By: Robert C. Hackney
Disclosure for Issuers
Please note: there are disclosure and other requirements for ISSUERS and other requirements for INTERMEDIARIES (funding portals and securities broker/dealers). First, we will discuss what the Issuer is required to comply with to stay out of trouble.
The following are the ISSUER Disclosure Requirements
As revised by the JOBS Act, now the Securities Act Section 4A(b)(1) requires specific disclosures that an issuer offering or selling securities in reliance on Regulation Crowdfunding must “file with the Commission and provide to investors and the relevant broker or funding portal, and make available to potential investors”.
These disclosures include:
• the name, legal status, physical address and website address of the issuer;
• the names of the directors and officers (and any persons occupying a similar status or performing a similar function), and each person holding more than 20 percent of the shares of the issuer; (this is different from the registered offerings which require all 10% shareholders and affiliates),
• a description of the business of the issuer and the anticipated business plan of the issuer;
• a description of the financial condition of the issuer;
• a description of the stated purpose and intended use of the proceeds of the offering sought by the issuer with respect to the target offering amount;
• the target offering amount, the deadline to reach the target offering amount and regular updates about the progress of the issuer in meeting the target offering amount;
• the price to the public of the securities or the method for determining the price; and
• a description of the ownership and capital structure of the issuer.
Who is covered as a person connected with an issuer that must be disclosed? An issuer is required to disclose information about its president, vice president, secretary, treasurer or principal financial officer, comptroller or principal accounting officer and any person routinely performing similar functions.
The required information includes all positions and offices held with the issuer, the period of time in which such persons served in the position or office and their prior business experience. The required disclosure about the business experience of the directors and officers (and any persons occupying a similar status or performing a similar function) must cover the past three years (vs. 5 years in registered offerings). So, for example, it would say something like: As of the date of this offering (December 2018), John Jones has been the Vice President of Operations since January 2018. From February 2014 to January 2018, he served as Vice President of Marketing. From March 2013 to February 2014, he was the Assistant Marketing Director. He has over 20 years of marketing and operational experience in the technology field, having served as an officer of a publicly held technology company for a period of over ten years.
Regulation Crowdfunding requires that an issuer disclose information about its business and business plan and provide a description of the purpose of the offering and intended use of the offering proceeds. Issuers much disclose the target offering amount and the deadline to reach the target offering amount, for example, “we intend to raise $500,000 and have set a deadline for a closing date of December 31, 2019.”
What happens if an Issuer makes material changes to the offering? In the offering document, the Issuer must disclose that if an investor does not reconfirm his or her investment commitment after a material change is made to the offering, the investor’s investment commitment will be cancelled and committed funds will be returned.
What is a material change? Books have been written about that, because it’s a facts and circumstances call, but the obvious ones are things like signing a major contract, the failure of a major product, the loss of senior management, major litigation and the like.
What happens if an investor wants to cancel his or her investment commitment? The new rules also make issuers explain the process to cancel an investment commitment or to complete the transaction once the target amount is met.
Issuers must include a statement that:
• investors may cancel an investment commitment until 48 hours prior to the deadline identified in the issuer’s offering materials;
• the intermediary will notify investors when the target offering amount has been met;
What happens if the Issuer reaches its funding goal prior to the deadline set in the offering documents? If an issuer reaches the target offering amount prior to the deadline identified in its offering materials, it may close the offering early but only if it provides at least five business days’ notice prior to that new deadline. For example, the deadline is December 31, and the Issuer reaches its goal on November 5. As long as there has been no a material change that would require an extension of the offering and reconfirmation of the investment commitment, the Issuer can give five days’ notice of the new deadline and close the offering early.
What if an investor does not cancel their commitment with the 48 hour period prior to the deadline? If that happens, the funds will be released to the issuer upon closing of the offering and the investor will receive securities in exchange for his or her investment.
What if the Issuer wants to raise $400,000 by June 30, and reaches the deadline with only $379,000 committed? Issuers are required to disclose that if the total of the investment commitments does not equal or exceed the target offering amount at the time of the offering deadline, no securities will be sold in the offering, investment commitments will be cancelled and committed funds will be returned. Under our example, the funds must be returned and the offering cancelled.
What does the Issuer have to disclose about the company’s capital structure and the ownership of the company?
The Issuer must disclose:
• the terms of the securities being offered and each other class of security of the issuer, including the number of securities being offered and those outstanding, ie: how many classes of securities does the Issuer have and how many of each are outstanding? The Issuer also must disclose whether or not such securities have voting rights, if there are any limitations on such voting rights, how the terms of the securities being offered may be modified and a summary of the differences between such securities and each other class of security of the issuer, and how the rights of the securities being offered may be materially limited, diluted or qualified by the rights of any other class of security of the issuer.
Here is an example of how something like that might be disclosed:
“General
The total number of shares which this corporation is authorized to issue is 250,000,000, consisting of three classes of shares to be designated, respectively, “Class A Common Stock,” “Class B Common Stock” (collectively the Class A Common Stock and the Class B Common Stock are referred to herein as the “Common Stock”) and “Preferred Stock.” The total number of shares of Class A Common Stock that this corporation shall have authority to issue is 150,000,000 shares, each with a par value of $0.001. The total number of shares of Class B Common Stock that this corporation shall have authority to issue is 50,000,000 shares, each with a par value of $0.001. The total number of shares of Preferred Stock that this corporation shall have authority to issue is 50,000,000 shares, each with a par value of $1.00.
Common Stock
(a) Voting Rights
(i) The holders of Class A Common Stock and the holders of Class B Common Stock shall vote together as a single voting group on all matters submitted to a vote of this corporation’s shareholders.
(ii) Each holder of Class A Common Stock shall be entitled to one (1) vote for each share of Class A Common Stock held as of the applicable record date on any matter that is submitted to a vote of the shareholders of this corporation (including, without limitation, any matter voted on at a shareholders’ meeting), and
(iii) Each holder of Class B Common Stock shall be entitled to ten (10) votes for each share of Class B Common Stock held as of the applicable record date on any matter that is submitted to a vote of the shareholders of the corporation (including, without limitation, any matter voted on at a shareholders’ meeting).
(b) Dividends and Distributions
(i) Subject to the preferences applicable to any series of Preferred Stock, the shares of Class A Common Stock and the shares of Class B Common Stock are entitled to the Distribution of the net assets of this corporation upon dissolution provided, however, that each Class A Common shareholder shall be entitled to a preference over all Class B Common shareholders to the extent of the original subscription amount paid by such Class A Common shareholder. In the event that there are net assets available for Distribution upon dissolution after payment to the Class A Common shareholders as stated above, all remaining net assets shall be shared equally, identically and ratably, on a per share basis with respect to the Distribution of the remaining net assets between the Class A Common shareholders and the Class B Common shareholders.
(ii) Subject to the preferences applicable to any series of Preferred Stock, if any, outstanding at any time, shares of Class A Common Stock and Class B Common Stock shall be treated equally, identically and ratably, on a per share basis, with respect to any Dividend as may be declared by the Board of Directors from time to time with respect to the Common Stock, unless in the event any such Dividend declared by the Board of Directors with respect to the Common Stock is paid in the form of Class A Common Stock or Class B Common Stock (or Rights to acquire such class of stock), then holders of Class A Common Stock shall receive Class A Common Stock (or Rights to acquire such stock, as the case may be) and holders of Class B Common Stock shall receive Class B Common Stock (or Rights to acquire such stock, as the case may be).
(c) Miscellaneous Rights and Provisions
Holders of Common Stock shall have no preemptive or other subscription rights, redemption or sinking fund provisions. Class B Common Stock may be converted into Class A Common Stock under certain circumstances. See the Company’s Amended and Restated Articles of Incorporation.
Preferred Stock
This corporation’s board of directors (the “Board of Directors”) shall have the full authority permitted by law to divide the authorized and unissued shares of Preferred Stock into series, and to provide for the issuance of such shares (in an aggregate amount not exceeding the aggregate number of shares of Preferred Stock authorized by this corporation’s articles of incorporation (as amended or restated from time to time) as determined from time to time by the Board of Directors and stated, before the issuance of any shares thereof, in the resolution or resolutions providing for the issuance thereof. The Board of Directors shall have the authority to fix and determine and to amend the number of shares of any series of Preferred Stock that is wholly unissued or to be established and to fix and determine and to amend the designation, preferences, voting powers and limitations, and the relative, participating, optional or other rights, of any series of shares of Preferred Stock that is wholly unissued or to be established, including, without limiting the generality of the foregoing, the voting rights relating to shares of such series of Preferred Stock, the rate of dividend to which holders of shares of such series of Preferred Stock may be entitled, the rights of holders of shares of such series of Preferred Stock in the event of liquidation, dissolution or winding up of the affairs of this corporation, the rights of holders of shares of such series of Preferred Stock to convert or exchange shares of such series of Preferred Stock for shares of any other capital stock or for any other securities, property or assets of this corporation, and whether or not the shares of such series of Preferred Stock shall be redeemable and, if so, the term and conditions of such redemption.
The 8% Cumulative Convertible Preferred Stock
Number of Shares; Designation.
A total of 1,000,000 shares of preferred stock of the Corporation are designated as 8% Cumulative Convertible Preferred Stock (the “Series”).
Rank.
The Series shall, with respect to rights (including to redemption payments) upon liquidation, dissolution or winding-up of the affairs of the Corporation, rank senior and prior to both Class A and Class B Common Stock, par value $.001 per share, of the Corporation (the “Common Stock”), and any additional series of preferred stock which may in the future be issued by the Corporation and are designated in the amendment to the Articles of Incorporation or the certificate of designation establishing such additional preferred stock as ranking junior to the Preferred Shares.
Dividends.
Dividends may be declared and paid on the Preferred Shares from funds legally available therefor as and when determined by the Board of Directors. The Series shall, with respect to the payment of dividends, rank pari passu with the Common Stock.
Liquidation.
The liquidation value per Preferred Share, in case of the voluntary or involuntary liquidation, dissolution or winding-up of the affairs of the Corporation, shall be an amount equal to $1.00 per share, subject to adjustment in the event of a stock split, stock dividend or similar event applicable to the Series.
Conversion. The shares of 7% Cumulative Convertible Preferred Stock are convertible into Class A Common Stock on a one for one basis.”
The Issuer must also disclose how the exercise of the rights held by the principal shareholders of the issuer could affect the purchasers of the securities. For example, if the principal shareholders have controlling voting rights after the offering, they will still be able to elect all of the directors of a corporation, and will still be in complete control of how the corporation is run. Similarly, the Issuer has to disclose the risks of minority equity ownership, the possibility that more securities will be issued in the future, (thus diluting the investors), the possibility of a sale of the company in the future, and any transactions with related parties, (such as supply contracts with the president’s wife’s company).
Another standard disclosure item is the name and ownership level of persons who are 20 Percent Beneficial Owners. This is a little different from some of the prior disclosure laws under different securities provisions that require disclosure of persons who beneficially own 10% of a company.
How has the Issuer valued the securities that they are selling? The Issuer has to disclose this, and with most start-up companies the answer is that the number is arbitrary, and only based on how much the company needs to start operations.
The Issuer must also describe any restrictions on the transfer of the securities. Since securities sold in Regulation Crowdfunding transactions have a one year holding period that must be disclosed, along with any other restrictions place on the securities by the company.
Has the Issuer or any of its predecessors previously failed to comply with the ongoing reporting requirements of Regulation Crowdfunding? If so, it must be disclosed.
The following additional disclosures are required:
There are lots of other disclosure items, like the current number of employees of the issuer; description of any debt of the Issuer (how much, what terms, etc.), information about any exempt offerings in the last three years, and any related party transactions of a certain size.
What about Risk Factors? Of course, the Issuer needs to provide a section disclosing what factors make this a speculative or risky investment, and certainly all start-ups are risky business.
When it comes to the intermediary involved in the offering, (funding portal or securities broker/dealer), the Issuer must disclose the name, SEC file number and Central Registration Depository number (“CRD number”) of the intermediary. As part of this intermediary disclosure, the Issuer must also describe the amount of compensation paid to the intermediary for conducting the offering, including the amount of any referral or other fees associated with the offering. This particular disclosure can be made as a dollar amount, or as a percentage of the offering amount. If the exact amount is not available when the offering begins, the Issuer can make a good faith estimate of the amount.
What about the Issuer’s website? The Issuer must disclose the location on the Issuer’s website where investors will be able to find the Issuer’s annual report and the date by which such report will be available on the website.
Financial Disclosure
Regulation Crowdfunding requires that the Issuer provide a narrative description of its financial condition. For each period set forth in its financial statements (quarterly, annual, etc.), the Issuer must discuss liquidity, capital resources and historical results of operations, along with material trends known to management.
What kind of financial statements are required? First, there is an overriding rule that you must remember. If the Issuer has audited financial statements, they must be used by the Issuer, and no other form of financial statement is allowed. In the event that the Issuer does not have audited financial statements (which most will not), there are levels of disclosure based on how much the Issuer is trying to raise in the offering, ie:
• For issuers offering $100,000 or less: disclosure of the amount of total income, taxable income and total tax as reflected in the Issuer’s federal income tax returns certified by the principal executive officer and financial statements certified by the principal executive officer to be true and complete in all material respects.
• Issuers offering more than $100,000 but not more than $500,000: financial statements reviewed by a public accountant that is independent of the Issuer.
• Issuers offering more than $500,000 but not more than $1,000,000:
– For issuers offering securities in reliance on Regulation Crowdfunding for the first time: financial statements reviewed by a public accountant that is independent of the issuer.
– For issuers that have previously sold securities in reliance on Regulation Crowdfunding: financial statements audited by a public accountant that is independent of the issuer.
So, boiling all that down to English, if you have an audit, you have to use it. If you are raising more than $100,000, your financial statements have to be reviewed, not audited (unless you have made a Regulation Crowdfunding offering before). If you raise $100,000 or less, your financial disclosure is minimal, but beyond that its either a review or an audit.
What about advertising the offering? Can an Issuer advertise?
Yes and no. An Issuer can generally solicit, but there are limits. A Crowdfunding Issuer can only advertise notices which direct investors to the funding portal or broker. Regulation Crowdfunding says that the notice can include no more than:
1. 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’s platform;
2. The terms of the offering (a) the amount of securities offered; (b) the nature of the securities; (c) the price of the securities; and (d) the closing date of the offering period; and
3. Factual information about the legal identity and business location of the issuer, limited to the name of the issuer of the security, the address, phone number and website of the issuer, the e-mail address of a representative of the issuer and a brief description of the business of the issuer.
According to the SEC, the permitted notices will be similar to “tombstone ads” under Securities Act Rule 134. The exception is that the notices are intended to direct an investor to the intermediary’s platform through which the offering is being conducted, typically through a link directing the investor to the intermediary’s platform.
The Annual Report
After the offering, Regulation Crowdfunding requires all companies to file an annual report, no later than 120 days after the end of the most recently completed fiscal year covered by the report, and the report also must be posted to the issuer’s website. Financial disclosure in the annual report is limited to financial statements of the Issuer certified by the principal executive officer as true and complete in all material respects, (but if an Issuer that has financial statements that have been reviewed or audited by an independent certified public accountant, it must provide them). Many will only have to file one report, because there is no requirement after certain events take place.
Those events are:
(1) the issuer is required to file reports under Exchange Act Sections 13(a) or 15(d);
(2) the issuer has filed at least one annual report and has fewer than 300 holders of record;
(3) the issuer has filed at least three annual reports and has total assets that do not exceed $10 million;
(4) the issuer or another party purchases or repurchases all of the securities issued pursuant to Section 4(a)(6), including any payment in full of debt securities or any complete redemption of redeemable securities; or
(5) the issuer liquidates or dissolves in accordance with state law.
Before we move on to the requirements for Intermediaries, just a quick word about the effect of state law on this process. In many areas of securities law, there is concurrent jurisdiction, which simply means that the federal government has its rules and the states have theirs, and you have to comply with both, unless there is “federal preemption” and then only the federal law applies. That is what has happened along with these changes. Section 305 of the JOBS Act amended Section 18(b)(4) of the 1933 Act to preempt the ability of states to regulate crowdfunding conducted pursuant to Section 4(a)(6). Because of preemption, issuers will not need to register crowdfunding offerings or sales made pursuant to Section 4(a)(6) with the various states where offers are being made to investors. Section 305 of the JOBS Act also amended Section 15(i) of the 1934 Act such that intermediaries, including funding portals, will not have to comply with state registration with respect to their crowdfunding activities, which would otherwise be required for broker-dealers.