Eliminate Barriers to Raising Capital Via Crowdfunding

Elesa Rectanus
Aug 13, 2015
5 min read

What is Crowdfunding?

Crowdfunding refers to the act of raising small amounts of capital from a large number of people (i.e., the “crowd”) through the internet. Generally, small businesses and startups are limited in their ability to raise capital and most frequently small businesses raise capital from owners’ personal savings, friends and family, angel investors and traditional business loans. The impetus behind crowdfunding is to remove the traditional barriers to capital that many small businesses face by providing small businesses with access to the general public through the internet for the purpose of raising capital.

There are three main types of crowdfunding, which vary by manner of reciprocity:

• Donation: where contributors do not receive anything in return for their monetary contribution, such as a donation to a non-profit organization.

• Reward: where contributors receive a perk in exchange for their monetary contribution, such as a t-shirt or the company’s product.

• Equity: where investors receive an ownership interest, including the possibility of future returns, in exchange for their monetary contribution.

The capital raised through donation and reward-based crowdfunding is treated as a donation whereas capital raised through equity crowdfunding is treated as an investment. For our purposes, donation and reward-based crowdfunding will be referred to simply as donation-based crowdfunding.

Equity Crowdfunding Under the JOBS Act

A company that raises capital through equity crowdfunding must either register the offering with the Securities and Exchange Commission (“SEC”) or fall within a registration exemption because an offer or sale of an ownership interest in a company which constitutes a “security” implicates the Securities Act of 1933 (the “Securities Act”), as well as state securities laws. Prior to April 5, 2012, small companies did not engage in equity crowdfunding transactions because the federal and state exemptions available for such transactions were simply unavailable or, as a general matter, too difficult to satisfy.

The unavailability of exemptions for equity crowdfunding transactions was, in large part, due to the use of the internet, which raised complex issues that the securities laws and regulations had yet to address. One of the primary issues was the restriction on general solicitation and general advertising in connection with an offer or sale of securities, which is a requirement included in most of the exemptions from registration. This general solicitation restriction prevented companies from utilizing equity crowdfunding platforms because the use of the internet in connection with an offering of securities would be deemed general solicitation. The number and type of potential investors in crowdfunding transactions also limited, or eliminated, many of the available exemptions. Most exemptions contain limitations on the number of investors depending on their qualifications, including net worth or net income. In contrast, crowdfunding is designed to reach an unlimited number of people regardless of specific qualifications.

The Jumpstart Our Business Startups (“JOBS”) Act, enacted on April 5, 2012, reflects an effort to make it easier for small businesses to gain access to potential investors and thereby raise capital. The JOBS Act contains three provisions that pertain to equity crowdfunding: Title II, Title III and Title IV of the JOBS Act. While those provisions provide new exemptions under which small companies may engage in equity crowdfunding, each provision is markedly different from the other.

Pursuant to Title II, the SEC removed the general solicitation restriction in Rule 506 of Regulation D under the Securities Act, effectively creating a new exemption, Rule 506(c). Rule 506(c) differs from the three other exemptions under Regulation D (Rules 504, 505 and 506(b)) because it allows companies to advertise their offerings to the general public (i.e., engage in general solicitation). The SEC adopted final rules for Title II on July 10, 2013, and such rules became effective on September 23, 2013.

Title IV amends Regulation A by increasing the monetary ceiling from $5 million under the existing Regulation A to $50 million. The final rules implementing Title IV, referred to as Regulation A+, create two tiers of offerings: Tier I for offerings raising up to $20 million and Tier II for offerings raising up to $50 million. The final rules implementing Title IV were adopted by the SEC on March 25, 2015 and became effective on June 19, 2015.

Title III of the JOBS Act, individually titled the CROWDFUND Act, creates a new statutory exemption Section 4(a)(6) of the Securities Act. Title III permits companies to engage in general solicitation over the internet for the purpose of raising capital up to $1 million during any 12-month period through a broker-dealer or a “funding portal,” a new type of online investment service. However, companies may not rely upon the equity crowdfunding exemption under Title III until the SEC adopts final rules implementing the exemption. The SEC promulgated proposed rules implementing the crowdfunding exemption under Title III, referred to as Regulation Crowdfunding, on October 23, 2013. While the SEC has released statements indicating that it intends to finalize the rules by the end of 2015; whether the SEC will, or should, do so is up for debate. Any expectations that the SEC will finalize these rules by the end of 2015 may be hampered by a report released on July 9, 2015 by the U.S. House of Representatives Committee on Appropriations, which criticizes the SEC regarding the proposed rules implementing Title III crowdfunding, referring to Regulation Crowdfunding as “inoperable.”

Who Can Participate in Crowdfunding?

Generally, anyone can participate in donation-based crowdfunding, whether as a contributor to a crowdfunding campaign or as a campaign owner seeking to raise capital through a crowdfunding campaign. However, each donation-based crowdfunding platform has its own rules on who can invest and the types of businesses or individuals that may raise funds through the platform. For instance, Kickstarter is a donation-based crowdfunding platform that limits the type of campaigns to those that encompass “creative projects,” and restricts the type of campaign owner or “creator” to individuals and for-profit entities other than non-profit organizations.

In contrast to donation-based crowdfunding, the securities laws and regulations impose restrictions on the type of investors that may participate in equity crowdfunding. Specifically, only accredited investors may participate in Rule 506(c) offerings, whereas all types of investors, whether accredited or non-accredited, may participate in Regulation A+ offerings and, as currently drafted, Regulation Crowdfunding offerings.

Prior to the SEC adopting Regulation A+, only accredited investors could participate in equity crowdfunding through platforms such as Crowdfunder and AngelList pursuant to Rule 506(c) of Regulation D. Accredited investors, as defined in Regulation D, are individuals with either (i) a net worth of at least $1 million or (ii) net income in excess of $200,000 for the current year and each of the prior two years. Because small businesses frequently do not have access to accredited investors, Rule 506(c) may not be a viable option for many small businesses.

With Regulation A+ now in effect, Title III and Regulation Crowdfunding, as currently drafted, may not prove as useful or beneficial to small businesses because ordinary people (i.e., non-accredited investors) are already able to participate alongside accredited investors in equity crowdfunding transactions pursuant to Regulation A+. Moreover, the regulatory obligations under Regulation Crowdfunding may result in significant transaction costs that render Regulation Crowdfunding prohibitive for small businesses and startups. Specifically, the offering limitation of $1 million is arguably too low in comparison to the costs imposed by the financial disclosures and the intermediary obligations required by Regulation Crowdfunding. Then again, Regulation A+ has its own shortcomings, as a Regulation A+ offering will be significantly more costly and time-consuming than private placement exemptions under Regulation D.

Even in the absence of Title III and Regulation Crowdfunding, Rule 506(c) and Regulation A+ are major steps forward in an effort to create a regulatory structure that enables small businesses and startups to pursue alternative methods to raise capital from a broader range of potential investors.