Small Business Funding — What You Need to Know Before Raising Money Through Equity Crowdfunding

Whether via social media channels or through personal investment experience, you’ve probably heard the term “crowdfunding” more frequently in recent years. Crowdfunding is generally defined as funding a project or venture by raising many small sums of money from a large number of people, usually over the Internet.

Crowdfunding can be divided into four types: reward-based, donation-based, lending-based, and equity-based. In reward-based crowdfunding, investors contribute money to a company in exchange for a reward or benefit, via a platform such as Kickstarter. In donation-based crowdfunding, investors donate money to a charity or cause with no expectation of anything in return, via a platform such as CrowdRise. In lending-based crowdfunding — also called peer-to-peer lending — investors loan money to a company via a platform such as LendingClub with full expectation of repayment, usually with interest.

I get the most questions from business owners about the fourth type of crowdfunding — equity-based crowdfunding. In equity-based crowdfunding, investors contribute money to a company in return for equity interests in that company. Much like investing in the stock market, investors hope to benefit from the growth and success of the company. Prior to the JOBS Act (Jumpstart Our Business Startups Act) of 2012, equity crowdfunding in private offerings had been essentially illegal.

Securities and Exchange Commission (SEC) regulations present obstacles for crowdfunding a business. In simple terms, every sale by a company (the issuer) of its securities needs to be registered with the SEC and applicable state securities commissions, or have an exemption from such registration. Registered offerings are public offerings — similar to IPOs — which are very expensive and time-consuming, and therefore not conducive for small and startup companies to use for raising capital.

Small and startup companies generally rely on private offering exemptions from federal and state securities laws to raise money, which require these companies or the brokers they engage to have a preexisting relationship with the investors and that they be accredited investors. Accredited investors are, generally, people with a net income of at least $200,000 in each of the last two years and an expectation of maintaining that same level of income in the current year (or $300,000 together with such person’s spouse) and/or a net worth in excess of $1,000,000 (excluding the value of such person’s primary residence).

For many companies, this available pool of investors is difficult to access. These companies want to be able to advertise on their website or elsewhere that they are raising money. However, trying to raise money over the Internet when the company does not have a preexisting relationship with its investors uses general solicitation or advertising to obtain those investors. That makes the offering a public offering under federal and state securities laws.

The JOBS Act has made it easier for crowdfunding companies to qualify for exemptions from registration, which enables them to crowdfund equity raises and avoid registered offerings. Title II and Title IV of this Act have been implemented as of the date of this article.

Title II of the JOBS Act went into effect in September 2013. Title II — or Rule 506(c) — permits certain companies to raise money over the Internet using a private offering exemption if all of the purchasers in those offerings are accredited investors. Companies relying on Rule 506(c) must take reasonable steps to verify that their purchasers are, in fact, accredited investors. Offerings under Rule 506(c) are exempt under state law, but some states may require a notice filing and payment of a fee, similar to Rule 506(b) (sometimes referred to as “old 506”) offerings. It is critical for companies using Rule 506(c) to comply with the specific provisions of the rule for their offerings to avoid a violation of the Securities Act.

Title IV of the JOBS Act, or Regulation A+, was implemented in June 2015, and expands Regulation A of the Securities Act, a rarely used exemption. Regulation A+ permits certain companies to raise up to $50,000,000 in a 12-month period from investors — both accredited and unaccredited. This regulation is subject to eligibility, disclosure, and reporting requirements, including the filing by the issuer of a mini registration statement with the SEC before any sales are made and compliance with relevant state law requirements in each state where investors are solicited. Any unaccredited investors in certain Regulation A+ offerings are prohibited from investing more than 10 percent of their income or their net worth, whichever is more. Compliance with Regulation A+ can be costly, but will allow investors to raise significant amounts of money without undergoing an even more expensive public offering.

Still on the table is Title III of the JOBS Act, or the Crowdfund Act. This section of the Act will, when finalized, create a private offering exemption from federal and state securities laws for certain offerings conducted through a broker or funding portal. The SEC has not finalized Title III and therefore these types of offerings remain illegal.

Although these new exemptions will allow companies to advertise online and potentially gain access to more investors and investment dollars than in the past, selling securities to investors in exchange for cash capital contributions — no matter how big or small — are securities offerings under federal and state securities laws. They therefore require registration or exemption therefrom. Always contact a corporate and securities lawyer to help you make the best fundraising decision for your company.

This article is made available by Pamela Zimlin and Royer Cooper Cohen Braunfeld LLC (“RCCB”) for informational purposes only, not to provide you with specific legal advice. By reading this article, you understand that there is no attorney client relationship between you and RCCB. The content of this article should not be used as a substitute for obtaining competent legal advice from a licensed professional attorney.

Pamela Zimlin is a member of the DailyWorth Connect Program. Read more about the program here.

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