Crowdfunding has a lot of buzz right now. You’ve heard about it. You’ve probably been asked by an old college roommate or your favorite band to their Kickstarter or Indiegogo campaign. But there is A LOT more out there than this, and A LOT more to come. While we’re gearing up all sorts of services for entrepreneurs and crowdfunding platforms (more on those soon), we wanted to share this great infographic that covers the basics. While the top covers what you’re probably familiar now, the ‘State of Affairs’ section below aims at the future of equity-based crowdfunding. In the simplest terms, if you are an entrepreneur and you want to raise money, you will be able to sell shares of your company to just about anyone you want, all over the internet. This means you can add crowdfunding to your financing options alongside the traditional bank loans and venture capital. Are you ready for this next wave of financing for startups and small businesses? There’s a lot to learn, and that’s why Blogging the Crowd (and CrowdTrust) are here! Ask your questions, and we’ll address them and keep you all posted on more insights on this arena!
The crowdfunding community has been buzzing lately due to a Bloomberg report which indicated that the SEC was going to allow self-certification of income levels for non-accredited investors participating in crowdinvesting.
Title III of the JOBS Act will allow non-accredited investors, for the first time ever, to invest in emerging growth companies through online raises. Many investor advocates had concerns that these retail investors would be getting in over their heads. In an effort to prevent these investors from investing more than they could reasonably afford, congress implemented an investing cap based on income. Individuals who make $100,000 or less per year may invest $2,000 or up to 5% of their income in a Title III crowdfunding offering. If they make over $100,000 they may invest up to 10% of their income. It was not clear whether individuals who meet the income standards of an accredited investor would be subject to any limits.
How are crowdfunding platforms supposed to know how much an individual investor makes? Are they going to be required to certify the incomes of individual investors? Congress decided to leave these decisions to the SEC as they write the detailed rules. This past week the SEC hinted that they would allow self-certification of income for individual investors doing a Title III crowdfunding offering. This means that retail investors will be able to voluntarily declare their annual income without a verification from a broker dealer or a crowdfunding platform. This is significant for a couple of reasons:
1) Income verification, while relatively simple to do, would create huge administrative costs that would have to be passed on to entrepreneurs and shareholders. This cost would not have provided a significant benefit other than complying with the law.
2) Allowing individuals to declare their own income presumably relieves broker dealers and crowdfunding portals from the liability risk of an investor lying about their income and investing more than they were allowed to by law. This means fewer lawsuits and cheaper insurance premiums for broker dealers and crowdfunding portals.
While this is significant news for the industry, the fact that the SEC is finally addressing items in Title III of the JOBS Act is much more important. On Monday the SEC announced that there would be an open meeting On October 23 to address Title III. Does this mean we will finally get crowdinvesting rules? That seems to be the case, but no one can be sure. While the news is definitely exciting, it’s important to remember that even if we did get the proposed rules on Wednesday, there are many more things that must occur before Title III crowdfunding is open for use. My best guess is that we have at least 6 months but probably closer to a year before Title III crowdfunding is available for use. However, no one can say for certain at this time.
Justin Maddox is the CEO of CrowdTrust a due diligence company that provides verified crowdfunding data for crowdfunding platforms based in Washington, DC. If you would like to learn more about crowdfunding please join the Crowdgoers meetup group: http://www.meetup.com/CrowdGoersDC/
In part 1 of this blog post we talked about the new changes to Rule 506 and the general sentiment of investors in regards to them. I would like to go into a little more detail as to why it is so easy to fall into the 506(c) trap. First, a little plug: my company is organizing a Meetup on Monday, 9/30, with two veteran securities lawyers who can help all of us navigate these murky waters. Please join us!
CASE STUDY: SEC REGS KEEPING STARTUPS PENNILESS
Say you have a startup. You’ve got a great team, built the MVP, and are getting good traction. In an effort to raise a seed round, you build a 3-minute video with a demo of the product, information about the team, and the terms of your offering. You post the video to your Angellist profile and tweet your followers that you are looking for investors. 31 days later, you land a meeting with famed angel investor Paul Singh, who ends up loving the company. Before writing a check, his lawyer does some quick due diligence, and that’s when everything falls apart. Why? Because it turns out you’ve inadvertently used general solicitation, and he does not want to deal with the ramifications. Including:
1. Accredited Investor Proof: According to the imminent SEC 506 amendments, your posts on Twitter and Angellist may constitute a 506(c) general solicitation offering. This method allows you to court only funders whom you have taken “reasonable steps” to ensure are accredited investors. Such certification would require Paul to provide his W2, tax returns, or a bank statement. Angel investors are very unlikely to hand over this information to a founder, no matter how interested they are in the company.
2. Advance notice of general solicitation: The new rules the SEC has written require you to file a “Form D” 15 days prior to any public statement about your fundraising. That means before you tweet or post a video, the written or spoken words must be provided along with any visual materials you post. Turns out, your tweet also should have been accompanied by one of those really long disclosures you see at the end of a legal document. That’s right, you will have to pre-file your tweets with the government – and no, the required disclosure won’t fit within Twitter’s 140 character limit.
3. 506(b) and 506(c) don’t mix: Remember that “friends and family” money you already raised? You are going to have to give it back. That money, raised without general solicitation from non-accredited investors, means you implicitly chose the 506(b) option. But when you went on Twitter and talked to Paul, you moved into 506(c) territory and the SEC forces you to choose one and only one. At this point, you have to stick with 506(c) or wait 6 months to try again with 506(b), a chunk of time you probably can’t afford to lose. So you stick with the 506(c) path but now you must return any money you had received from people who don’t meet the standards for an accredited investor – even your parents.
4. Landing in SEC penalty box is easy: Remember the video and tweet you sent out without first submitting a Form D 15 days beforehand? The SEC gives you a one-time-only pass if you make the filings within 30 days of your posts. Trouble is, you didn’t even realize this was an issue until you met Paul and his lawyer 31 days after posting. You’re a day too late, and it may cost you everything.
5. Strict penalties: Your failure to follow the 506(c) solicitation guidelines means that the SEC can force you to return any money you’ve raised and ban you from raising money at all for one year. This ban stays with you for the next 5 years as well, meaning your next startup is doomed before you begin.
General Solicitation: Worth All the Trouble?
So, if you’ve been following, you’re now familiar with the minefield that is Rule 506(c) – basically you can advertise your fundraising, but only if you comply with a slew of draconian rules that will serve to stop most in their tracks. You’ll have to file a Form D 15 days prior to talking about your company every single time, even in the smallest way (a tweet, a shared video, etc.). Every time you make a change to anything considered offering materials (and the SEC’s definition of this is exceptionally wide, which Pandodaily has written a great post on), you will have to re-submit that form. And, everything you send out to the general public must include a legal disclosure far too long for even the shrewdest tweeter.
With rules that are so restrictive and consequences so severe, the question is clear: Why would any startup use the general solicitation offered in the proposed changes to Rule 506(c)? Startups would be better off raising money through angels and VCs with the new Rule 506(b). That would be a good approach, except that the SEC has made it too easy to fall into the general solicitation route by accident; the definition is just too vague. Many things that founders currently do could be considered general solicitation. A demo day, a video of your pitch being posted to the internet, an angelist profile, a tweet that you are raising money: All of these things could be construed as general solicitation and the SEC has not made it clear where they will draw the line. Unless these rules are clarified, investors might steer startups into using 506(c) to be on the safe side, leading right back to the tangle of issues they were initially hoping to avoid.
WHAT’S TO BE DONE?
The SEC has mandated that general solicitation under the new rule 506(c) goes live on Monday, September 30. However, SEC Chairwoman Mary Jo White has told Congress that the additional rules I’ve been discussing will go into effect at an as yet undetermined date. This means that there is still time to submit comments to the SEC telling them that the proposed rules are overly burdensome on startups and do not align with the spirit of the JOBS Act legislation, which was to make this all easier not impossible. Angelist and Pandodaily have organized letter-writing campaigns with some suggested bullet points and an easy link to send your comments to the SEC. I have sent my own letter and urge you to do the same.
Again, these rules are complicated, and if they’re adopted, your startup life becomes riskier than it already was. I would love to see you at our MeetUp where you can get more information about all of this. Thanks for reading.
As an entrepreneur or startup founder you may be passingly familiar with fundraising terms like “Reg D” or “Rule 506.” If you’re like me, you’ve probably had too much on your plate to really understand them. I’m afraid now is the time. In a matter of days, the SEC plans to implement several big changes and continuing to operate with anything less than full understanding could tank you. This post should help, as will the Meetup I’ll tell you about at the end.
A LITTLE BACKGROUND
The vast majority of seed round investment in tech startups happens under Rule 506 of Regulation D of the Securities Act Section 4(2). Nearly a trillion dollars was raised this way in 2012 alone. If you’re hoping to raise money from an Angel or a VC, this is probably the exemption your lawyer will use, so you should understand the changes that are about to take effect.
Congress legislated these changes in last year’s JOBS Act to make fundraising easier for startups. It required, for the first time since the SEC was created to regulate such things, that the SEC truly open up the avenue of “general solicitation,” allowing startups to publicly advertise their fundraising to anyone and everyone as long as they only take money from accredited investors (basically wealthy people). This form of fundraising is being offered under a new exemption called 506(c). The SEC took the traditional form of the 506 exemption that Angels and VCs typically used and are now calling in 506(b). This could have been a really great move. Unfortunately, the SEC decided to create an additional set of rules well beyond what Congress had required that make 506(c) nearly impossible to use. These rules are so bad that founders who use them could easily find themselves shunned by investors. Ed Chalfin, an angel investor and entrepreneur whose company was successfully acquired by Texas Instruments, put it bluntly: “I will not invest in opportunities where this new requirement applies.”
In addition to the bad sentiment investors have in regards to 506(c), the new rules come with some really tough penalties if you make a mistake. To give you a sense of their seriousness, the penalties start with a 6-month prohibition on fundraising and can range to a 1-year ban that will follow the individual entrepreneurs for 5 years even at new startups. Also, in case you think this is just for those intending to use equity crowdfunding, the crown jewel of the JOBS Act, that is not the case. These rules for general solicitation apply whether you stick to the Angel and VC community or decide to take your fundraising to the crowd.
Most investors have not made a big deal about the changes because the SEC still allows them to invest in startups the old fashioned way under Rule 506(b). Famed investor Fred Wilson summarized those sentiments in a great blog post a few weeks ago. Unfortunately, I think these opinions are wrong. The way that the SEC set up these rules, many founders will inadvertently be forced to use the 506(c) exemption, which could be a major problem for the entire industry.
This stuff can get a bit confusing, which is why this post will continue tomorrow, when I’ll write more specifically about why these changes are so problematic and what can be done to fix the situation. It’s also why I’m helping to organize a Meetup where you can hear from two expert attorneys with decades of experience on SEC regulations, crowdfunding, and startup law. Please join our group and attend on Monday, 9/30!