new SEC Form C containing certain business, financial, and
offering information. Among other things, Form C requires disclosure of: the names of the
issuer’s officers, directors, and 20% owners; a description of the issuer’s business and its
planned use of the proceeds from the offering; a description of the financial condition of
the issuer; the target offering amount and target deadline; the issuer’s capital structure; the
price of the securities and the method for determining the price; and certain related-party
transactions. The issuer is also required to provide two years of financial statements (or, if
shorter, financial statements since inception). The nature of the financial statements to be
provided scale depending on the size of the offering. Any material change to the offering
terms requires an amendment to Form C. The issuer is also required to provide risk factor
disclosure tailored to the issuer’s business and offering. In a February 16, 2016 Investor
Bulletin, the SEC has identified some of the risks associated with an offering under
Regulation CF.1 A basic tenet of securities offerings also applies—the issuer must include
any material information necessary in order to make the statements made, in light of the
circumstances under which they were made, not misleading.
5. Ongoing annual reporting: Within 120 days of its fiscal year end, any issuer who has sold
securities under Regulation CF is required to file an annual report with the SEC and post a
copy of the report to its website. Annual reports are required until either: the issuer is
required to file periodic reports under the Securities Exchange Act; the issuer has filed at
least one annual report and has fewer than 300 holders of record; the issuer has filed at least
three annual reports and has total assets not exceeding $10 million; the issuer or another
party purchases all securities issued in the crowdfunding offering; or the issuer liquidates or
dissolves in accordance with state law. Issuers are also required to provide updates about
the progress of the crowdfunding offering.
6. Intermediary requirements: Intermediaries must take reasonable steps to prevent fraud
and ensure that issuers and investors comply with Regulation CF. Intermediaries may rely
on representations from issuers and investors, but at a minimum, intermediaries are
required to conduct a background and securities enforcement regulatory history check on
each officer, director, and 20% owner of the issuer. To facilitate communication among
investors—the essence of crowdfunding being the ability to rely on the “wisdom” of the
crowd—intermediaries’ basic function is to create communication channels on which
investors may discuss offerings with each other and with the issuer. The intermediaries are
also responsible for electronically delivering to investors educational materials that address
the risks of purchasing securities. Failure by an issuer’s portal to comply with its
requirements may jeopardize the offering’s exemption (but not if the issuer did not know
of the failures or they occur in some other offering).
7. Funding portal restrictions: Funding portals are prohibited from: offering investment
advice or providing recommendations; soliciting purchases, sales, or offers to purchase
securities displayed on its platform; compensating promoters and others for solicitations,
or based on the sale of securities; and handling investor funds or securities. Funding portals
may not take a financial interest in an issuer using it as an intermediary unless: (i) the
interest is compensation for the funding portal’s services in connection with the offering;
and (ii) the interest consists of securities in the same class and subject to the same terms as
those sold to investors.
8. Advertising: Issuers generally may not advertise the terms of an offering, except for
providing notice to potential investors directing them to the intermediary through which
the offering will be held. The notice may only include: a statement that the issuer is
conducting an offering, the name of the intermediary through which the offering is being
conducted, and a link directing the investor to the intermediary; the terms of the offering,
including the amount of securities offered, the nature of the securities, the price of the
securities, and the closing date of the offering; and factual information about the legal
identity and location of the issuer. Thus, issuers should tailor their communications to
1
U.S. Securities and Exchange Commission. Investor Bulletin: Crowdfunding for Investors. February 16, 2016.
Available at https://www.sec.gov/oiea/investor-alerts-bulletins/ib_crowdfunding-.html.
comply with Regulation CF, or, if conducting parallel offerings under Regulation CF and
Regulation D, to comply with the restrictions under both sets of regulations.
9. Resale restrictions: Securities purchased in a Regulation CF transaction generally may not
be resold for one year unless the securities are transferred to the issuer, to an accredited
investor, as part of a registered offering, to certain members of the investor’s family, to the
investor’s trust or a family trust, or due to the investor’s death or divorce. The resale
restrictions apply not only to the initial investor, but also to any subsequent transferee
during the one-year period following the securities’ issuance.
10. Excluded issuers: Companies that are ineligible from using the Section 4(a)(6) exemption
include: non-U.S. companies; Securities Exchange Act reporting companies; investment
companies (including private investment funds and other vehicles excluded from the
definition of investment company under Section 3(c) of the Investment Company Act);
companies with “bad actor” disqualifications; companies that have failed to comply with
the annual reporting requirements under Regulation CF; and companies without a specific
business plan, or whose business plan is to engage in a merger or acquisition with an
undisclosed company or companies.
Companies interested in holding an offering under Regulation CF are now permitted to submit test
filings on Form C using EDGAR, the SEC’s filing website, provided that the company has a Central
Index Key (“CIK”) and a CIK Confirmation Code (“CCC”). Further information provided by the
SEC regarding test filings on Form C may be found here.2
For more information on the content of this alert, please contact your regular Nixon Peabody
attorney or:
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2
Deborah McLean at [email protected] or (585) 263-1307
Daniel McAvoy at [email protected] or (212) 940-3112
Richa Naujoks at [email protected] or (212) 940-3148
Brian Becker at [email protected] or (585) 263-1028
U.S. Securities and Exchange Commission. Opportunity for Companies to Test File in Preparation for Crowdfunding
Offerings. December 18, 2015. Available at https://www.sec.gov/corpfin/ announcement/cf-announcement--crowdfunding-testing.html.