SEC’s new JOBS Act Title III Crowdfunding Rules: Overview and First thoughts

9 years ago by
ArticlesInvestment Crowdfunding
SEC

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Today the SEC voted in favor of the final JOBS Act TitleIII Crowdfunding rules.

The new JOBS Act TitleIII Crowdfunding rules will finally allow individuals to invest in startups online by purchasing equity securities in crowdfunded companies via SEC registered crowdfunding portals. The rules require companies raising money to disclose certain information about their business and securities offering, limit how much individuals can invest based on their income and net worth, and creates a new regulatory framework for the crowdfunding portal intermediaries facilitating crowdfunding transactions. 

The new rules will take 180 days after they are entered into the federal register.

The rules for Crowdfunding Portals will go into effect Jan 29th 2016.

You can read the final rules here: http://www.sec.gov/rules/final/2015/33-9974.pdf

Differences between the previously proposed rules and today’s final rules:

The final Crowdfunding rules have eased some of the filing burdens on companies raising money via the new investment crowdfunding exemption, permitting issuers to take advantage of an optional “Q&A” format for their disclosures in the Form C initial filing, replacing the requirement for the issuer’s principals to disclose their tax returns, instead merely requiring disclosure of certain information from the returns. Lastly, the final rules also exempt issuers raising between $500,000 and $1 million from the requirement to obtain and disclose audited financials, but only for the issuer’s first crowdfunding offering (unless the issuer already has audited financials, in which case disclosure of the financials is required).

The final rules are tougher on the investment crowdfunding portals. The new rules give the allowance and put the responsibility on intermediaries to say no to potentially fraudulent offerings, while still barring intermediaries from providing investment advice to investors, engaging in the offer or sale of securities, or taking possession of investment funds. Though, an upshot for the platforms is that the final rules do allow intermediaries to take an equity position in an issuer as compensation, provided that the securities provided to the intermediary as compensation have the same terms as the securities being offered in the crowdfunding offering.

Crowdfunding portals will also be responsible for educating investors about the process and risks of crowdfunding, providing information about offerings, facilitating communication channels between issuers and prospective investors, and to ensure that investors are in compliance with the investment limitations under the rules. A safe harbor is provided for intermediaries who engage record-keeping companies to assist in these requirements. The final rules also permit intermediaries to rely on representations made by issuers, unless the intermediary has some reason not to rely a representation.

The final rules are also very protective of investors, setting investment caps on the LESSER of income and net worth thresholds, when the initial proposal was based on the greater. This means that people earning less than $100,000 per year will be limited to investing 5% of their income in crowdfunded offerings.

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The new Title III Crowdfunding rules allow:

  • A company to raise a maximum aggregate amount of $1 million through crowdfunding offerings in a 12-month period via a registered broker-dealer or registered crowdfunding portal;

Under the rules certain companies would not be eligible to use the exemption, including non-U.S. companies, Exchange Act reporting companies, certain investment companies, companies that have failed to comply with the annual reporting requirements under Regulation Crowdfunding during the two years immediately preceding the filing of the offering statement, and companies that have no specific business plan or have indicated that their business plan is to engage in a merger or acquisition with an unidentified company or companies. 

 

Investor Limitations:

  • Both accredited investors and non accredited investors may invest in Title III crowdfunding offerings subject to caps based on their income and net worth.
  • Individual investors, over a 12-month period, can invest in the aggregate across all crowdfunding offerings up to:

    • If either their annual income or net worth is less than $100,000, than the greater of $2,000 or 5% of the lesser of their annual income or net worth.
    • If both their annual income and net worth are equal to or more than $100,000, investors are allowed to invest up to 10 percent of the lesser of their annual income or net worth
  • During the 12-month period, the aggregate amount of securities sold to an individual investor through all crowdfunding offerings may not exceed $100,000.
Securities purchased in a crowdfunding transaction generally could not be resold for one year. Holders of these securities would not count toward the threshold that requires a company to register its securities under Exchange Act Section 12(g) if the company is current in its annual reporting obligations, retains the services of a registered transfer agent and has less than $25 million in total assets as of the end of its most recently completed fiscal year.In addition, all transactions relying on the new rules would be required to take place through an SEC-registered intermediary, either a broker-dealer or a funding portal.
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Disclosure by Companies:

Companies that rely on the new rules to conduct a crowdfunding offering must file certain information with the Commission and provide this information to investors and the intermediary facilitating the offering, including among other things, to disclose:

  • Financial Reporting Requirements. GAAP Financial statements of the company that, depending on the amount offered and sold during a 12-month period, are accompanied by information from the company’s tax returns, reviewed by an independent public accountant, or audited by an independent auditor.:
    • Under $100k – Internal financial statement review
    • $100k-500k – CPA reviewed financial statements
    • 500k-1M – 3rd Party audited financial statements
    • 1st time crowdfunding issuers offering more than $500,000 would be permitted to provide reviewed, rather than audited, financial statements.
  • The price to the public of the securities or the method for determining the price, the target offering amount, the deadline to reach the target offering amount, and whether the company will accept investments in excess of the target offering amount;
  • A discussion of the company’s financial condition;
  •  A company offering more than $500,000 but not more than $1 million of securities relying on these rules for the first time would be permitted to provide reviewed rather than audited financial statements, unless financial statements of the company are available that have been audited by an independent auditor;
  • A description of the business and the use of proceeds from the offering;
  • Information about officers and directors as well as owners of 20 percent or more of the company;
  • Certain related-party transactions. In addition, companies relying on the crowdfunding exemption would be required to file an annual report with the Commission and provide it to investors. Annual reports do not have to be audited or reviewed. 
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Requirements for Crowdfunding Platforms:

Crowdfunding marketplace websites will be required to register with the SEC via the new “Funding Portal” form, and become a member of a national securities association (currently, FINRA). A fundraising company relying on the rules would be required to conduct its offering exclusively through one intermediary crowdfunding platform at a time.
 The rules would require intermediaries to:
  • Provide investors with educational materials that explain, among other things, the process for investing on the platform, the types of securities being offered and information a company must provide to investors, resale restrictions, and investment limits;
  • Take certain measures to reduce the risk of fraud, including having a reasonable basis for believing that a company complies with Regulation Crowdfunding and that the company has established means to keep accurate records of securities holders;
  • Make information that a company is required to disclose available to the public on its platform throughout the offering period and for a minimum of 21 days before any security may be sold in the offering;
  • Provide communication channels to permit discussions about offerings on the platform;
  • Provide disclosure to investors about the compensation the intermediary receives;
  • Accept an investment commitment from an investor only after that investor has opened an account;
  • Have a reasonable basis for believing an investor complies with the investment limitations;
  • Provide investors notices once they have made investment commitments and confirmations at or before completion of a transaction;
  • Comply with maintenance and transmission of funds requirements;
  • Comply with completion, cancellation and reconfirmation of offerings requirements.
  • Registered Funding Portals will have become members of a national securities exchange commission (currently FINRA).

The rules also would prohibit intermediaries from:

  • Providing investment advice or recommending particular offerings to investors.
  • Soliciting purchases, sales or offers to buy securities or compensating promoters and other persons for solicitations or based on the sale of securities;
  • Directly holding, possessing, or handling investor funds or securities.
  •  Providing access to their platforms to companies that they have a reasonable basis for believing have the potential for fraud or other investor protection concerns;
  •  Having a financial interest in a company that is offering or selling securities on its platform unless the intermediary receives the financial interest as compensation for the services. The equity provided to a platform must same terms as to crowd investors and with full disclosure to crowd investors.
  • Compensating any person for providing the intermediary with personally identifiable information of any investor or potential investor. Regulation Crowdfunding would contain certain rules that are specific to registered funding portals consistent with their more limited activities than that of a registered broker-dealer.
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Initial Thoughts:

The new rules are a mixed victory. The SEC went to great lengths to make the rules workable for issuers, the companies raising money, by providing them with simplified disclosures, and an exemption from audited financial statements for first time issuers. The rules are very protective of investors. Investors are allowed to invest within limits based on their income and net worth, with low investment caps for those who earn less than $100,000 per year.

Unlike the existing Title II (Regulation D) and Title IV (Regulation A) rules, Crowdfunding offerings must me made through an intermediary, and the regulatory compliance burden has largely been transferred to the crowdfunding portals. The SEC has decided the Crowdfunding Platforms have to keep the peace. Platforms are required to do due diligence on issuers, educate investors, make sure investors are investing within their income limits, and provide data to the SEC. There was some upside to the portals in the new rules, as they are allowed to take an equity stake in companies that list with them, and can represent the crowdfund investors during issuers’ future fundraising rounds.

While these rules will be tough on the portals, there are a lot of well-funded companies fighting to be the leader in this new investment crowdfunding space, and a few of them are going to figure out how to operate profitably within the new SEC framework. I think the SEC made a good choice to shift as much of the compliance burden off of the issuers and investors and on to the portals as possible. Make them deal with it, as they are the ones that have the most to gain.

Interestingly, because the intermediaries are allowed to take an equity state in the issuers they host, and allowed to be choosey about who they let in, I wonder if we might see them start to look like some of the big name startup incubators, being exclusive about who they accept and validating the startups on their platforms by associating them with their own brand.

 

The New Title III Rules are Good for Issuers:

  • Reasonable and flexible disclosure and compliance steps will help issuers to get through the process. Q&A style disclosures easier for issuers to do without too much help from their attorneys. The exemption from providing audited financial statements for first time issuers is a good move as well.

 

The New Title III Rules are Tough on Portals:

  • Portals have a lot of responsibility. They need to do due diligence on issuers, keep track of investors investment limits based on income and net worth, and provide a lot of information to the SEC.

 

Upshot for Portals:

  • Portals can take an investment share in the issuers they host, and can represent the crowd in negotiations with later more sophisticated investors on future rounds in order to defend crowd investors from dilution, etc.

Limits on Investors:

  • Investors are limited to how much they can invest by their income and net worth. Investors with < $100,000 annual income or net worth can invest the lesser of 5% of their annual income or net worth. Investors with over $100,000
  • 12 month limit on resales.
  • Currently no secondary market yet available for crowdfunded securities.

 

Improvements to Intra-State framework:

  • Rule 147 to be revamped as a new exemption, allowing intrastate offerings to raise up to $5m per year.
  • Requires investment limitations.

Bright Future for Secondary Trading:

  • Luis Aguilar put a lot of emphasis on the importance of secondary markets in the meeting. Calling for the SEC to support the steps nessicary to allow for a robust secondary marketplace, and to help modernize the back-office processes of clearance and settlement of trades.

Don’t forget about Title IV, Regulation A+:

  • While Title III stole the show today, remember, we’re only starting to see the impact of the Title IV Regulation A+ rules that went into effect on June 19th 2015. This created a framework for companies to engage in a “Mini-I.P.O.”, which costs the issuer about $100k to file takes about 6 months to push through the SEC, but allows them to raise up to $50million per year, and might end up having a bigger impact in the long run than the rules announced today. So far the SEC has only approved 3 Reg A+ offerings, but at least 50 have been submitted and are in the queue to come online in the next several months.

Title II Accredited Investor Only Crowdfunding has been going strong too:

  • You won’t see it unless you’re an accredited investor, or registered with any of the about 30 or so major accredited investor only crowdfunding platforms. But there’s a whole industry just barely hidden away allowing accredited investors to buy equity in startups and income generating ownership share of real estate investments using the rules created under Title II of the JOBS Act.

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Questions? Comments? Corrections? You can discuss this article on our Crowd Experts LinkedIn group here: https://www.linkedin.com/grp/post/6568366-6065950494126325762?trk=groups-post-b-title

David Pricco

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