As we continue to navigate through this pandemic, now more than ever, entrepreneurs have to get creative when it comes to funding their businesses. This includes creating crowdfunding campaigns that target social media followers, clients, customers, and other supporters in order to raise capital through small individual contributions from a large number of people. In fact, regulation crowdfunding has grown in popularity with more and more startups and small businesses using it as a premiere way to raise early-stage capital.
For example, Aisha Grant raised $82,000 from over 1,700 donors to help capitalize Salt Eaters. Just as Aisha, one can freely engage in this type of crowdfunding campaign without additional legal burdens simply because they seek donations, grants, or money without an expectation of a return. If one desires to offer something of value to a contributor in exchange for their contribution, then that business owner may end up in Securities law land and should strongly consider hiring a securities attorney to help them navigate potential legal issues that may arise from their campaign.
The Securities Act of 1933 requires the offer and sale of securities to be registered with the Securities Exchange Commission (SEC) unless it meets an exemption. A security is defined broadly by federal law and includes a stock, certificate of interest, investment contract, or participation in any profit-sharing agreement. The SEC is a federal agency that is tasked with protecting investors and the national banking system, especially against market manipulation. FINRA is authorized by the United States Congress to protect American investors by ensuring that the exchange markets, broker-dealers and registered crowdfunding portals operate fairly and honestly.
Regulation Crowdfunding (“Reg CF”) is a federal securities exemption that preempts State-level securities registration. Some States still require notice filings for Reg CF offers for businesses domiciled in that particular State or businesses that raise a significant amount of money from investors in that particular State. The state preemption 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. Nonetheless, a rewards-based crowdfunding offer does provide something of value and the question is whether this something of value creates a financial return for contributors or some other indica of security. Some States have construed a rewards-based crowdfunding offer as an actual offer of securities under the “risk capital” test. It is therefore important to hire a securities attorney to help navigate these potential legal issues even for a seemingly non-security offer. Still, some offers are clearly securities, such as those offered through Reg CF.
There are four main features of Reg CF worth mentioning here:
(1) you can raise up to $5 million dollars within a 12-month period from contributors all over the country;
(2) you can raise money from up to 2,000 equity investors, including 500 non-accredited investors, without having to register your offer with the SEC so long as your company's asset remain below $25 million and you have engaged a transfer agent;
(3) you can now create a special purpose vehicle (SPV) to help manage investors and facilitate investment into your company which will also give you the ability to raise money from more than 2,000 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. You should hire a securities attorney to help you structure this new Reg CF feature in order to get the most out of it;
(4) all Reg CF offers and communications regarding the offer must go through a SEC registered intermediary or crowdfunding portal; and lastly,
(5) you will need to disclose all risk factors and other pertinent information to investors in a document called Form C. Form C along with other investor documents, such as a Subscription Agreement and Term Sheet, and any governing documents such as an Operating Agreement, if applicable, will need to be filed with the SEC for qualification as well as the chosen crowdfunding intermediary for approval. 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 non-crowdfunding security 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.
In addition, there are limitations on communication between businesses and investors. The SEC requires all communications by the company to its investors and potential investors to be conducted only through the crowdfunding platform/portal/ intermediary because it is easier for the SEC to monitor the activities of the Company to ensure compliance with its crowdfunding rules. Outside of the crowdfunding intermediary/portal, communications 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 type of 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 intermediary/ portal to gather the full information regarding the offer.
Another important thing 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. Furthermore, if you do decide that you would like to move forward with a Reg CF offer, there are several disclosures that you will need to make on the Form C, including but not limited to:
(1) information about the officers, directors and owners of 20% or more of the company;
(2) the price of the securities or method for determining the price; (3) a
description of the business and financial information; and (4) a description
of the offering itself, including how the proceeds from the offering will be
used and the particular risks associated with the offer. You must then file the
Form C, including the accompanying exhibits, on the SEC’s Electronic Data Gathering,
Analysis and Retrieval (EDGAR) System, as well as with the intermediary/portal of
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 minimum and target 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.
Also, investors are required to reconfirm their investment commitment within five (5) business days when there is a material change to the offer. If not, the business is required to return the monies to the investor. This is something that the registered crowdfunding portal should be able to assist with. 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 conclusion, the Regulation Crowdfunding exemption or Reg CF is complex, and it's important that you hire a securities attorney to not only make the crowdfunding process clearer, but to also make sure that you 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