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The
Entrepreneurial Spirit
®
Newsletter
Special 2016 New Year Edition - Crowdfunding
Getting ready for the new year? We can help, so let's get right to it.
In this special edition of the The Entrepreneurial Spirit ®,
we address the new way to raise money for
your venture: Crowdfunding: A Game Changer.
Our legal assessment report is
produced separately; this short article is intended to warm
you up for the new way to raise money—coming in 2016—for inventors,
artists, at-home parents,
innovators, high-tech companies, publishers, medical products, real
estate syndicates, film-makers, as well as everyone
else. Please keep in mind that Crowdfunding is
a complex area of law and you need to consult with an
experienced lawyer regarding implementation of your
strategies and goals.
Crowdfunding: A Game Changer
Coming May 16, 2016.
On April 5, 2012, the Federal Government enacted the "Jumpstart
Our Business Startups" Act, better known as the
JOBS
Act. On October 30, 2015, the
Securities and Exchange Commission (SEC) issued the
Final Rules, which become effective on May 16, 2016.
You can review the regulations from
our
law firm's
statute repository.
Get ready for May, 2016. Crowdfunding is a
game-changer.
What is Crowdfunding?
Crowdfunding is to
fund something by placing it before a "crowd" for
consideration, pooling money via the Internet,
to support a mission, idea or business plan. The
possibilities are endless.
Why is this a big deal?
You've heard of the
Stock Market Crash of 1929.
Among other things, the perceived causes of the '29
Crash included a lack of governmental control over the
securities (raising money) markets, along with a
significant amount of fraud. To rectify the
problem, the U.S. Congress enacted the
Securities Act of 1933 and the
Securities Act of 1934.
With these investor protections came a myriad of complex
limitations on the ability of entrepreneurs to raise
capital.
Complex securities laws have made raising money
difficult: one problem solved, another problem created.
When business has a difficult time raising money,
innovation is stifled, because opportunities can't get
financially leveraged to the marketplace. It has
been, and it remains, a contention in the industry to
find the balance between investor protection and raising
capital flexibility.
Laws v. Regulations?
"Acts" are
laws enacted by the legislative bodies of
government, such as Congress. "Regulations"
are issued by the administrative agency that has been created to oversee
the details of the administration of the law. So,
technically,
we have "laws" and we have "regulations"; sometimes both
are referred to as "laws" generically, because
both have the practical effect of law. For
example, Congress
enacted the Tax Act, and the administrative agency, the IRS, issues
the tax regulations; similarly,
Congress enacted the JOBS Act, and the administrative
agency, the SEC, issues the
regulations. Any disputes are ultimately
resolved in court. Crowdfunding, although enacted
in 2012, needed to await the writing and effectiveness
of the SEC regulations, coming in May, 2016.
Ambiguous Term, "Crowdfunding."
Be
careful, there are two types of “crowdfunding.”
If you google the term, you will find articles
claiming that crowfunding is already legal and other
articles saying that crowfunding is not yet legal. Which
is it?
1. Non-Equity.
One type of crowdfunding (also sometimes called "crowdsourcing")
that has already been implemented is to fund a
product by pre-sales.
www.Kickstarter.com
is a site that has implemented this model. That
is, to make a conditional product available.
This is the "If you fund it, we will build it"
model. If
enough pre-sales are achieved, the product is
produced. This is (probably) not a securities
issuance model because it is not equity-based.
Fraud potential still applies. This is the
only model available for non-profits, because
non-profits do not have equity-based opportunities.
Non-equity crowdfunding is, of course, an important
opportunity for both non-profits and for-profits.
2. Equity.
The other type of crowdfunding is a securities,
or equity-based, issuance model. That is, to sell
equity interests in an enterprise. This is the heart
of the securities paradigm revolution, and the
subject of the new regulations. The
equity-based crowdfunding model effectively pits
small companies to compete for pooled public
investment funds with a "best deal wins" capitalism
paradigm. It also permits small investors to
get into the game.
Equity-based crowdfunding is coming in 2016. Private
companies will now have the ability to raise money in
capital markets by selling equity shares via the
Internet, legally! It is still a complex area of
law, but it is a significant revolutionary paradigm
shift.
Golden Rule of Securities Law.
All
offers and sales of securities (e.g., raising
money by selling equity) must be registered with the
applicable securities agencies,
unless an exemption from registration exists.
Yes, be careful, securities laws apply to the
sale of a few shares of your equity to kindly Aunt Flo,
and other "family and friends."
Registration v. Exemptions.
You've probably heard of companies like FACEBOOK "going public."
This is a public offering registered with the
SEC; it is a complex and expensive set of transactions
for SEC registration and getting listed on a public
trading exchange.
You probably also know (or least you intuit) that many
sales of equity interests in companies occur without
securities registration. (Ala, the sale of
equity stock to Aunt Flo, and family and friends.) The reason is because
those unregistered sales of private equity, assuming performed in legal
compliance (sometimes accidentally by the unknowing), were pursuant to exemptions from
registration with the SEC. Basically, there
are a number of exemptions from registration for
"small" offerings and "private" sales of equity. Some of the
exemptions from registration are "self-executing
exemptions—meaning you automatically have the
exemption available to you; other exemptions from
registration are available only if you file a document
to claim it, called "non-self-executing exemptions." For non-self-executing exemptions, filing a document
to claim the exemption can be complex, but it is still not a
registration. Then, additionally, there is the
Federal system, as well as the dual applicability of every
state's ("Blue Sky") laws that are
affected by the equity transaction. And, apart
from the concept of registrations and exemptions, you
still need to ensure that there is a proper disclosure
of information to educate the prospective purchaser
regarding the nature of the investment.
Try saying the Golden Rule to yourself, now slightly
augmented: "Every sale of securities must
be registered, unless an exemption from registration
exists, and I know that there are a lot of exemptions from
registration, but I need to confirm that federal and
state exemptions are actually available for my intended transaction,
and, irrespective of registrations and exemptions, I
must provide disclosure documentation." If you
disregard the Golden Rule, you are simply "flying
blind." And, getting lucky is not good strategy.
But, what is
a "small" or "private" offering?
Regarding exemptions from registration, what exactly are
"small" and "private" offerings? If I sell to 5 people is that
private? If I put an advertisement in a small
newspaper, is that private? If I say on my webpage
that I am offering shares, is that private? If I
am only raising $10K, is that private? That
very question has caused significant litigation, but, to help
everyone out, sort of, the SEC has issued regulations to define
what is a small and/or private offering; that is, an acceptable context
to permit catch-all legal "safe harbor" exemptions from
registration. This is where SEC
REGULATION D, or "REG D" comes in to play. There
are three primary Reg D references: 504, 505 and 506,
each supplying context and conditions that permit raising capital
without registration. However, each has it
benefits and detriments. Unlike Reg. D 504 and
505, if an issuer meets the conditions, Reg D 506—called a "506
Offering" or "506 Private Placement"—allows raising an
unlimited amount of capital, and with "minimal" state
law involvement. Reg. D 506 preempts state
securities laws, which is a very big deal, because
federal law prevents the investment terms of a 506
Offerings from being reviewed by the applicable states.
States can have administrative filings, some of which
are now unified by the
North American Securities
Administrators Association (NASAA).
The JOBS Acts Modifications.
Generally, the JOBS Act creates a new registration exemption
that permits certain issuers to raise up to $1M within
any twelve month period. However, the maximum investment by any investor in such a
transaction must be limited to:
1. If either the investor's annual income or net worth
is less than $100K then: the greater of $2,000 or 5% of
the investor's annual income or net worth within any
twelve month period; or
2. Otherwise, if either the investor's annual income
or net worth is at least $100K then: 10% of the
investor's annual income or net worth, not to exceed $100K.
With this new opportunity for the private sale of
equity, significant investor
protections in connection with crowdfunding were put
into place:
1. A “funding portal” is an
intermediary in a securities offering that satisfies
certain requirements, including not offering
investment advice or recommendations, not soliciting
purchases, sales or offers to buy securities, and
not compensating employees or others based on the
sale of securities;
2. Ban on advertising the terms of the
offering;
3. Restricting the transfer of securities sold
under the exemption for one year;
4. Imposing personal civil liability onto the
principals for material misstatements or omissions
in connection with the offering;
5. Requiring the issuer to file with the SEC
(and to provide to investors and financial
intermediaries) certain information about the issuer
and its business, anticipated business plan,
financial condition, and details of the proposed
crowd funding transaction; and
6. Depending on the size of the offering, the
issuer would be required to provide different levels
of financial information: a) income tax returns and
financial statements certified by the principal
executive officer of the issuer for offerings of
less than $100,000; b) reviewed financial statements
by a certified public accountant for offerings of
more than $100,000, but not more than $500,000; and
c) audited financial statements for offerings of
more than $500,000.
The key to the entire crowdfunding paradigm is the
"Funding Portal," because the Funding Portals provide
the center-point for the offer and investment
transaction management. How Funding Portals will
actually roll
out in the marketplace, comply with the standards,
compete with each other, and add value, will be nothing
less than fascinating.
Funding Portals effectively act as a broker or funding
intermediary. The broker or funding portal must register with the SEC and any applicable
self-regulatory organization as a broker or funding
portal. It must provide certain disclosures to potential
investors relating to risks, with other investor education materials and ensuring that potential
investors review and acknowledge these disclosures.
Funding Portals must reduce the risk of fraud by
issuers, including conducting back-ground checks on
issuer principals, as well as make available to the SEC and potential investors any
information that the issuer provides to investors and
intermediaries. Moreover, Funding Portals must confirm compliance by issuers with the limitations on
investment amounts for crowd funding transactions set
forth above.
Conclusion.
The new crowdfunding exemption from registration is a
paradigm shift for raising capital in a now
pseudo-private market, brought to everyone by
embracement of the new online technologies. The
law limits the amount that an issuer can offer, and
limits the amount that an investor can invest. In
this way, the new law attempts to strike a new balance
between keeping the opportunities small and private,
with continued investor protections for the context.
The regulations are complex, because there are a number
of technical issues, such as integration of different
offering exemptions, measurement of the limitations,
etc.
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Crowdfunding gives
every idea and innovation a new hope of becoming a
reality. Every Amelia Earhart, Thomas Edison
or Henry Ford of our generation has a new hope of
disrupting the course of things by taking his
or her
idea directly to the public. Crowdfunding embraces the
American Entrepreneurial
Spirit.
—
Gregg Zegarelli |
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