Raising Capital Over the Internet: Equity Crowdfunding vs. Accredited Investor Offerings
Are you looking to raise capital for your company over the Internet? Have you been hearing about the new SEC rules that will allow crowdfunding of start-ups and other growing companies by offering stock for sale directly to investors? Or are you considering a web or email-based capital-raising campaign to take advantage of the new SEC Rules permitting advertising and general solicitation to accredited investors? Shumaker Mallory LLP is an experienced, results oriented law firm of business and securities law experts located in Beverly Hills and serving Los Angeles, Santa Monica and all of Southern California, who offer quality services at rates that are a fraction of those charged by large corporate law firms. Call now at (424) 256-8560 for a free consultation, or send us an email via our contact form.
Raising Capital Over the Internet
One of the most frequent questions that we receive is “how can I go about raising capital for my company over the Internet?” As with many other areas, the law has struggled to keep up with the changes that the Internet has brought to all aspects of business and the economy.
Many business owners and entrepreneurs are surprised to learn that the law severely limits their ability to raise capital over the Internet, dictating the types of investors they may approach, the type of advertising and solicitation that they may undertake, the level of financial and other information that must be provided to potential investors, their ability to pay commissions to finders and other referral sources, and a host of other matters. These restrictions apply to even the most informal friends-and-family type of investments, not to mention venture capital and other institutional financings. Furthermore, both Federal and state securities laws (which are not always consistent) must be examined, and if there are investors from more than one state participating in the financing, then the laws of each state of residence will need to be followed.
It may seem unfair that, with minimal effort and expense, anyone can set up a website and immediately begin taking in money from the general public for the sale of virtually any product or service with almost no regulation or interference from the government, short of fraud or other seriously bad behavior. Yet, when it comes to selling stock in a company, a host of Federal and state laws are triggered that make the process difficult, expensive, time consuming and fraught with traps for the unwary.
The reasons are partly historical. When Congress enacted the Federal securities laws in the early 1930’s, following the 1929 stock market crash, they made it the organizing principle that every purchase or sale of a security must first be registered with the Securities and Exchange Commission (SEC), an expensive and time consuming process that requires the preparation and delivery to investors of a detailed prospectus disclosing material information about the company (including its audited financial statements). Failure to register can lead to civil (and in some cases criminal) penalties, as well as liability in private lawsuits.
For start-up and other growth companies wishing to raise capital by selling stock or other forms of equity, there are basically three alternatives that are available today:
- the traditional private placement to a small group of sophisticated investors, using personal contacts and avoiding all advertising and general solicitation;
- a private placement solely to accredited investors (i.e., rich people), which, under new rules adopted by the SEC in September 2013, may be made via web sites, email campaigns and other forms of general advertising and general solicitation; and
- An offering via an equity crowdfunding portal under rules that became effective in May 2016.
For more information, please see my article Raising Capital for Your Business—An Overview.
Traditional Private Placements
A “private placement” is , in the words of Section 4(2) of the U.S. Securities Act of 1933 (Securities Act), an offering of securities “by an issuer not involving any public offering.” Regulation D of the SEC is most often relied upon when making a private placement. It contains three basic exemptions from the requirement to register the offering: Rule 504, for offerings in which the aggregate offering price does not exceed $1,000,000; Rule 505, for offerings in which the aggregate offering price does not exceed $5,000,000; and Rule 506, for offerings in which the aggregate offering price may be any amount. Rules 505 and 506 are limited to 35 non-accredited investors; Rule 504 does not have any such limitation, and permits certain types of public offerings if regulated by the states in which the securities are sold.
Most private placements are done under Rule 506, which offers the greatest flexibility. This article will therefore concentrate on Rule 506. For those seeking further details on Regulation D, including the other exemptions it provides, please see my article Private Placements under Regulation D: Rules 504, 505 and 506.
It should be noted that all of these exemptions apply only to the requirement to register the securities with the SEC; the other provisions of the Securities Act, including the anti-fraud provisions, are still applicable. Other key concepts, such as when two separate placements will be treated as a single transaction (“integration”); the categories for qualifying as an accredited investor; and the rules for counting the number of purchasers are discussed in my article Regulation D Private Placements: Overview.
Rule 506 Requirements
Section 926 of the Dodd-Frank Wall Street Reform and Consumer Protection Act required the SEC to adopt rules that disqualify securities offerings involving certain felons and other bad actors from reliance on Rule 506. In Securities Act Release No. 33-9211 (May 25, 2011), the SEC proposed implementing amendments to Rule 506. The list of disqualifying matters is similar to but not exactly the same as that applicable to Rule 505 and Regulation A offerings.
No Limitation on Aggregate Offering Price
Unlike Rules 504 and 505, there is no limitation on the aggregate offering price. Thus Rule 506 is the most flexible of the Regulation D exemptions.
Number and Qualification of Purchasers
Rule 506 offerings are limited to no more than 35 non-accredited investors. Each purchaser who is not an accredited investor either alone or with his purchaser representative(s) must have such knowledge and experience in financial and business matters that he is capable of evaluating the merits and risks of the prospective investment, or the issuer reasonably believes immediately prior to making any sale that such purchaser comes within this description.
A purchaser representative must be unaffiliated with the issuer and its officers, directors and 10% shareholders, and meet the following additional criteria:
- The purchaser representative must have such knowledge and experience in financial and business matters that he is capable of evaluating, alone, or together with other purchaser representatives of the purchaser, or together with the purchaser, the merits and risks of the prospective investment;
- The purchaser representative must be acknowledged by the purchaser in writing, during the course of the transaction, to be his purchaser representative in connection with evaluating the merits and risks of the prospective investment; and
- The purchaser representative must disclose to the purchaser in writing a reasonable time prior to the sale of securities to that purchaser any material relationship between himself or his affiliates and the issuer or its affiliates that then exists, that is mutually understood to be contemplated, or that has existed at any time during the previous two years, and any compensation received or to be received as a result of such relationship.
If an issuer sells any securities under Rule 506 to any purchaser that is not an accredited investor, the issuer must furnish the information specified in Rule 502(b) of Regulation D.
The type of information that must be furnished depends on several factors. In this article, I will focus n offerings made by domestic (U.S.) private issuers. The disclosures for public companies are based on their filed disclosure documents, and are detailed in Rule 502(b).
Disclosure of Non-Financial Information.
For private issuers, at a reasonable time prior to the sale of securities the issuer must furnish to the purchaser, to the extent material to an understanding of the issuer, its business and the securities being offered both financial and non-financial information. If the issuer is eligible to use Regulation A, it must provide the same kind of information as would be required in Part II of Form 1-A. If the issuer is not eligible to use Regulation A, it must provide the same kind of information as required in Part I of a registration statement filed under the Securities Act on the form that the issuer would be entitled to use.
Disclosure of Financial Information.
Offerings up to $2,000,000. The information that must be provided is that required in Article 8 of Regulation S-X, except that only the issuer’s balance sheet, which shall be dated within 120 days of the start of the offering, must be audited.
Offerings up to $7,500,000. The financial statement information that must be provided is that required in Form S-1 for smaller reporting companies. If an issuer, other than a limited partnership, cannot obtain audited financial statements without unreasonable effort or expense, then only the issuer’s balance sheet, which shall be dated within 120 days of the start of the offering, must be audited. If the issuer is a limited partnership and cannot obtain the required financial statements without unreasonable effort or expense, it may furnish financial statements that have been prepared on the basis of Federal income tax requirements and examined and reported on in accordance with generally accepted auditing standards by an independent public or certified accountant.
Offerings over $7,500,000. The financial statement information that must be provided is that which would be required in a registration statement filed under the Securities Act on the form that the issuer would be entitled to use. If an issuer, other than a limited partnership, cannot obtain audited financial statements without unreasonable effort or expense, then only the issuer’s balance sheet, which shall be dated within 120 days of the start of the offering, must be audited. If the issuer is a limited partnership and cannot obtain the required financial statements without unreasonable effort or expense, it may furnish financial statements that have been prepared on the basis of Federal income tax requirements and examined and reported on in accordance with generally accepted auditing standards by an independent public or certified accountant.
In addition, at a reasonable time prior to the sale of securities to any purchaser that is not an accredited investor in a transaction under Rule 505 or Rule 506, the issuer shall furnish to the purchaser a brief description in writing of any material written information concerning the offering that has been provided by the issuer to any accredited investor but not previously delivered to such unaccredited purchaser. The issuer shall furnish any portion or all of this information to the purchaser, upon his written request a reasonable time prior to his purchase.
The issuer shall also make available to each purchaser at a reasonable time prior to his purchase of securities in a transaction under Rule 505 or Rule 506the opportunity to ask questions and receive answers concerning the terms and conditions of the offering and to obtain any additional information which the issuer possesses or can acquire without unreasonable effort or expense that is necessary to verify the accuracy of information furnished.
At a reasonable time prior to the sale of securities to any purchaser that is not an accredited investor in a transaction under Rule 505 or Rule 506, the issuer shall advise the purchaser of the limitations on resale in the manner discussed above.
Manner of Offering and Resale Restrictions
In a traditional Rule 506 offering, neither the issuer nor any person acting on its behalf shall offer or sell the securities by any form of general solicitation or general advertising. As discussed below, in offerings made solely to accredited investors, this requirement has been eliminated.
General solicitation and general advertising includes (1) any advertisement, article, notice or other communication published in any newspaper, magazine, or similar media or broadcast over television or radio; and (2) any seminar or meeting whose attendees have been invited by any general solicitation or general advertising.
Securities acquired in a transaction under Rule 506 “have the status of securities acquired in a transaction under section 4(2) of the [Securities] Act and cannot be resold without registration under the Act or an exemption therefrom.” Accordingly, Rule 502(d) of Regulation D requires the issuer to exercise reasonable care to assure that the purchasers of the securities are in compliance. This reasonable care may be demonstrated by the following:
- Reasonable inquiry to determine if the purchaser is acquiring the securities for himself or for other persons;
- Written disclosure to each purchaser prior to sale that the securities have not been registered under the Act and, therefore, cannot be resold unless they are registered under the Act or unless an exemption from registration is available; and
- Placement of a legend on the certificate or other document that evidences the securities stating that the securities have not been registered under the Act and setting forth or referring to the restrictions on transferability and sale of the securities.
While taking these actions will establish the requisite reasonable care, it is not the exclusive method to demonstrate such care. Other actions by the issuer may satisfy this provision. In addition, the issuer is required to deliver to non-accredited investors in a Rule 505 or 506 offering written disclosure of the limitations on resale to investors.
Filing of Form D
An issuer relying on a Regulation D exemption must file a form D with the SEC within 15 days of the first sale. Rule 503 details requirements for amending Forms D and related matters.
Private Placements to Accredited Investors Using General Advertising and General Solicitation, Including Internet Offerings
Can I set up a website to help market my company’s private placement to prospective investors? Can I send out email blasts? Advertise through Google Adsense or other online advertising? Set up a marketing program based on in-person seminars or on-line videos? What about crowdfunding portals?
Traditionally, advertising and “general solicitation,” such as cold calling programs, were strictly prohibited for private placements. This all changed in April 2012 with the passage of the Jumpstart Our Business Startups (JOBS) Act. Section 201 of the Act directed the SEC to amend Rule 506 of Regulation D to eliminate the restriction on advertising and general solicitation for offerings to accredited investors. The SEC adopted these revisions to Regulation D, which became effective in September 2013. Securities Act Release No. 33-9415.
Verifying Accredited Investor Status
One trade off for utilizing the new Rule is that the issuer must take reasonable steps to verify the accredited investor status of each investor. The final rules contain a detailed non-exclusive and non-mandatory list of methods that issuers may use to verify the accredited investor status of natural persons. However, none of these is available if the issuer has knowledge that the person is in fact not accredited. According to the Release, whether the steps taken are “reasonable” will be an objective determination by the issuer (or those acting on its behalf), in the context of the particular facts and circumstances of each purchaser and transaction. It will also be important for the issuer to maintain adequate records to support the steps that it took to verify the investors’ status. The following are the four methods described in the Release:
In regard to whether the purchaser is an accredited investor on the basis of income, reviewing any Internal Revenue Service form that reports the purchaser’s income for the two most recent years (including, but not limited to, Form W-2, Form 1099, Schedule K-1 to Form 1065, and Form 1040) and obtaining a written representation from the purchaser that he or she has a reasonable expectation of reaching the income level necessary to qualify as an accredited investor during the current year. In the case of a person who qualifies as an accredited investor based on joint income with that person’s spouse, the issuer would be deemed to satisfy this verification requirement by reviewing copies of Internal Revenue Service forms that report income for the two most recent years in regard to, and obtaining written representations from, both the person and the spouse.
Net Worth Verification
In regard to whether the purchaser is an accredited investor on the basis of net worth, reviewing one or more of the following types of documentation dated within the prior three months and obtaining a written representation from the purchaser that all liabilities necessary to make a determination of net worth have been disclosed:
- With respect to assets: bank statements, brokerage statements and other statements of securities holdings, certificates of deposit, tax assessments, and appraisal reports issued by independent third parties; and
- With respect to liabilities: a consumer report from at least one of the nationwide consumer reporting agencies.
In the case of a person who qualifies as an accredited investor based on joint net worth with that person’s spouse, the issuer would be deemed to satisfy this verification requirement by reviewing such documentation in regard to, and obtaining written representations from, both the person and the spouse.
Written Third-Party Confirmation
Obtaining a written confirmation from one of the following persons or entities that such person or entity has taken reasonable steps to verify that the purchaser is an accredited investor within the prior three months and has determined that such purchaser is an accredited investor:
- A registered broker-dealer;
- An investment adviser registered with the SEC
- A licensed attorney who is in good standing under the laws of the jurisdictions in which he or she is admitted to practice law; or
- A certified public accountant who is duly registered and in good standing under the laws of the place of his or her residence or principal office.
The terms of the offering will also affect whether the verification methods used by the issuer are reasonable. The SEC states that a purchaser’s ability to meet a high minimum investment amount could be a relevant factor to the issuer’s evaluation of the types of steps that would be reasonable to take in order to verify that purchaser’s status as an accredited investor. “By way of example, the ability of a purchaser to satisfy a minimum investment amount requirement that is sufficiently high such that only accredited investors could reasonably be expected to meet it, with a direct cash investment that is not financed by the issuer or by any third party, could be taken into consideration in verifying accredited investor status.”
In regard to any person who purchased securities in an issuer’s Rule 506(b) offering as an accredited investor prior to the effective date of the Release and continues to hold such securities, for the same issuer’s Rule 506(c) offering, obtaining a certification by such person at the time of sale that he or she qualifies as an accredited investor.
The Release recognizes that a person could provide false information or documentation to an issuer in order to purchase securities in an offering made under the new Rule 506(c). Thus, even if an issuer has taken reasonable steps to verify that a purchaser is an accredited investor, it is possible that a person nevertheless could circumvent those measures. If a person who does not meet the criteria for any category of accredited investor purchases securities in a Rule 506(c) offering, the SEC stated that it believes that the issuer will not lose the ability to rely on Rule 506(c) for that offering, so long as the issuer took reasonable steps to verify that the purchaser was an accredited investor and had a reasonable belief that such purchaser was an accredited investor at the time of sale.
Form D has been modified to include a check box to indicate that the offering is being made in reliance on the new Rule 506(c). A related release, Securities Act Release No. 33-9416, deals with these and related matters, including the temporary requirement for filing proposed general solicitation materials, mandatory legends and other disclosures to be included in solicitation materials and coordination of the new rules with Rule 156. A separate article will cover these items in greater detail.
What is an Accredited Investor?
Accredited investors are considered to be capable of evaluating the risks of an investment and to have the financial resources necessary to withstand the risk of loss. For this reason, the minimum level of information that must be disclosed to non-accredited investors in Rule 506 offerings does not apply to accredited investors. Unlike with non-accredited investors, there is no limit on the number of accredited investors that ay participate in a Rule 506 offering.
There are eight categories of accredited investor. Any person who comes within any of these categories, or who the issuer reasonably believes comes within any of the following categories, at the time of the sale of the securities to that person, will be accredited:
(1) Most types of banks, insurance companies, securities broker-dealers, insurance companies, mutual funds and registered investment companies and small business development companies, SBA small business development companies, state employee benefit plans with total assets in excess of $5,000,000, and ERISA benefit plans if the investment decision is made by a plan fiduciary that is either a bank, savings and loan association, insurance company, or registered investment adviser, or if the employee benefit plan has total assets in excess of $5,000,000 or, if a self-directed plan, with investment decisions made solely by persons that are accredited investors;
(2) Any private business development company under the U.S. Investment Advisers Act of 1940;
(3) Any non-profit organization described in section 501(c)(3) of the Internal Revenue Code, corporation, Massachusetts or similar business trust, or partnership, not formed for the specific purpose of acquiring the securities offered, with total assets in excess of $5,000,000;
(4) Any director, executive officer, or general partner of the issuer of the securities being offered or sold, or any director, executive officer, or general partner of a general partner of that issuer;
(5) Any natural person whose individual net worth, or joint net worth with that person’s spouse, exceeds $1,000,000. For these purposes:
The person’s primary residence is included as an asset;
Indebtedness that is secured by the person’s primary residence, up to the estimated fair market value of the primary residence at the time of the sale of securities, is not included as a liability (except that if the amount of such indebtedness outstanding at the time of sale of securities exceeds the amount outstanding 60 days before such time, other than as a result of the acquisition of the primary residence, the amount of such excess must be included as a liability); and
Indebtedness that is secured by the person’s primary residence in excess of the estimated fair market value of the primary residence at the time of the sale of securities must be included as a liability;
(6) Any natural person who had an individual income in excess of $200,000 in each of the two most recent years or joint income with that person’s spouse in excess of $300,000 in each of those years and has a reasonable expectation of reaching the same income level in the current year;
(7) Any trust, with total assets in excess of $5,000,000, not formed for the specific purpose of acquiring the securities offered, whose purchase is directed by a “sophisticated person,” as described in Rule 506.
(8) Any entity in which all of the equity owners are accredited investors.
The relaxation of the prohibition on general advertising and solicitation applies only to offerings to accredited investors. To enable start-ups and other companies to make private offerings of stock and other securities to non-accredited investors, Congress, in Title III of the JOBS Act, created a new regime for equity crowdfunding. Under this new provision, equity crowdfunding transactions must be made either through a registered securities broker-dealer or through a “funding portal,” which is a website through which equity crowdfunding transactions may be consummated. These funding portals must meet a number of statutory requirements and must be registered with the Securities Exchange Commission (SEC).
In October 2013 the SEC published its long-awaited proposed rules implementing the equity crowdfunding provisions of the JOBS Act. The SEC published its final rules in October 2015, and they went into effect in May 2016. The SEC and FINRA began processing crowdfunding portal applications at that time.
The JOBS Act and the proposed rules impose a number of limitations on equity crowdfunding portals and transactions:
$1,000,000 Limitation on Amount Raised
The amount of funds that a company may raise in any 12-month period is limited to $1,000,000.
Limitations on Individual Investments
The maximum amount that any person may invest in an equity crowdfunding transaction is limited to the following mounts:
- The greater of $2,000 and 5% of the annual income or net worth of the investor, if either the investor’s annual income or net worth is less than $100,000; and
- 10% of the annual income or net worth of the investor, not to exceed an investment amount of $100,000, if either the investor’s annual income or net worth is equal to or more than $100,000
Audit and Disclosure Requirements
Issuers must file with SEC and provide to investors basic information disclosure, including:
- Names of officers, directors, 20% shareholders
- Description of business
- Financial information
- Purpose and terms of the offering
- Ownership and capital structure
The financial information must include reviewed or audited financial statements depending on the offering size:
- Up to $100,000: corporate tax returns plus financial statements certified by the principal executive officer of the company to be true and complete in all material respects
- $100,000 to $500,000: financial statements reviewed by an independent accountant
- More than $500,000: audited financial statements
These requirements will impose significant costs on companies using equity crowdfunding. The disclosure requirements will make the use of an experienced securities lawyer strongly advisable, and the review and audit requirements will require that the company hire an independent accountant at a not insubstantial cost.
- Companies may not advertise the terms of the offering except to direct investors to the funding portal.
- Compensation of finders is to be limited as provided in the SEC rules.
- A report of the results of operations and financial statements must be provided to investors and filed with the SEC at least annually.
- Liability for material misstatements and omissions is imposed on companies engaging in equity crowdfunding capital raises.
- Issuers, brokers and funding portals that have committed past securities violations and other infractions are prohibited from engaging in the equity crowdfunding transactions.
Will Equity Crowdfunding Become a Major New Avenue for Start-Ups and Growing Companies to Raise Capital?
Because of the costs and restrictions imposed on issuers wishing to engage in equity crowdfunding transactions, it is unclear whether the reality will match the hype surrounding this new mode of capital raising for startups and other small companies. However, for the company that does not need more than $1,000,000 per year and is able to navigate the regulatory minefield established by the JOBS Act, equity crowdfunding may provide a viable alternative to the traditional private placement or a web-based placement directed solely to accredited investors. In any case, until the new Rules go into effect, companies must either raise capital through a traditional private placement, and avoid all forms of general advertising and general solicitation, or limit the offering to verified accredited investors, in which case they can use general advertising and general solicitation, over the Internet and otherwise.
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