President Obama is slated to sign the Jumpstart Our Business Startups (JOBS) Act on Thursday, and the final, authoritative text of the bill has finally been made available to the public – you can take a look at http://www.gpo.gov/fdsys/pkg/BILLS-112hr3606enr/pdf/BILLS-112hr3606enr.pdf. Note that Title III is the crowdfunding part.
There have been a number of brief summaries floating around the web, but they all miss points that we believe are important – this bill is simply very long and detailed. Instead of a summary, we chose to provide you with a comprehensive look at Title III of the JOBS Bill, in plain English. Its long, but if you can hang in there you’ll be an expert on the new crowdfunding legislation and will most certainly win friends and influence people.
I. Crowdfunding Exemption
In general, a company (a.k.a. an “issuer”) can’t sell securities (e.g. stock) to the public, unless that company has either (a) registered its securities offering with the SEC (an expensive, time consuming process – think IPO), or (b) has an exemption from registration that it can rely on.
You’ve probably heard of Reg D offerings (504, 505 and 506 offerings). Reg D is one example of an exemption from registration; if the company follows the prescribed steps, jumps through the appropriate hoops, sells only to certain investors, etc, etc, then they can sell shares of their company without a registration. It still requires a somewhat tedious legal process, but its way easier than registering. Exemptions are good.
The JOBS Act creates a new exemption from registration for securities sold via crowdfunding offerings, so long as certain criteria are met, namely:
(A) no more than $1,000,000 is raised via crowdfunding in any 12 month period; and
(B) no single investor invests more than a specified amount in the offering, namely:
i. the greater of $2,000 or 5% of the annual income or net worth of the investor, as applicable, if the investor has annual income or net worth of less than $100,000; or
ii. 10% of the annual income or net worth of the investor, as applicable, if either the annual income or net worth of the investor is equal to more than $100,000, capped at a max of $100,000 invested.
(C) the offering is conducted through a registered broker or “funding portal” (a new term made up by the JOBS Act); and
(D) the issuer complies with certain other requirements that we’ll get to below.
Let’s look at a couple of examples of those dollar limits.
An investor who makes $30,000 per year (or who has $30,000 in net worth) can invest up to $2000 in crowdfunding campaigns in a given year. If their annual income or net worth is $80,000, then the investor can invest up to $4,000. If their annual income or net worth is $100,000 or more, then he/she can invest 10% of his/her annual income/net worth, up to a maximum of $100,000 (in the case that their income or net worth is $1,000,000).
Also, note the bit about the broker or funding portal. This is important, as it essentially forbids companies from crowdfunding their own offerings on their own websites – companies must go through an intermediary if they want to crowdfund, and those intermediaries must in turn be registered with the SEC. What does that mean? Read on.
II. Requirements on Intermediaries
The JOBS Act requires crowdfunding intermediaries to register with the SEC, either as a broker (which is an expensive and onerous process), or as a new thing called a “funding portal”. It isn’t clear yet what registering as a funding portal will entail – the SEC is writing the requirements at this very moment. What is clear is that the SEC has broad discretion with respect to this requirement – they can make funding portal registration as simple, or as burdensome, as they see fit. In addition to the SEC, funding portals will also be required to register with FINRA, the financial industry self-regulatory organization.
Moreover, the JOBS Act imposes a host of other requirements and limitations on crowdfunding intermediaries, including:
(A) providing certain disclosures and investor education materials to investors
(B) ensuring that the investor has reviewed educational materials and answers questions indicating that he/she understands the risks involved
(C) performing certain background checks on the issuer
(D) provide a 21 day review period before any crowdfund securities are sold
(E) ensure that an issuer does not receive investment funds until its target investment minimum has been reached, and that investors may cancel their commitments to invest as provided by the SEC (no word yet on how these cancellation provisions are going to look)
(F) ensure that no investor surpasses the investment limits set forth above in a given 12 month period in the aggregate – i.e. the limits described above with respect to investors apply to all crowdfunding investments in a given 12 month period, not just to individual investments, and the burden is on the intermediary to monitor this
(G) take steps to protect the privacy of investors
(H) not pay finders fees to promoters or lead generators with respect to investors (it appears to be okay to pay finders fees for issuer leads)
(I) not allow the intermediary’s directors, officers or partners to have a financial interest in an issuer using its services
All this, plus “meet such other requirements as the Commission may, by rule, prescribe” – it is clear that Congress does not intend for being a funding portal to be easy. Presumably this is why companies are forbidden to crowdfund themselves without an intermediary – by heavily regulating the intermediaries, and requiring all crowdfunding dealflow to go through registered intermediaries, Congress and the SEC keep crowdfunding on a tight leash, in theory safeguarding against fraud and abuse.
III. Requirements on Issuers
But wait, there’s more! The JOBS Act also imposes substantial requirements on companies seeking to utilize the crowdfunding exemption. For starters, they have to file with the SEC, the intermediary, and all potential investors, a beefy disclosure document that will include, at a minimum:
(A) name, legal status, address, website, etc.
(B) names of directors, officers, and 20% stockholders
(C) “a description of the business of the issuer and the anticipated business plan of the issuer” – the devil is really in the details of this one, and it remains to be seen whether the SEC will require this “description” to be 4 pages or 40 in order to be sufficient
(D) prior year tax returns, plus financials – see below for details
(E) description of intended use of proceeds
(F) target offering amount, deadline, and regular progress updates through the life of the offering
(G) share price and methodology for determining the price
(H) a description of the ownership and capital structure of the issuer, including a lot of detail about the terms of the securities being sold, the terms of any other outstanding securities of the company, a summary of the differences between them, a host of disclosures about how the rights of shareholders can be limited, diluted or negatively impacted, “examples of methods for how such securities may be valued by the issuer in the future, including during subsequent corporate actions”, and a disclosure of various risks to investors
We mentioned financials above, and this is a big one.
Companies looking to raise $100,000 or less via crowdfunding can provide financials that are merely certified as true by the officers of the company. Companies looking to raise between $100,000 and $500,000 must provide “reviewed” financials, which means they have to pay a CPA to go through them. Companies looking to raise over $500,000 must provide full-blown audited financial statements prepared by a CPA. Moreover, every year after a successful crowdfunding offering, issuers must file with the SEC and with investors reports of the results of operations and financial statements of the issuer.
Finally, an issuer must clearly disclose any compensation it pays to any person promoting its offerings through a broker or funding portal. In addition, issuers are not allowed to advertise the terms of the offering, except for notices with direct investors to the intermediary. Again, this goes back to the underlying principle that general solicitations for crowdfunding must at all times flow through an SEC-registered intermediary.
IV. Other Important Stuff
The JOBS Act goes on to clarify certain other features of the crowdfunding landscape, notably:
(A) the SEC has 270 days to make the rules that will flesh out this new law.
This is worth some elaboration. The way these things work is that Congress passes a law, which is essentially a skeleton, and then instructs the SEC to make rules to flesh out the law. Although, by all accounts, Congress got way more granular with this bill than is typical, there is still plenty to be fleshed out by the SEC.
Moreover, until the SEC has finished its rulemaking process, the current rules remain in effect. Assuming the SEC takes all 270 days allowed for rulemaking, this would mean that nobody could start crowdfunding under the new exemption until 2013 (to say nothing of the further delay caused by intermediaries having to be approved as a registered funding portal). Moreover, the SEC could miss this 270 day deadline – it’s not as if Congress is going to fire them.
So, the point is, while we technically have a law, in reality, its going to be awhile before anybody can use it.
(B) Crowdfunded shares shall, “conditionally or unconditionally”, be exempted from the 500 shareholder cap.
This is another big change.
Note that, prior to the JOBS Act, a company was essentially forced to go public if it ever got to 500 shareholders and $10 million in assets. A separate provision of the JOBS Act increases this threshold to 500 non-accredited investors or 2000 total investors, and excludes from the headcount employees who have received certain company stock as compensation.
That in and of itself is good news. But the provision in Title III is even better, as it hints that all crowdfunded shareholders will be excluded from the headcount – a tremendous benefit, given that a successful crowdfunding campaign is likely to bring in well over 500 non-accredited investors. We say “hints” because the SEC still has to make the rules, but we’re hopeful.
(C) The states are not permitted to layer extra regulations on top of crowdfunding offerings or crowdfunding intermediaries, and are very limited in their ability to impose filing fees on crowdfunded securities. However, Congress affirms the rights of the states to bring enforcement actions if they feel crowdfunding offerings are violating state securities laws. Moreover, states are to be provided with the details of crowdfunding offerings.
(D) an investor can sue an issuer, as well as its directors, partners and officers, for making an untrue statement of a material fact or omitting to state a material fact necessary in order to make the statements, in light of the circumstances under which they were made, not misleading (i.e. the standard fraud test for securities)
(E) crowdfunded securities cannot be transferred or resold for the first year after purchase, unless transferrred to the issuer, an accredited investor, as part of a registered offering, or to family members in some circumstances (i.e. death, divorce)
(F) only US offerings are eligible for the crowdfunding exemption. In addition, certain companies such as publicly listed companies, investment companies, and private equity and hedge funds may not use the exemption
(G) using the crowdfunding exemption does not preclude the raising of funds through other means – this is a good thing, it means companies can do a crowdfunding round simultaneously with an angel financing round under Reg D 506 or similar (though there are some pitfalls there – make sure to consult a securities lawyer)
(H) Certain “bad actors” who have violated securities laws in the past are forbidden from using the new exemption – if you’re not sure what this means, you’re probably in the clear
V. Wrap Up and Our Two Cents
If you’re still reading, then congratulations, and we’re sorry. We would have preferred this summary to have fit into a tweet; but this is the law we have been given. In fact, this is only the beginning – the bill is just the skeleton; the flesh must still be added by the SEC.
So, what does this all mean?
Well, on one hand, the bill is certainly more complicated than it could have been. A lot of industry proponents would have liked to have seen the original House bill passed, which was a lot less restrictive (but then again, after SEC rulemaking, who’s to say that we wouldn’t have ended up in exactly the same place?). For us personally, as a company who intends to be a crowdfunding intermediary, this looks like a lot of work. Weekends that could be spent on a mountain bike (or given the 270 day timing, on skis) will instead be spent filling out a lengthy application to register as a funding portal and to join FINRA. Yes, that will be annoying.
But, on the other hand, we get it. We understand that Congress and the SEC are concerned with protecting investors from fraud and abuse, and rightly so. Balancing investor protection with the promotion of economic growth is not an easy task, especially when you’ve got interest groups pulling from all sides. Would we have drawn the lines exactly where they did? Perhaps not. But, do we think what they’ve done is reasonable on the whole? Yes, we do.
We’re glad to see that the per-investor maximums are higher than they were in some iterations of the bill. We’re also pleased that crowdfunding offerings are required to go through an intermediary – we have been arguing for months that this is the best way to safeguard the integrity of the crowdfunding ecosystem.
More generally, we’re happy to see that our politicians and regulators are trying to build a system that the public trusts, and that is sustainable, and effective, and a durable part of our financial landscape. There is a lot of red tape; but then again this is the securities industry – investment-based crowdfunding is a fundamentally different animal than donation-only crowdfunding.
Above all, we’re thankful for the opportunity we’ve been given to engage in this great experiment. The legal and compliance bills for issuers and intermediaries may turn out to be higher than many hoped, but at the end of the day, we got a crowdfunding exemption.
When the dust settles, entrepreneurs and small business owners will have access to a revolutionary new method of raising capital, and ordinary Americans will be given the opportunity to invest in their friends, family, and favorite companies, and not just the behemoths offered by Wall Street.
Will the system be perfect? Nope. Will some clever criminals find a way to game it? Quite possibly. But remember, Enron was publicly traded, and Bernie Madoff once served as the chairman of the Nasdaq stock exchange. No law or regulation is perfect, and no corner of the securities landscape is free from abuse. Our politicians have handed us a bipartisan bill (no small thing in an election year) and given us rules of the road.
Others can complain if they wish – we prefer to build.