Coming soon: the crowdfunding you already think exists (part 1)

You may have heard that crowdfunding is already on its feet and on its way to becoming the next big thing.  In fact, the crowdfunding you may think already exists… doesn’t.  Not yet, anyway.  The average investor and the small business owner are both standing by, like participants waiting to jump into a game of double dutch, but the time has not quite come.  Here’s a quick primer.

Businesses need to raise capital.  One of the main ways they do so is by selling equity, or shares of ownership (also known as “securities”).  As a general rule, if a business wants to sell securities, it has to register on the federal level with the SEC (Securities and Exchange Commission) and often on the State level, too.  Registration is time consuming and expensive.  Businesses, especially small businesses (which employ half of the private workforce in America), often need to raise capital for growth but don’t want to deal with registration.  These businesses can raise capital from accredited investors (primarily people who make more than $200,000 per year or have more than $1 million in assets) without having to register, but they cannot currently raise capital from non-accredited investors without registration. This is an issue for a couple of reasons.

According to the New York Times, the median household income in the United States is about $52,000 per year.  That means that most Americans are non-accredited investors.  With certain exceptions, small businesses cannot sell to these non-accredited investors without first registering.  Accredited investors, who make up a relatively small minority of the population, may be more difficult to find (though perhaps easier to find now that the ban on general solicitation has been lifted (see Facebook Friend Seeks Funds: Title II of the Jobs Act (part 1)).  This cuts off a major potential source of funding for small businesses. The system is designed to protect unsophisticated investors from risky investments.  After all, according to the Wall Street Journal, three out of every four start-ups will likely fail, and about three quarters of them never return investors’ capital. On the other hand, many small investors feel that it is fundamentally unfair that the law deprives them of many opportunities to invest in local businesses or benefit from successful non-registered start-ups in the way that “rich people” can. All of this may cause you to wonder, “Well how can a business “crowdfund” if it cannot raise equity capital from the majority of people… from the crowd?”  That’s a great question, and that’s why the crowdfunding you think exists, doesn’t (yet).

Crowdfunding, at its core, is the ability to raise money directly from a large pool of everyday investors with minimal hurdles, using technology and social media to facilitate the fundraising.  Crowdfunding became law in 2012 through Title III of the Jobs Act, with the purpose of providing a relatively simple way for entrepreneurs and small businesses to gain access to more capital in order to grow the economy. Although crowdfunding is now legal, for the most part, it doesn’t yet exist.  The reason is that while the Jobs Act tells us what the law is, the SEC must then promulgate rules to tell us how the law works in practice.  The SEC hasn’t yet issued final rules to inform us how Title III will be implemented, but the SEC has recently issued proposed rules, which is a first big step (see Crowdfunding – SEC Proposes Rules on Title III of the Jobs Act).  So, we still wait, but we are getting closer!

As it stands, under federal law, businesses cannot yet raise equity capital from the majority of Americans (from the “crowd”).  This may confuse you, and you may be thinking, “Well what about Kickstarter, that’s crowdfunding, right?”  Good question.  There is an important distinction between equity-based funding and rewards or donation-based funding.  This distinction is explored in detail in part 2 of this post.


Crowdfunding – SEC Proposes Rules on Title III of the Jobs Act

Yesterday, the SEC finally announced proposed rules for Title III of the Jobs Act.

As those of you who follow this blog or crowdfunding news in general know, the Jobs Act was enacted in April of 2012 and was supposed to be implemented by SEC rules within 270 days of the law’s enactment.  The SEC rules are critical to supply the nuts and bolts of how the Act will work in practice, and the SEC rules have the force of law.

For a number of reasons, however, the SEC failed to meet the 270 day deadline, and as 2013 has grown long in the tooth, proponents of crowdfunding have been wondering if it would ever become reality.  Well, now the wait is over…. or, at least, the end of the wait has begun.

On October 23, 2013, the SEC proposed rules for Title III of the Jobs Act – weighing in at a mere 585 pages long.  The public is permitted to comment on the rules for 90 days, and anyone can do so on the SEC’s website.  How long will this take?  Well, in a related matter, the SEC proposed rules this summer relating to Form D, and because the public interest was so great, the SEC has extended the comment period until November 4, 2013.  My guess is that the proposed rules on Title III will garner even more interest, perhaps signaling the likelihood that the comment period will be extended for Title III’s proposed rules as well.

By way of brief refresher, Title III of the Jobs Act permits small enterprises, under rules to be established, to raise capital from non-accredited investors (basically, people with less than $200,000 per year income and less than $1 million in net worth).  This is a significant change in the landscape of equity investment because, traditionally, a start-up enterprise selling equity shares would typically avoid registering its securities with the SEC (an expensive and time-consuming process) only by utilizing one of a number of “safe harbors.”  This generally means selling shares only or primarily to accredited investors – those higher-income individuals.  Of course, such a restrictive means of selling securities leaves ordinary Joes out of the investment game and prevents start-up enterprises from seeking funds from the public at large (the “crowd.”)

Skeptics have maintained that there is no way the SEC would permit start-ups to sell securities to non-accredited investors without a blanket of regulation so thick as essentially to smother the freedom from regulatory formalities that true crowdfunding is supposed to embrace.   On the other hand, the very purpose of many securities laws is to prevent issuers from taking advantage of investors, which can easily be the case if a seller, a little-known start-up perhaps, is permitted to sell to an unsophisticated investor without any required disclosures.

The skeptics may be correct, at least in part, as the newly proposed rules require the issuer of securities to jump through a few more hoops than proponents of unadulterated crowdfunding may like.  It is proposed that an issuer will be able to raise up to $1 million a year from the crowd (non-accredited investors), but that if it raises over $500,000, it must provide audited financial statements, which can be a small hurdle for startups with no accounting history.  The issuer must also disclose information regarding its officers and how the proceeds of sale will be used, and it must also release financial statements.  In addition, the issuer can only sell through a broker-dealer (a long recognized conduit for sale of securities) or a crowdfunding portal, a new breed that has its own requirements and regulations.

But perhaps a few more hoops is not so bad.  As a business attorney, I help small small businesses comply with a variety of regulations which offer far less gain for the business (if any) than crowdfunding seems to offer.  Although the proposed rules may be somewhat cumbersome, if they open a door to new possibilities that small businesses have been seeking for so long, the price of admission may well be worth it.

Finally, it should be emphasized that these rules are still only proposed rules.  You should certainly speak to a securities lawyer of your choice before offering shares to the crowd! We at Briskin, Cross & Sanford would be glad to assist you.

Hat tip to Reuters.

Bulldozers and bad Investments

The bulldozers are back.  All around town I see buildings being knocked down, dirt lots being leveled, and all the hum and bang of construction getting back in swing.  In the first ten minutes of my commute alone there are three major construction sites underway.  The prospect of an upswing in real estate whets a lot of appetites and conjures visions of great sums of money to me made.

But how exactly to get in on the action?

Here’s one bright idea that became the subject of a recent Georgia Court of Appeals case: a corporation accepts money from multiple people to build up a pool of funds.  In exchange for their money, the corporation gives each person a promissory note (a promise to pay back the funds on terms specified in the note).  The corporation also takes loans from banks at favorable rates to build up the pool of funds.  It then uses the pooled funds to make loans to real estate developers at higher interest rates.

Money making money… sounds pretty simple, right?

This was the setup in Cushing v. Cohen, Case No. A13A0736 (decided July 16, 2013).  For many years it was quite successful, but ultimately, three large deals failed all at once and the investors wanted their money back… all of it.

The investors argued that the defendant violated Georgia law by selling them unregistered securities.  Indeed, under the Georgia Securities Act of 1973, OCGA § 10-5-1 et seq. (which has since been updated by the Georgia Uniform Securities Act of 2008), the purchaser of an unregistered (and non-exempt) security is entitled to a full refund of his or her investment. 

The defendant argued that it did not sell securities, but only gave promissory notes to investors.  The Court of Appeals disagreed and found that the investments were in fact sales of securities.

A security is defined as (a) an investment in a common venture with (b) a reasonable expectation of profit from the entrepreneurial or managerial efforts of someone else.  First, the Court of Appeals found that the loans were investments in a common venture because in order to reach a mandatory minimum amount required for a deal, the investors had to pool together.  Second, the court found that the profits earned by investors would be based on the defendant’s skill in selecting the deals, managing the loans, and salvaging capital if the borrowers defaulted.  As such, these were not straightforward pass-through loans, but in fact securities as defined by law. Indeed under Georgia law, if a security is not registered (or exempted), a purchaser of said security has the right to receive a return of their full investment.  Moreover, the Court found, under former OCGA § 10–5–14(c), “every executive officer of an entity that sells unregistered securities is liable jointly and severally.”

Oh, and did I mention…  the investors invested over $14 million.  That’s a heck of a refund.

The lesson from this case is that there are many creative ways to structure a business, but there are legal implications for each one of them.  Talk to a business planning attorney at Briskin, Cross & Sanford to make sure that as you build your business, you do so on solid legal ground.

Facebook Friend Seeks Funds: Title II of the JOBS Act (part 1)

Today is September 23, 2013, the day that the SEC rules flowing from Title II of the JOBS Act regarding general solicitation become effective.

The Old Rules

Until today, issuers of securities who claimed an exemption from registration under Rule 506 of Regulation D were prohibited from generally soliciting or advertising sales of their securities.  Since a Rule 506 offering is a “private” placement, it makes sense that general advertising or solicitation would negate the private nature of the offering and would therefore not be permitted.  However, in order to remove a potential barrier to investment, Title II of the Jobs Act has since amended Section 4 of the Securities Act of 1933 to state that offers and sales exempt under Rule 506 shall not be deemed public offerings as a result of general advertising or general solicitation. (You can read the Jumpstart Our Business Startups Act, or JOBS Act, in its original form here.)

In practice, this means that, prior to today, an issuer of securities under a Rule 506 exemption could only solicit accredited investors with whom it had a preexisting relationship.  Alternatively, the issuer could engage a broker-dealer, thereby opening the pool to those accredited investors in the broker’s circle.  So take, for example, equity crowdfunding websites (here, we are talking about sites that offer a real investment stake in a business in exchange for a capital contribution rather than companies that might give “investors” a free t-shirt or similar reward in exchange for a smaller contribution).  Up until today, these sites have only permitted an issuer’s detailed business plan or “pitch” to sell securities to be seen by accredited investors, who must must first register and log in to the website to gain this level of access.  This way, the website could not be accused of making a “general solicitation,” as it surely would be if it advertised the sale of securities on the internet to the general public.  Here are examples of these websites’ policies:; and by the time you click these links general solicitation will be permitted, and these sites may have changed their policy, so here are some screen shots from pre-September 23, 2013, to give you an idea what kind of advertising restrictions were in place (click on each one for a larger view):




The New Rules

The newly-effective SEC final rules now permit an issuer to engage in general solicitation or advertising in offering securities pursuant to Rule 506, provided that (i) the issuer is not abad actor” who has had previous ‘troubles’ with securities laws, (ii) all purchasers of the security are accredited investors, and (iii) the issuer takes reasonable steps to verify that such purchasers are accredited investors.  (You can read a summary of the rule here, and the full rule here).  This means that Pat’s Pizza, a hypothetical small business with a fledgling 3 stores looking to grow can let the world know on its Facebook page, “Pat’s is growing and looking for investors!!”  The catch, however, is that Pat’s still can only accept investments from accredited investors.  Moreover, Pat’s must now take additional steps to verify that an investor is in fact accredited, whereas formerly accredited investors were self-identified.

The means of verifying accredited investor status was one of the main tasks for the SEC in issuing rules pursuant to Title II of the Jobs Act.  The newly-effective rules are codified in Rule 506(c).  There is no mandatory or exclusive method of verifying accredited investor status, but the issuer is required to consider the facts and circumstances of each purchaser.  Although there is no exclusive list of verification methods, the SEC has identified a couple of ways an issuer may comply; for example, by reviewing copies of the investor’s tax returns and having the investor verify his/her income in the coming year, or by receiving a written confirmation from a registered broker-dealer, attorney, or CPA stating that such person has taken reasonable steps to verify the purchaser’s accredited status.

As a note, if an issuer wishes to solicit or advertise only to accredited investors and chooses not to generally advertise, the issuer is not then required to verify accredited investor status, and accredited investors can be self-identifying, the rules essentially operating just as they did prior to Title II.

To add just one more layer, on the same date the SEC issued final rules regarding general solicitation, it issued proposed rules that would require the issuer to disclose information about itself prior to general solicitation (currently, issuers claiming exemption under Rule 506 of Regulation D must file a fairly simple form with the SEC, called Form D, within 15 calendar days after the first sale of securities in the offering). In addition, the proposed rules would require the filing of a closing amendment to Form D after the termination of a Rule 506 offering, would require general solicitation materials to include certain legends and other disclosures, and would require submission of general solicitation materials to the SEC.  Many people have submitted comments to the SEC requesting that no new rules be enacted to make the process overly cumbersome. How this next round will play out remains to be seen.

In practice, even though issuers relying on a 506 exemption can now advertise (subject to the restrictions outlined above), even to include social networking sites, such promotion must still lead back to a platform where the issuer can verify accredited investors prior to sale.  Arguably, then, an issuer should still advertise where it is likely to find accredited investors, because ultimately it cannot sell to non-accredited investors, at least for now.  Title III of the Jobs Act does permit crowdfunding from non-accredited investors, however, unlike Title II, the new SEC rules have not yet been enacted (see PayPal and crowdfunding: fools rush in… but the rest of us are still waiting).  More on crowdfunding in a forthcoming post.

This is, of course, a complex area of law, and the above summary does no more than introduce the general concepts and developments involved in a small part of it.  If you are contemplating any sort of private placement, speak to a securities lawyer at Briskin Cross & Sanford before you do anything… and certainly before you post your offering on Facebook!

PayPal and crowdfunding: fools rush in… but the rest of us are still waiting

Further to our earlier discussion of crowdfunding in Georgia, PayPal recently announced on its blog that it is overhauling its policies with regard to the use of the PayPal gateway by crowdfunders in light of “unique regulatory and risk aspects inherent to this new way to raise money from supporters around the world.”

PayPal’s VP of Risk Management, Tom Barel, does not call out crowdfunding sites by name but seems to want to suggest that fools rush in where angels fear to tread, warning that the crowdfunding model is it is “potentially open to abuse” and that PayPal does not want to have to explain to customers where their money went if someone soliciting funds from the “crowd” does not fulfill its promises, at least while the regulatory waters are still murky,

Barel, while describing crowdfunding as on the one hand “pretty complicated” and inherently risky, at the same time acknowledges that the widespread public ability to invest in startups may be a “powerful catalyst for innovation.”  As a risk manager, perhaps his job is to let PayPal have it both ways, though some have seen the announcement as damage control following PayPal’s recent about-face when it froze and then just as quickly released  Nyu Media’s funds for the video game Yatagarasu Attack on CataclysmHat Tip to Eric Johnson of AllThingsD.

While crowdfunding by the general public is quite legal in certain other advanced economies (e.g., the UK and Australia), the Securities and Exchange Commission has been slow to permit US businesses to move from currently permitted reward/donation crowdfunding (where “investors” get a t-shirt or the warm fuzzy feeling of having supported a worthy cause, a scientific experiment, or a local band’s new album) to true equity funding (where investors actually own a stake in the startup venture and gain or lose cold hard cash depending on how well the business does).

So what’s the holdup?  Equity crowdfunding rules that the SEC was required to finalize by December 31, 2012 have still to go into effect.  These rules would permit an exemption to the 1933 Securities Act that is necessary to open the way for public advertisement and sale of certain securities to non-accredited investors (basically those of us who make $200,000 or less per year and have less than $1M in net worth).  Such sales, of course, would be subject to certain oversight and restrictions… and there’s the rub.

Nonetheless, SEC Chair Mary Jo White has promised that the rules are on the front burner, and says, “I define the front burner to be sometime into the fall.”  Well, fall is less than a week away now, so watch this space… or just listen for the whoosh as the many small-budget angels finally enter the market.

Crowdfunding Craft Beer and Food in Wisconsin

Following the lead of Georgia (which we discussed here), Kansas, North Carolina and Washington, Wisconsin this week became the 5th state to pursue an intrastate exemption that would allow Wisconsin businesses to advertise and sell equity in Wisconsin companies to Wisconsin residents.  Hat tip to CraftFund: Equity Crowdfunding for Craft Beer and Food.

A game changer for startups? Invest Georgia Exemption removes barrier to equity crowdfunding in Georgia

If the provisions of the Jumpstart Our Business Startups Act, a/k/a the JOBS Act, that were intended to ease restrictions on crowdfunding for small businesses sparked a rush of excitement nationwide, the Securities and Exchange Commission, ever cautious, has not exactly stoked that fire.  In fact, the SEC has still to grind out rules that will allow the law to go into effect and finally open the throttle of this economic engine nationwide. Rumored finally to be out this fall, many still say it will be 2014 before the SEC is ready to publish its final rules.

Undaunted, Georgia has leapt ahead of the pack with the Invest Georgia Exemption (IGE), allowing non-accredited residents of Georgia to invest in Georgia companies under certain conditions.  Using this exemption, Georgia companies can raise up to $1 million annually from non-accredited as well as accredited investors, and–in what may or may not be the game changer–can solicit investments in Georgia from Georgia-based residents, even if they are non-accredited (up to a limit of $10,000 in each Georgia issuer per investor).  See Equity Crowdfunding: Much Ado About Nothing?

The Secretary of State provides a synopsis of the rules here, and full Rules of the Georgia Commissioner of Securities can be found here.  You may still need an attorney to interpret them, but crowdfunding websites like Kickstarter will undoubtedly make the process easier very soon.  Although the debate continues as to how willing small investors will actually be to fund fledgling enterprise, one thing is certain: with the Invest Georgia Exemption, Georgia has taken another step forward in establishing itself as one of the most startup friendly states in the US and now offers some of the most fertile ground in the nation for investment-seeking tech and non-tech startups alike.