By: Robert C. Hackney
Crowdfunding Requirements for Intermediaries
Crowdfunding transactions are required to be conducted through an intermediary, which is either a funding portal or a registered securities broker/dealer. We all know what a registered securities broker/dealer is, but what is a “funding portal?” It’s a whole new entity, created just for Regulation Crowdfunding.
A “funding portal” is defined in Section 3(a)(80) of the 1934 Act. A “funding portal” is any person acting as an intermediary in a transaction involving the offer or sale of securities for the account of others, solely pursuant to Section 4(a)(6) of the 1933 Act, (ie: the law under which Regulation Crowdfunding was created) that does not: (1) offer investment advice or recommendations; (2) solicit purchases, sales or offers to buy the securities offered or displayed on its website or portal; (3) compensate employees, agents or other persons for such solicitation or based on the sale of securities displayed or referenced on its website or portal; (4) hold, manage, possess or otherwise handle investor funds or securities; or (5) engage in such other activities as the SEC, by rule, determines appropriate.
The limitations set forth above were put in place because a funding portal is not a fully registered securities broker/dealer, and therefore can’t engage in the same kinds of activities as those who have been registered. Although they are not registered as securities broker/dealer, they do have to go through a process with the SEC by filing the new Form Funding Portal, and becoming a member of FINRA.
Issuers need to be aware that they are required to conduct their offerings exclusively through one intermediary platform at a time, and cannot use multiple intermediaries for the same offering.
A funding portal can be a non-resident, ie: a non-US entity, but only if there is an information sharing arrangement in place between the SEC and the competent regulator in the jurisdiction under the laws of which the nonresident funding portal is organized or where it has its principal place of business.
Can an intermediary own an equity interest in an Issuer? Any director, officer or partner of an intermediary, or any person occupying a similar status or performing a similar function, may not have a financial interest in an issuer that is offering or selling securities under Regulation Crowdfunding with one exception. The intermediary may receive a financial interest from the issuer as compensation for the services provided and the financial interest consists of securities of the same class and having the same terms, conditions and rights as the securities being offered or sold on the intermediary’s platform. This simply means that an intermediary can be compensated for its services in the form of stock (or other securities) or the Issuer, but only if it is the same class of security.
What is the definition of a financial interest? A financial interest in an Issuer means a direct or indirect ownership of, or economic interest in, any class of the issuer’s securities.
Opening of an Account with an Intermediary
No intermediary or associated person of an intermediary may accept an investment commitment in a transaction involving the offer or sale of securities in a Regulation Crowdfunding offering until the investor has opened an account with the intermediary and the intermediary has obtained from the investor consent to electronic delivery of materials.
Regulation Crowdfunding requires intermediaries (including funding portals) to provide educational materials that explain, among other things, the process for investing on the platform, the types of securities being offered, and the information a company must provide to investors, and resale restrictions. The investor must also be told about the investment limits that have been placed on each investor in Regulation Crowdfunding transactions. The intermediary must explain the limitations on an investor’s right to cancel an investment commitment and the circumstances in which an investment commitment may be cancelled by the issuer.
Part of the intermediary’s duty when opening an account for an investor is to establish a reasonable basis for believing an investor complies with the annual individual investment limitations.
Compensation Disclosure
In connection with establishing an account for an investor, an intermediary must inform the investor that any person who promotes an issuer’s offering for compensation, whether past or prospective, or who is a founder or an employee of an issuer that engages in promotional activities on behalf of the issuer on the intermediary’s platform, must clearly disclose in all communications on the intermediary’s platform, respectively, the receipt of the compensation and that he or she is engaging in promotional activities on behalf of the issuer.
As for the intermediary itself, when establishing an account for an investor, an intermediary must clearly disclose the manner in which the intermediary is compensated in connection with offerings and sales of securities pursuant to Regulation Crowdfunding.
The intermediary is also prohibited from compensating any person for providing the intermediary with personally identifiable information of any investor or potential investor.
Communication Channels
One of the most important aspects of the platform relates to the establishment of the intermediary’s communication channels. An intermediary must provide on its platform communication channels by which persons can communicate with one another and with representatives of the issuer about offerings made available on the intermediary’s platform. This is the essence of crowdfunding, where the crowd can communicate and discuss the pros and cons of an offering.
Regulation Crowdfunding provides the following limitations on Communication Channels:
(1) If the intermediary is a funding portal, it does not participate in these communications other than to establish guidelines for communication and remove abusive or potentially fraudulent communications;
(2) The intermediary permits public access to view the discussions made in the communication channels;
(3) The intermediary restricts posting of comments in the communication channels to those persons who have opened an account with the intermediary on its platform; and
(4) The intermediary requires that any person posting a comment in the communication channels clearly and prominently disclose with each posting whether he or she is a founder or an employee of an issuer engaging in promotional activities on behalf of the issuer, or is otherwise compensated, whether in the past or prospectively, to promote the issuer’s offering.
An intermediary has the duty to reduce the risk of fraud, by having a reasonable basis for believing that an Issuer complies with Regulation Crowdfunding and that the Issuer has established means to keep accurate records of securities holders. If an intermediary suspects that there is the potential for fraud or other investor protection concerns, it must deny access to its portal to such an Issuer.
An intermediary is required to make an Issuer’s required disclosures available to the public on its platform for a minimum of 21 days before any security may be sold in the offering; must provide investors notices once they have made investment commitments and confirmations at or before completion of a transaction; must comply with maintenance and transmission of funds requirements; and must comply with completion, cancellation and reconfirmation of offering requirements.
Form C
As part of this process, an issuer is required to file the required disclosures on a new form, which is called a “Form C: Offering Statement.” This form is filed with the SEC prior to the commencement of the offering of securities. In the event that an issuer amends the offering during the offering period, it is also required to file amendments to Form C to disclose any material change in the offer terms or any material disclosure previously provided to potential investors. Form C is really just the beginning, because there are related follow-up forms, including “Form C-U: Progress Update,” which is simply the form the issuer must file “no later than five business days after each of the dates when the issuer reaches 50 percent and 100 percent of the target offering amount.”
Unless the reporting has been terminated, as we have explained earlier in this publication, an issuer is required to file an annual report on “Form C-AR: Annual Report.” This form will contain similar information as Form C, but will have a lessened standard for the financial disclosure, which should save small companies a substantial amount of money. Remember that in Form C, most companies would be required to file financial statements that were either reviewed or audited by an independent certified public accountant. In the annual report, however, the rules only require financial statements of the issuer that are certified by the principal executive officer of the issuer to be true and complete in all material respects. An issuer is required to file the annual report no later than 120 days after the end of the fiscal year covered by the report.
Now, don’t get the impression that you are finished with the report filing if you are an issuer. If you as an issuer become eligible to terminate your obligation to file annual reports, you must then file a “Form C-TR,” ie: Form C: Termination of Reporting.
Cost Analysis
So, what will all of this cost? According to the SEC in its final rules release relating to Regulation Crowdfunding, they stated as follows: “Accordingly, in our Economic Analysis we estimate a cost range estimate for Form C and the financial statement review of: $2,500 for the smallest offerings, $4,000 to $23,000 for the larger offerings, $6,500 to $38,000 for first-time crowdfunding issuers conducting offerings between $500,000 and $1,000,000, and $7,500 to $50,000 for other issuers conducting an offering in the largest offering amount category.”
Conclusion
So far, about 40 companies have been approved to be licensed as funding portals. Here are a few for you to take a look at now:
Next Seed, Inc. (nextseed.com)
We Funder, Inc. (wefunder.com)
Sprowtt Crowdfunding (sprowttcf.com)
VentureCapital500 (venturecapital500.com)
Growth Fountain Capital (growthfountain.com)
We are not affiliated with any of the above organizations, are not specifically recommending them and only provide their names as a sample of the companies acting as intermediaries.
Is Regulation Crowdfunding perfect? Far from it. Will Regulation Crowdfunding be useful to small companies? It absolutely can be helpful. Does it change the way things have been done to the business as usual approach in the securities world? Of course. Can it be improved? A lot. This will not be an easy process, but at least it opens up the potential investment community to the general public as opposed to just the wealthy investors. No one knows if the general public will embrace this concept, and will invest in start-up companies using these new rules, but as non-equity crowdfunding has shown us, a good idea can be funded by the crowd, and this gives new companies a fighting chance to expose their possibilities to a much larger audience. We are hopeful that this new approach will level the playing field with the venture capital world, and give the small investor, who is non-accredited, an opportunity to participate in the ground floor of the next billion-dollar company. Just remember, even with good products, good management and funding, the best ideas don’t catch on. Gageing public acceptance and public demand is a shot in the dark, and timing, and sometimes pure luck play a large part of any company’s future success.