By Robert C. Hackney
Intro to the Equity Crowdfunding Rules
Having been involved in hundreds of private placements of securities over the years, and I can tell you that these new law changes are radical and will undoubtedly completely change the way young start-up companies are financed, including real estate related ventures.
Every Venture Capitalist plays by a rule book that says that out of 10 investments in startups (that have been carefully chosen, by the way), that 7 will fail completely, 2 might break even, and one will be a home run that makes up for all the rest.
The playing field, however, has never been level and the small investor has never had the opportunity to invest a small amount at the startup level. The federal securities laws would just not permit that to happen. By the time small investors have been allowed to invest small amounts, it is in, or after, a public offering and most of the upside has already been locked in by the Venture Capitalists.
The internet has provided the mechanism and the new law now provides the method for the whole system to change. A lot of people today talk about disruptive technologies. The new Title III Crowdfunding Regulations have provided the most disruptive technology in the history of the federal securities laws.
This is a game changer. Fasten your seat belts, there is a massive change in the wind.
The concept of the new rules flies directly in the face of the underlying theme that the securities laws have promoted for nearly 90 years since their inception. That theme is that unless you register your offering with the Securities & Exchange Commission (a daunting, expensive and risky proposition), you cannot advertise, you cannot generally solicit, and you are bound by numerous other restrictions. The JOBS Act, on the other hand, has turned the old thinking on its head, and has accepted the theme of the internet, ie: that the wisdom of the crowd prevails and that together the crowd will pick the winners, and that advertising and general solicitation is now allowed.
Taking the VCs rulebook, now any investor can invest a small amount in startup companies, and if an investor puts a few hundred dollars into 10 startups, their chances are theoretically the same as the Venture Capitalist.
In 2012, the JOBS Act made a number of changes to the way companies can raise money. The new Title III Crowdfunding rules are the latest changes to be implemented.
For background, the JOBS Act changed the old private placement rules so that companies could use general solicitation to raise money, but only from accredited investors. Those changes are referred to as Title II Equity Crowdfunding. The new law also changed the old Regulation A into something called Regulation A plus, and its referred to as Title IV Crowdfunding. But by far the biggest changes to the landscape came with the new Title III Equity Crowdfunding, which is the subject of this blog post. Discussion of Title II Equity Crowdfunding and Title IV Equity Crowdfunding will not be discussed here, but will be addressed in another forum.
The key to Title III Equity Crowdfunding, which became effective in May of 2016, is that now anyone, not just an accredited investor, can be generally solicited and can invest in the equity of a company or can participate in the ownership of a loan. This has never been permitted by law before.
What is Equity Crowdfunding
By now almost everyone has heard of Crowdfunding. It started some years ago and was restricted to donation type crowdfunding and rewards crowdfunding, and sometimes a mix of both. If someone had a catastrophic event, like a serious illness or a tornado destroyed their home, their friends and family would promote donations through a site like Go Fund Me to raise money. Similarly, if someone wanted funding for a personal goal, like funding the production of a play that they had written, they would start a campaign on a site like Kickstarter.
After the JOBS Act was passed, some crowdfunding sites turned to lending money to refinance credit card debt, or car loans, or other personal needs, that might be less costly than paying huge credit card interest rates. Of course, only accredited investors could fund the loans. This type of crowdfunding is generally referred to as Equity Crowdfunding, because instead of a good feeling, or a product purchase or some small reward for contributing, you now get an ownership interest in the company, or a partial ownership interest in a loan.
Banks have been syndicating loans forever. If a big developer wants to borrow $100 million, ten banks might each take $10 million of the loan to participate. Each bank has less risk, and the borrower gets his loan. The JOBS Act opened that kind of activity to accredited investors, and now the new rules have opened it up to the general public (although on a much smaller scale than described above.)
While there has been some equity crowdfunding activity since 2012, it has involved accredited investors buying stock, or accredited investors funding loans. Now, anyone can invest.
A Word of Warning
We are going to take you through the process of how Title III Equity Crowdfunding works. Over the years I’m sure you have heard lots of stories about what you can do and what you can’t do, as someone who either wants to raise money or someone who wants to invest in a young company or a startup real estate transaction. I want you to forget everything you ever heard before because even if it was right some years ago, it’s wrong now. There have been major changes in the law recently, some good, some not so good, and we will talk about them all. When you finish this series of blog posts, you should have an extremely good understanding of the real story about raising money.
I also need to give you the standard disclaimer. Every situation is different, and a small variation in a fact pattern can completely change how you approach your situation, therefore, we always recommend that you see an attorney about your company’s plans before undertaking a capital raising endeavor, or talk to a lawyer if you are unsure of your position as an investor.
This series of blog posts is intended solely for information and educational purposes. If you are contemplating a private placement, or any legal transaction, you should consult an attorney who can provide you with the advice that you need, for your specific circumstances. Securities law, and corporate finance, is not the area for novices to play. Incorrect documentation can have serious ramifications for all involved parties.
My goal for you is twofold, one, to give you an understanding of the Equity Crowdfunding money raising process and the laws surrounding it, so that you can make informed decisions on what direction to take. At the very least, it should save you a lot of time and money when you start talking to lawyers or investment bankers, because you will already have a fundamental understanding of the process. If you save just an hour of the time you would otherwise spend with your lawyer explaining some of these concepts, you will have saved a few dollars.
My second goal is to help you understand some of the things that you should not do, so that you can avoid headaches.
To understand agencies like the Securities & Exchange Commission, you need only look by analogy to the Department of Energy. DOE was started in the 1970s as a result of the Arab Oil Embargo, and America did not want to be caught unprepared like we were back then. The DOE’s initial mission and purpose was to make America energy independent.
I remember well the oil embargo, because I had recently graduated from college and had a pretty new car with a big engine. The owner of the gas station I usually frequented had blocked his driveways, and would only let in the customers that he recognized. Most of the other stations had lines a mile or two long waiting to get gas, and the amount they would let you buy was limited. It was a very strange time in America, and if some of the young people today heard some of the horror stories, I don’t think they would believe them.
By the early 2000’s, the DOE had 16,000 employees and 100,000 others under contract to perform services. While in the 70’s we had been importing about 40% of our oil, by the 2000s, the number was more like 70%.
Because of fracking and new oil finds, today we have too much oil, but it’s not because of anything that the DOE did, and they still have about 14,000 employees and 100,000 others under contract. Did they make us energy independent or have they just lost sight of their mission?
Shortages and bad economic times create opportunities for government to respond by creating agencies, and the Securities & Exchange Commission is no different. The initial federal laws governing money raising were the Securities Act of 1933 and the Securities Exchange Act of 1934. Do those dates sound familiar? It was the middle of the Great Depression. Today the SEC has over 4,000 employees, and the 50 state agencies that regulate securities on a state level certainly exceed that number. I am not knocking them, but the nature of the system is that they need cannon fodder on a constant basis. If you are looking to raise money using the new Equity Crowdfunding rules, I don’t want you to be cannon fodder, so be careful.
Some background in the securities world
If you have heard the term “private placement” once, you have heard it a thousand times. Do you really know what a private placement is? I am not sure anyone really does, because in the thousands of pages of laws and regulations surrounding the securities laws, there is not one place where you will find the term “private placement” defined. So what is it and where did it come from?
To start, we have to discuss the very basic framework of the securities laws as they relate to raising money. I am sure you have hard the term “there is an exception to every rule.” Well, the basic rule is that every security is required to be registered with the SEC, unless there is an exemption from registration that can be claimed by the company issuing the security.
I am not going to belabor the point, but even the term “security” contains so many twists and turns that only an octopus could have come up with the definition. Here is the definition of a “security:”
“The term ‘‘security’’ means any note, stock, treasury stock, security future, security-based swap, bond, debenture, evidence of indebtedness, certificate of interest or participation in any profit-sharing agreement, collateral-trust certificate, preorganization certificate or subscription, transferable share, investment contract, voting-trust certificate, certificate of deposit for a security, fractional undivided interest in oil, gas, or other mineral rights, any put, call, straddle, option, or privilege on any security, certificate of deposit, or group or index of securities (including any interest therein or based on the value thereof), or any put, call, straddle, option, or privilege entered into on a national securities exchange relating to foreign currency, or, in general, any interest or instrument commonly known as a ‘‘security’’, or any certificate of interest or participation in, temporary or interim certificate for, receipt for, guarantee of, or warrant or right to subscribe to or purchase, any of the foregoing.”
When you look at this definition you can see that there are many things that you ordinarily would not think of when you use the term “security.” The killer is that this is just the beginning of this law.
To get back to our point, there are two categories of exemptions under the ‘33 Act, exempt securities and exempt transactions. If you have a typical for-profit corporation, most of the exempt securities exemptions won’t fit you, so you need to find an exemption for your transaction. Section 4 of the ’33 Act has an exemption from registration for “transactions by an issuer not involving any public offering.”
So, if an offering is not public, what is it? It must be private. So now you know the dirty little secret, that although the law can give you a 26 category definition for what a security is, it can’t even give you a definition of a private placement.
That particular section of the ’33 Act has resulted in a plethora of crazy court decisions trying to define a private offering (or private placement), many of which conflicted with each other, depending upon what jurisdiction you were in at the time. It created utter chaos, which could have been fixed by Congress at any given time, but I guess they were too busy with the lobbyists. The result, of course, was that the industry had no clear picture of what it was allowed to do, and what it was not.
An attempt to fix this and give some comfort to people depending upon an exemption occurred in the 1990s, when the SEC created Regulation D, and earthshattering change in the landscape. Not perfect by any means, but much better than what was in existence at the time. Under Regulation D, there are a series of Rules, numbered 500 through 508. The first three provide general conditions and definitions, with 504-506 containing three specific exemptions, and the last two relating to penalties and enforcement.
Although the Jumpstart Our Business Startups Act (“JOBS Act”) made revisions to Regulation D and specifically Rule 506, this guide is not about Regulation D. The JOBS Act changes to Regulation D and Rule 506 are aimed at “accredited investors.” This guide is focused on a particular part of the JOBS Act, known as Title III of the JOBS Act, which created a whole new regimen and a whole new world.
Under the direction of Title III of the JOBS Act, the U.S. Securities and Exchange Commission adopted the new Regulation Crowdfunding, effective as of May of 2016. From a legal standpoint, Regulation Crowdfunding is focused on the offer and sale of securities under Section 4(a)(6) of the Securities Act of 1933, as amended (“1933 Act”).
Regulation Crowdfunding is not just for companies that want to raise money (“issuers”) but also lays out the rules for a brand new entity which is called a “funding portal.” Securities can only be sold through these new funding portals, or by registered securities broker/dealers. Funding portals and securities broker/dealers participating in offerings through Regulation Crowdfunding are also sometime referred to as an “intermediary.” As mentioned earlier, Regulation Crowdfunding opens up funding of companies to “the crowd” through the use of the Internet. Everyone can be part of the crowd, no need to be an “accredited investor.” This is the first time ever that general solicitation has been permitted in any way to the general public without first having a registration statement filed with the Securities and Exchange Commission. For all of us who have worked in this area for decades, it is amazing, and even as of a few years ago, totally unthinkable.
That is not to say that these rules are the greatest thing to ever happen, they certainly have their restrictions and drawbacks, but it is a giant step forward (for mankind?). Neil Armstrong would be proud.
Regulation Crowdfunding Overview
Section 4(a)(6) of the Securities Act of 1933 now exempts from the registration provisions of the 1933 Act any securities offering of less than $1 million on an aggregate basis during a 12-month period, but only so long as the offering is conducted through a securities broker/dealer or a funding portal.
Not every issuer of securities can use Regulation Crowdfunding. The following can’t use the new rules for crowdfunding transactions:
1. Companies not formed in the United States (Non-U.S. companies);
2. Companies that are disqualified under the disqualification provisions of Regulation Crowdfunding, which are similar to disqualification rules used in connection with Regulation D, and sometimes called the bad actor rules;
3. Investment companies as defined in Section 3 of the Investment Company Act of 1940 and companies that are excluded from the definition of investment company under Sections 3(b) or 3(c) of the 1940 Act.
4. “Reporting Companies” under the Securities Exchange Act of 1934, as amended (“1934 Act”);
5. Companies that were required to file ongoing reports required by Regulation Crowdfunding and have not done so; and
6. So called “Blind Pool” companies, ie: companies with no specific business plan or have indicated that their business plan is to engage in a merger or acquisition with an unidentified target.
Other than the companies list above, any other company not so excluded may raise investment capital through Regulation Crowdfunding. For flexibility, it is important to note that any kind of securities can be offered and sold under Regulation Crowdfunding. This simply means that if a company wanted to offer not just common stock, but preferred stock, promissory notes, bonds, debentures, or any combination thereof, it could do so.
Buyers of securities in a crowdfunding transaction are restricted from transferring their securities for a period of one year from the date of acquisition.
One of the provisions that will be difficult to track, by investors themselves, issuers and funding portals, is the limit on the total amount of securities that any one investor can acquire during a twelve month period.
• Individual investors, over the course of a 12-month period, are permitted to invest in the aggregate across all crowdfunding offerings up to:
– If either their annual income or net worth is less than $100,000, then the greater of:
$2,000 or
5 percent of the lesser of their annual income or net worth.
– If both their annual income and net worth are equal to or more than $100,000, then 10 percent of the lesser of their annual income or net worth; and
• During the 12-month period, the aggregate amount of securities sold to an investor through all crowdfunding offerings may not exceed $100,000.
Let’s talk about that a little bit, because it’s an important issue and as written, it’s a little hard to understand.
Let’s look at some examples:
Example 1: If you have an annual income of $105,000 but only a net worth of $90,000, you can invest $4,500 because that is equal to 5% of $90,000, ie: it’s the greater of $2,000, and 5% of the lesser of annual income or net worth. Remember that if EITHER your annual income or net worth in less than $100,000, this is the rule you follow.
Example 2: If you have an annual income of $50,000 and a net worth of $30,000, you can invest $2,000, since that is more than 5% of $30,000, or $1,500.
Basically, if you have a net worth and an income of less than $40,000, you can still invest $2,000, so this system is really open to anyone who wants to invest $2,000.
Example 3: If you have an income of $200,000 and a net worth of $500,000, you can invest $20,000, because that is 10% of the lesser of net worth and income.
Example 4: If you have an income of $1,250,000 and a net worth of $5,000,000, you can only invest $100,000, because that is the maximum you can invest in a 12 month period.
There are two interesting things to keep in mind with regard to determining how much an individual can invest:
1. There is no independent monitoring method to make sure an investor does not go over the limits, because an investor could invest through a number of different funding portals, so the issuer and the funding portal have to rely upon the investor to keep track of their investments. The funding portal has the responsibility and the issuer can rely upon the funding portal, as long as the issuer does not know that the funding portal is wrong and the investor really has more investments; and
2. the way you calculate income and net worth for these rules is the same way you calculate it for an “accredited investors.” This means that the primary residence is excluded in the calculation, unless the house is “upside down,” then you have to count the excess debt as a liability. Just like an accredited investor, you can count the married couple jointly as one investor.