New Options for Small Businesses to Raise Capital in a Public Offering Using Crowdfunding12/10/2014 | Winter 2014 Newsletter
Congress, in 2012, created a crowdfunding exemption in federal securities laws to allow companies to raise up to $1,000,000 in a public offering without the complexity of a traditional IPO. This will eventually allow small and emerging businesses to raise capital at lower costs.
In October, the Securities and Exchange Commission issued proposed regulations to implement the statute. Comments on the proposal may be submitted until February 3, 2014. In December, I organized, as Chair of the Business Law Section of the New York State Bar Association, a program on the proposal. The SEC representative who spoke at the program wouldn’t speculate when final rules will be adopted, but based upon some things she said, I expect final rules before the summer.
Modern crowdfunding is alleged to have started in 1997, when American fans of the British rock group Marillon raised $60,000 on the Internet so the band could tour the US. The web site Kickstarter raises money for everything from crazy inventions to space exploration. However, these solicitations do not offer an interest in the profits of a business enterprise. Thus, they are not offering a security. Kickstarter style websites don’t violate securities laws because they offer a t-shirt or a warm feeling. It is completely different if a business opportunity is available through the Internet, and people invest in that opportunity with the expectation of a profit.
The JOBS Act crowdfunding exemption will allow companies to raise up to $1,000,000 per year from the general public without an expensive filing with the SEC. The companies will not have to satisfy the quarterly report, annual report and proxy statement requirements that are appropriate for Microsoft and Citigroup, but not for a company raising $1,000,000 or less for startup capital, or to grow its business. These new offerings will be made to the public through an electronically accessible independent portal similar to Kickstarter, but with more disclosure and more control. The company must disclose information on the portal about its officers and other people in control, its financial statements, and its business plan. The company will not be able to hype the offering outside the portal and “the crowd” of people interested in the offering will be allowed to discuss the offering on the portal.
Some people worry that crowdfunding will allow issuers to defraud unsophisticated investors because anyone is permitted to invest in such a deal. There is no minimum education requirement, no minimum income requirement, no minimum net worth requirement and no requirement that the investment be suitable for the investor. My 91 year-old mother may invest in a speculative startup issuing long term zero coupon bonds. The SEC makes it clear that the investor decides whether the investment is suitable, with no requirement for a broker dealer or investment advisor.
There are limits on the amount that each investor is allowed to invest each year, based upon the investor’s income and net worth. Each investor is allowed to invest at least $2,000 per deal per year. The investment can be as high as $100,000 per year for investors with income or net worth over $1,000,000.
Should you consider crowdfunding to raise capital for your existing company, or to fund your new business idea? The answer is, “it depends.” Remember, you are limited to raising $1,000,000 per year. You have to be prepared to tell your story to the public, and you have to be prepared to issue meaningful financial statements. If you are raising more than $500,000, you will probably even need audited financial statements. Once you raise money this way, you will have to continue to make annual filings of your financial statements.
However, you have tremendous flexibility in structuring your offering. You can raise capital for a corporation, a partnership, and most other business entities. You can offer voting interests or nonvoting interests. You can offer equity, like stock, or debt, like fixed or variable interest bonds. You have an almost unlimited ability to invent the terms of your security. You can limit investors to only members of your local community if you think that’s appropriate. You can set a low maximum investment limit and try to get a lot of investors who will be motivated to patronize your company, or you can set a high minimum to try to limit the number of stakeholders.
How much will it cost? It’s hard to say and will depend on exactly how the SEC regulations finally take shape. At the seminar I organized, general counsel to one of the portals suggested that the fees to the portal could be between 5% and 10% of the offering. There will be accounting fees and legal fees, and you will have to spend time your own time putting the deal together. However, you can raise equity capital with no mandatory dividend, which could make crowdfunding a lot less expensive than, for example, a bank loan with points, fees and an annual interest payment obligation.
If you want to discuss the possibility of raising money through crowdfunding, let us know and we will keep you up to date as the SEC regulatory proposal is finalized.
About the author: Jay L. Hack is a partner at Gallet Dreyer & Berkey, LLP and head of the firm’s banking department. Mr. Hack’s practice focuses on providing a full range of legal services to banks and other financial institutions. Mr. Hack can be reached at firstname.lastname@example.org.