As we continue to overcome the impacts of the pandemic, escalating inflation, and a potential recession in early 2023, entrepreneurs have to get even more creative when it comes to funding their businesses. This includes creating engaging and tactical crowdfunding campaigns that mobilizes a large number of their social media followers, clients, customers, and other supporters to invest in their businesses through individual contributions of any size. This is made possible through Regulation Crowdfunding (Reg CF), which has grown in popularity with increasingly more start-ups and small businesses using it as their main route to early-stage capital especially during socio-economic crises.
In the early months of the pandemic, Asha Grant who founded the Salt Eaters Bookshop (a Black woman owned bookstore serving Black women, femmes, and non-binary people) raised over $81,000 in online community capital from hundreds of donors byAugust 2020. Many start-ups and businesses like the Salt Eaters Bookshop are able to freely engage in this type of online crowdfunding campaign without additional legal burdens because they sought donations, grants, or money from contributors who did not expect a return or other financial gain. However, if a business desires to offer something of value to a contributor in exchange for their contribution, such as a share of equity within their company or an appreciated good, then that business owner may end up having to comply with U.S. Securities laws and should strongly consider hiring a securities attorney to help them navigate potential legal issues and financial costs that may arise during their campaign.
The United States Congress’ Securities Act of 1933 requires the offer and sale of securities such as business offerings associated with crowdfunding campaigns to be registered with the Securities Exchange Commission (SEC) unless it meets an exemption. A security is broadly defined by federal law and includes, but not limited to, a stock, certificate of interest, investment contract, debt or note instrument, and a revenue or profit-sharing agreement. The SEC is a federal agency that is tasked with protecting investors like crowdfunding participants from fraud and market manipulation. The Financial Industry Regulation Authority (FINRA) is authorized by the United States Congress to also protect crowdfunding investors by ensuring that the exchange markets, broker-dealers and registered crowdfunding portals operate fairly and honestly.
Reg CF is a federal securities exemption that overrides State-level securities registration. Some States still require notice filings for Reg CF offers for businesses with residence in that particular State or businesses that raise a significant amount of money from investors in that particular State. The State overriding feature of Reg CF makes capital raising less costly for small businesses and opens up more investment opportunities from contributors. Reg CF should not be confused with donation-based crowdfunding such as Asha Grant’s offer or with rewards-based crowdfunding.
A rewards-based crowdfunding campaign is not likely to be considered securities offering if structured in a way that does not create an expectation or an actual financial return to investors. Still, a rewards-based crowdfunding offer does provide something of value in exchange for individual contributions. The question then becomes whether this something creates a financial return for contributors or some other sign of a “security,” as that is broadly defined. This question is evaluated under a “risk capital” test by State courts. It is therefore important for businesses and entrepreneurs to hire legal counsel in order to help them navigate these complex legal issues even for a rewards-campaign offer. Still, some offers are clearly securities, such as those offered through Reg CF.
There are six main features of Reg CF that businesses should know about:
(1) businesses are eligible to raise up to $5 million dollars within a 12-month period from investors across the nation;
(2) businesses can raise money from up to 2,000 investors, including 500 non-accredited investors, without having to register their crowdfunding offer with the SEC as long as their company's assets remain below $25 million and they have engaged a transfer agent;
(3) businesses can now create a special purpose vehicle (SPV) to help manage investors and facilitate investment into their company which will also give them the ability to raise more money from more investors without having to register or engage a transfer agent since the SPV (and the investors that will fall under it) only count as a single investor;
(4) all Reg CF offers and communications regarding the business’ offer must go through a SEC registered intermediary or crowdfunding portal;
(5) businesses must disclose all risk factors and other pertinent information to investors in a document called Form C; and lastly,
(6) businesses should hire their own legal counsel when raising capital even through Reg CF in order to protect their interests and ensure proper legal compliance.
The main documents that should be filed with the SEC when conducting a Reg CF offer is the:
Form C with appropriate Risk Factors and other material disclosures;
Subscription Agreement
Term Sheet;
Operating Agreement or By-Laws; and
Note, where applicable;.
There are also a few limitations of the Reg CF exemption that businesses should be aware of. This includes the $5 million cap in any 12-month period. As stated, businesses can now raise up to $5 million in a 12-month period from a previous cap of $1 million (effective March 15, 2021). This cap includes any amount of money already raised during the 12-month period prior to undergoing a Reg CF offer in addition to the amount the company will raise in its current Reg CF offering. This means that companies will have to combine the amounts that were raised prior to their Reg CF offer, including any other Reg CF offerings, which can severely limit how much the company can raise in its current Reg CF campaign. Additionally, investors are further limited in how much money they can invest in any given year across all Reg CF platforms. This means that if an investor has invested $2,200 or 5%-10% of the greater of their annual net worth or income in one crowdfunding intermediary, then it cannot invest in another portal for a period of 1 year.
Other limitations concern business communications, especially communication to its investors. The SEC requires all communications by the company to its investors and potential investors to be conducted only through the crowdfunding platform because it is easier for the SEC to monitor the activities of the business and gauge compliance with its crowdfunding rules. Communications outside of the crowdfunding portal are extremely limited. For instance, businesses may provide a written notice to potential investors that they are conducting a Reg CF offering and may include certain terms of the offering, such as the total amount of money the business is raising; the price of the offering; the nature of the offering - i.e. equity, debt or convertible note; and the closing date for when the last investment may be made. This notice may also provide the contact information and description of the business. However, the notice must direct all potential investors to the crowdfunding portal to gather the full information of the offering.
Another important note to keep in mind is that there are some businesses that are ineligible to use the Reg CF exemption. Some of these include non-U.S. companies; companies that are already Exchange Act reporting companies; companies that are disqualified under the disqualification rules for Reg CF, and investment funds, including those that are exempt under the Investment Company Act of 1940.
It is also very important to update investors of any changes that occur before the Reg CF offering is closed or terminated. Generally, these are progress updates regarding the target or maximum offering amount. The target offering is the minimum amount the business would like to raise in a 12 month period. The maximum offering is the total amount that a business is allowed to raise in a 12-month period. In addition, the business must file an amendment with the SEC if any of the changes or updates to the Form C or offer are material. Amending the Form C carries a slight risk because investors will be required to reconfirm their investment within five (5) business days or the business will lose their investment and monies will be returned to the investor. Finally, the Reg CF exemption requires businesses that have already sold securities to file an annual report called Form C-AR. This should occur, at the latest, 4 months after the end of the business' fiscal year in which its offering closed.
In conclusion, Reg CF allows businesses to receive investment much easier than other routes, but it is legally complex. Therefore, it is important that businesses hire their own business capital and corporate securities attorney to not only make the crowdfunding process clearer, but to also make sure that they are compliant with the various SEC rules! Contact us today for a Reg CF consultation session!
*co-authored by Elizabeth L. Carter, Esq., Managing Attorney
*updated on December 20, 2022