Raising Capital & Securing Funding

Crowdfunding

In the context of financing, crowdfunding is the process of getting funding, usually online, for a project from a large number (or crowd) of people who typically each contribute small dollar amounts. With crowdfunding platforms such as Kickstarter, the entrepreneur will set a target for the dollar amount to be raised, the deadline by which it must be raised and any reward to the persons contributing to the project. Typically, the dollar amount to be raised must reach the targeted amount on or prior to the deadline or all funds raised must be returned to the people who contributed to the project. As noted, contributors in this type of crowdfunding offering typically receive a reward—a copy of the product that their contribution helped fund or some other token of appreciation. They do not receive any ownership interest in the company in the form of shares of stock, convertible notes or other securities.

In securities-based crowdfunding, on the other hand, those who contribute funds receive equity or another security in exchange for their “contribution.” These types of transactions are subject to the US federal securities laws, which require that every offer and sale of securities must be registered or qualify for an exemption from registration. In 2012, the JOBS Act was enacted in an effort to simplify and ease capital formation. Among its provisions was a new exemption for specified crowdfunding transactions, which the SEC implemented through Regulation Crowdfunding in 2015. These new rules became available for use starting in 2016.

Regulation Crowdfunding permits the offer and sale of debt and/or equity securities through crowdfunding, subject to specified conditions. Unlike certain other securities offering exemptions, it does not restrict participation by unaccredited investors. It does, however, include the following provisions intended to protect investors who engage in crowdfunding offerings:

• Issuer Eligibility Requirements: Only certain companies may take advantage of the exemption created by Regulation Crowdfunding. Ineligible issuers include non-US companies, Exchange Act reporting companies, certain investment companies, companies subject to “bad actor” disqualification, companies that have failed to comply with their reporting obligations under Regulation Crowdfunding during the preceding two years, and companies that have no specific business plan or have indicated their business plan is to engage in a merger or acquisition with an unidentified company or companies. 
• Issuer Offering-Size Limitations: Pursuant to amendments adopted by the SEC on November 2, 2020 (the “Rule Amendments”) and effective March 15, 2021, eligible issuers may now raise up to $5 million in any 12-month period through offerings under Regulation Crowdfunding. Depending on the facts and circumstances of the offering, amounts sold by affiliated entities of the issuer may also be counted against this maximum. 
• Issuer Manner-of-Offering Requirements: All transactions relying on Regulation Crowdfunding must take place exclusively through an SEC-registered “intermediary”—either a broker-dealer or an internet platform known as a “funding portal.” Offerings must be held open for a minimum of 21 days, and potential investors have certain opportunities to cancel their commitments prior to closing. Advertising and other forms of solicitation are permitted under Regulation Crowdfunding but are subject to significant limitations. 
• Issuer Disclosure and Filing Obligations: Prior to commencing an offering under Regulation Crowdfunding, an eligible issuer must complete and file a Form C, which requires the public disclosure of certain business and financial information of the issuer including financial statements prepared in accordance with US GAAP. An issuer must file offering progress reports to disclose material changes to this information until the offering has been completed and is required to file reports updating this information annually following the offering until the issuer becomes public, repurchases all securities issued pursuant to Regulation Crowdfunding, liquidates or dissolves, or qualifies, for other specified exemptions. 
• Investor Investment Limitations: The amount an individual may invest across all offerings under Regulation Crowdfunding during any 12-month period will depend on the individual investor’s annual income and net worth. Pursuant to the Rule Amendments, accredited investors are not subject to individual investment limitations. Individual investment limitations for non-accredited investors are now based on the greater of annual income or net worth, up to a cap of $107,000.

The crowdfunding landscape continues to evolve. As noted, in November 2020, the SEC adopted the Rule Amendments, which impacted the offering-size limits and investor investment limits under Regulation Crowdfunding among other changes. The Rule Amendments also created an exemption for certain special purpose vehicles (“SPVs”) to aggregate and serve as a conduit for crowdfunding investments in specific offerings.

In May 2020, the SEC provided eligible issuers conditional relief from certain Regulation Crowdfunding requirements to streamline the offering process including the reduction of certain financial statement requirements, the suspension of the requirement that offerings remain open for a minimum of 21 days, and modifications to the process by which investors may cancel their orders. In August 2020, this relief was extended to include securities offerings initiated under Regulation Crowdfunding between May 4, 2020, and February 28, 2021. With the November 2020 rulemaking, the temporary relief providing an exemption from certain Regulation Crowdfunding financial statement review requirements for issuers offering $250,000 or less of securities in reliance on the exemption within a 12-month period was further extended for 18 months, applying to offerings initiated through August 28, 2022.

An issuer considering a crowdfunded offering needs to weigh the costs and benefits of compliance with the regulations, including whether it has available the required financial statements and, more importantly, whether it is willing to publicly disseminate financial statements and other information about its financial condition and business mandated by Form C and to obligate itself to update such information on an ongoing basis. The issuer should work closely with its lawyers and accountants to understand the expected costs and expenses associated with the initial filings and ongoing compliance with Regulation Crowdfunding, particularly in light of recent and proposed changes to applicable rules. In addition, the issuer should consider the impact of having a large stockholder base early in its lifecycle, including the administrative costs and corporate governance challenges associated with crowdfunding stockholders, many of whom may be unaccredited investors.