It’s semi-good news, slightly frustrating for entrepreneurs who have watched the regulatory process since President Obama signed the Jumpstart Our Business Startups Act (JOBS Act) in the spring of 2012. The bottom line today, however, is that it's a little easier for start-ups to raise money than it was two years ago.
To protect investors, the Securities Act of 1933 requires issuers to disclose a great deal of information and to register stock with the SEC. Rule 506 provides an exemption from these general rules for private offerings. The loophole was hard to use, however, because it prohibited marketing equity shares through advertising and general solicitation. The issuer could sell securities to “accredited” investors and a limited number of unaccredited investors who could demonstrate that they understood the risks involved. Since financial sophistication is difficult to measure, the rules use an income test as a way of determining “accreditation.” Only the wealthy could play.
Critics found this attempt to strike a balance between protecting the unwary and opening up markets too restrictive. The ban on general solicitation effectively prohibited equity crowdfunding. Rule changes under the JOBS Act try to adjust the balance.
Let’s look at three ways to raise capital:
- Accredited crowdfunding,
- Retail crowdfunding and
- Registered crowdfunding
Accredited crowdfunding. Regulations implementing the changes in Rule 506 have been in effect since September 23, 2013, and so this situation is relatively clear. Under the newly designated Rule 506(c), issuers can now advertise to the general public, subject to certain conditions. Only accredited investors are permitted to purchase securities, and the issuer must take reasonable steps to verify that each investor is accredited. Ironically, this may actually make it harder to raise capital from friends and family, those start-up stalwarts. There is no cap on the amount of money that may be raised, however. Securities must be held for a year and may be marketed only through a registered broker-dealer.
For those discouraged by these requirements, it is still possible to raise equity yourself under the old rules, now designated Rule 506(b). Although it is not possible to advertise or solicit, the potential pool of investors may be a little larger. It is also not necessary for an individual to either be a registered broker-dealer or work through one.
Retail crowdfunding. This is what the buzz is really about. The comment period for these proposed regulations has just ended, so the situation is still fluid. Under these provisions, an issuer could raise up to $1,000,000 without having to register with the SEC. The issuer would have to disclose information on a sliding scale based on the size of the offering. All investors must receive educational materials to insure that they appreciate the risk involved. Offerings of $100,000 to $500,000 would have to provide additional financial data, and offerings of between $500,000 and the $1,000,000 cap would have to provide audited financial statements. The general public could invest, subject to individual investment limits based on an annual income of $100,000. Everyone can play, but the wealthy get to play a little more. Investors would have to hold securities for one year.
Securities might be offered either through a registered broker-dealer or a “registered funding portal,” but it’s not entirely clear what the latter is. Guidance on that issue will probably not be available until the end of the summer. In the short-run, the only option is to use a registered broker-dealer, as is the case with accredited crowdfunding.
Registered crowdfunding. As its name suggests, this requires registration and far more extensive reporting requirements, including audited financial statements. The caps are much higher, it can be available to the general public and there is no holding period. It is also not clear that this alternative is of any use to start-ups because the anticipated cost would be much higher.
What Comes Next?
For start-ups who have the investor base and the means to work with a registered broker-dealer, accredited crowdfunding may be a good option. We are all waiting with baited breath to discover what that term "registered funding portal" means in the retail crowdfunding category, but it may be only a matter of a few months. In recent guidance dealing with specific transitional issues, the SEC seems to be telegraphing an interest in making the lives of entrepreneurs easier rather than harder. Wait and see has become a bit of a reflex, but the news seems to be getting gradually better.