Should We Raise Capital Through Equity Crowdfunding?

Lots of people are excited by the potential for equity crowdfunding ever since the federal government passed the JOBS Act. Many new businesses are popping up to exploit the new model, and there is a lot of buzz about equity crowdfunding these days. Of course, it is still not legal yet, and won’t be until the SEC finishes writing the rules. But I still hear the same question over and over: Should my company raise capital through equity crowdfunding? Unfortunately, in the case of most startups I don’t think it makes sense. Here’s why:

Securities laws: Registration and Exemptions.

Federal law requires companies to either register their securities and provide detailed disclosure (i.e., go public), or issue securities under certain exemptions from registration. Currently, the main exemption most companies rely on is the private placement exemption under Section 4(2) of the Securities Act, which provides that securities not issued pursuant to a “public” offering are exempt, so most small businesses that raise money from friends and family are covered by 4(2). But since the language of 4(2) is somewhat fuzzy (what exactly is a “public” offering?), the SEC has issued “safe harbor” exemptions under Regulation D, including the exemption under Rule 506 that is the exemption used by virtually all tech company startups looking to raise capital.

Rule 506: No Disclosure Required to Accredited Investors

Rule 506 is so popular because it allows companies to raise as much money as they want from as many “accredited investors” as they want. What’s an accredited investor? Simply put, an accredited investor is an institutional investor or a person who has either a net worth that exceeds $1 million or income exceeding $200,000… in other words, reasonably wealthy people.

But the big kicker is that under Rule 506 if the Company only raises money from accredited investors, it doesn’t have to provide regular written disclosure about its business. This disclosure requirement, which applies to the other exemptions, is similar to what is required when your company goes public. It is expensive to get right and could expose the company to a lot of liability and litigation. That’s why the vast majority of companies go with Rule 506 and only accredited investors: it is the easiest way to get out of the disclosure requirement.

New Crowdfunding Exemption

The JOBS Act provides for a new crowdfunding exemption once the SEC finishes establishing rules, including rules on disclosure that are likely to be similar to the requirements for disclosure when going public (which is the main reason why the crowdfunding exemption probably won’t have much of an effect). In addition, the Act limits the crowdfunding exemption in a couple of important ways:

  • A company can raise no more than $1M in any one year period. That alone probably pushes many high-potential startups out… they won’t want to risk having a need to raise more capital but not be able to do so.
  • Companies can’t make direct offers or sales. Rather, offers and sales need to go through a third party intermediary: either a registered broker-dealer or a compliant “funding portal,” presumably some sort of website. It remains to be seen what this will look like once the SEC rules are issued.
  • Companies can’t advertise the offering. On the contrary, one of the changes in the JOBS Act that will actually have a big effect is that companies operating under the Rule 506 exemption may now advertise their offerings.
  • There are detailed ongoing disclosure requirements subject to SEC rule-making.

Bottom Line on Equity Crowdfunding

It comes down to this: If you are a company looking at private equity funding options, you can either:

  1. Go with a Rule 506 exemption, which allows you to raise unlimited funds, advertise your offering, and make direct sales and offers to as many accredited investors as you want. You can also make sales to up to 35 non-accredited investors, so long as you give them detailed disclosure that will probably be similar to whatever is required of the crowdfunded exemption. Or,
  2. Go with the crowdfunding exemption, which will limit you to $1M every year, you can’t advertise, you have to use a regulated broker-dealer or funding portal for your offering, and you have to do the detailed disclosure, all in order to get this one benefit over a 506 exemption: your broker-dealer or funding portal can make offers and sales to more than 35 non-accredited investors, subject to detailed limitations on the amount of each person’s investment.

So the question is: why would you use the crowdfunding exemption rather than Rule 506? Just because you want to offer to non-accredited investors? If you are going to do the detailed disclosure anyway, Rule 506 allows up to 35 non-accredited investors, and without the limits on amounts raised, limits on advertising and solicitation, and the requirement to operate through a third-party intermediary. It seems to me there is a fairly narrow group of companies that needs more than 35 non-accredited investors, but less than $1m, and is additionally willing to take on the expense of the other requirements.

Where I get really concerned is this: what businesses can’t or won’t go the relatively easy route of convincing a few rich people to invest in them, but instead go to considerable expense and risk to convince large numbers of relatively unsophisticated regular people to invest in them? It may be that there are a few reputable companies out there that have modest capital needs and like the democratic nature of crowdfunding, but the vast majority are going to choose to go with Rule 506. And if you really liked the democratic nature of crowdfunding, you could just register your securities and go public, even on the OTC markets.

The bottom line for companies considering equity crowdfunding: think very carefully about whether this is a good strategy for your company, and make sure to consult with counsel experienced in securities offerings.