20+ Crowdfunding Investment Tips (2019)

Crowdfunding Investment Tips

Crowdfunding Investment Tips

There are different from project-specific donation crowdfunding platforms such as Kickstarter because the investments are made in exchange for equity rather than “rewards” or preordered merchandise. This blog explores 20+ best Crowdfunding Investment Tips, ideas and rules.


Are You an Accredited Investor?

The concept of an accredited investor under federal securities laws. Here is a bit more detail; Rule 501 of the SEC’s Regulation D, adopted in the early 1980s, defined accredited investors as:


Certain institutional investors such as banks, employee benefit plans, venture capital firms, and the like Insiders such as directors, executive officers, or general partners of the issuing company Wealthy individuals—people who have a net worth.


or joint net worth with a spouse in excess of $1 million or who had an individual income in excess of $200,000 or a joint income with a spouse in excess of $300,000 in each of the last two years and anticipated in the current year


Entities—all of whose beneficial owners meet the above three criteria of accredited investors


In determining whether you have sufficient net worth to be an accredited investor, you exclude the value of your principal residence. In determining whether you have sufficient annual income to be an accredited investor, you can include your spouse’s income.


The concept of an accredited investor has no meaning for crowdfunded offerings of securities. You do not have to be an accredited investor to buy securities under Title III of the JOBS Act.


The concept is much more important, however, if you are thinking about making an investment in a private placement under the SEC’s Rule 506(c), created by Title II of the JOBS Act which by definition is limited to only accredited investors. 


If you are close to the line, you should consider speaking to your tax adviser or a lawyer familiar with securities law, either of whom can help you refine the calculation of your net worth and annual income for the requisite time periods and decide one way or the other if you qualify.


What Is Your Tolerance for Risk?

Tolerance for Risk

Investing in crowdfunded securities is not for the faint of heart. Every investment portfolio should contain three types of securities:


1. Income-only securities. These may not be too exciting, but they provide regular income with a minimum of risk (think bank certificates of deposit and money market funds).


2. Growth-and-income securities. These give you both income and the opportunity for growth with a moderate amount of risk (stock in publicly traded companies, for example).


3. Aggressive-growth securities. These give you little current income and are highly risky. When they hit, they tend to hit big, but when they crash and burn, you lose your entire investment.


Any sort of crowdfunded investment

Let me put it a different way: when you buy securities in a crowdfunded offering, you are rolling the dice in Vegas. Despite your best due diligence before buying the security, you have absolutely no clue how things are likely to turn out. You are trusting 100 percent that the company founders know what they are doing and that their business plan is a solid one.


There are countless reasons small companies do not survive. Among some of the situations I have personally encountered in my practice were:

  1. The company’s founder died in an auto accident.
  2. The company failed to secure the necessary patents for its invention. Key members of the management team left the company (sometimes to a competitor). A large competitor entered the field and wiped out all smaller companies.


The market for the company’s products and services wasn’t as robust as the company founders thought.

The company founder chucked it all and went to law school. (Ahem) an investor stole the company’s idea and launched his own company with better funding.


The offering documents will contain pages and pages of risk factors, describing everything that could possibly go wrong with the crowdfunded company and cause you to lose your entire investment.


They aren’t kidding—they really, really mean it when they issue these warnings. You should not—not—invest in a crowdfunded company unless you are psychologically prepared to lose your entire investment if the company crashes and burns, as start-up companies frequently do.


Calculating Your Investment Limit Under Title III

Calculating Your Investment

Regulation Crowdfunding allows you to purchase securities in crowdfunded offerings up to certain limits. Generally:


If your annual income or net worth (whichever is greater) is less than $100,000, you can invest up to 5 percent of your annual income or net worth (whichever is greater) in crowdfunded securities during a rolling twelve-month period up to a maximum of $5,000 (5 percent of $100,000).


If your annual income or net worth (whichever is greater) is $100,000 or more, or if you are an accredited investor, you can invest up to 10 percent of your annual income or net worth (whichever is lesser) in crowdfunded securities during a rolling twelve-month period up to a maximum of $100,000 (10 percent of $1 million).


As with the accredited investor determination, your net worth excludes the value of your principal residence, and your annual income includes your spouse’s income.


The investment limits are the SEC’s way of determining a safe amount investors can put at risk by investing in crowdfunded securities. How it determined that someone with an annual income of $30,000 can afford to spend $2,000 a year on extremely risky securities is beyond my comprehension, but that’s the way it is.


Can You Lie About Being Legally Able to Invest?


Title III of the JOBS Act and Regulation Crowdfunding impose hefty penalties on issuers and funding portals that run afoul of the rules, but, interestingly, they say nothing about investors who engage in bad behavior.


Here’s a question: as an investor, can you lie when submitting information to a funding portal before investing in a crowdfunded offering?


Let’s say you have reached your investment limit for the year but a really, really terrific investment crosses your email inbox. You know the industry, you’ve read something about the company, the founders are all ex-Google employees, and all necessary patents have been secured. How can this possibly go wrong?


You contact the funding portal that is handling the offering, send it all your personal financial information it requests (more on that below), and answer most of its questions straightforwardly, but when it asks if you have exceeded your investment limit under Regulation Crowdfunding, you answer no.


Now, this is not a good thing you did (and I am not encouraging you to do anything of the sort), but unless the portal has information to the contrary (for example, all of your prior crowdfunded investments were handled by the same portal).


There isn’t really a practical way for it to find out—at least right away (if the portal is looking at your tax returns and bank statements over a long period of time, sooner or later your investment activity will be transparent to it).


What happens?

Regulation Crowdfunding

Under Regulation Crowdfunding, your lie would not void the company’s crowdfunded offering. Issuers under Regulation Crowdfunding can rely on a funding portal’s determination that you were a qualified investor for a crowdfunded offering. The bigger questions are:

  1. How much diligence does the portal have to do to determine you are not lying?
  2. What remedies and recourse does the portal have if it finds out you lied to it?


This, in my humble opinion, is probably the biggest loophole in Regulation Crowdfunding. While funding portals will almost certainly ban from future offerings any investor they discover has lied to them, I’m not sure the portals will have the practical ability to sue those investors in court.


How would they calculate damages in such a case, since the crowdfunded offering went ahead as planned and may have been wildly successful, despite the investor’s lie?


Participating in a Crowdfunded Offering

Since I haven’t been able to dissuade you from investing in crowdfunded offerings in the last few pages (and hopefully have not encouraged you to lie about your investment limits when dealing with crowdfunding portals), here are the steps you need to take to make your investment the right way:


Opening Accounts with Funding Portals

 Crowdfunded Offering

Although you will be able to view information regarding crowdfunded offerings on a funding portal without having to register or otherwise log in to the portal’s website, you cannot participate in a crowdfunded offering.


or communicate with the issuer through the portal’s communications channels, unless you have opened an investment account with the funding portal that is handling the offering.


If you are planning to buy crowdfunded securities on more than one funding portal, you will have to open an account at each portal.


Although the SEC does not specify the exact information the funding portal must obtain from an investor, it is expected that opening an account will include at least providing the portal with basic identifying information, such as the investor’s full name, email address, and physical mailing address.


Also, as part of the process, you would consent to the electronic delivery of materials. Besides email, electronic delivery may include such methods as posting material on the funding portal’s website.


A funding portal could comply with its obligation to provide materials to investors simply by posting materials on the website and would not be required to send any messages directly to investors.


You will also be asked to disclose whether you are engaging in promotional activities on behalf of the issuer, whether you are receiving compensation from anyone if you are engaging in those activities and the amount of such compensation. Likewise, the portal must disclose to you how it is being compensated for handling the issuer’s offering.


You may also be required to disclose any relationship you have or have had with the company, its founders, and its promoters.


Reviewing the Portal’s Educational Materials

Funding portals

Funding portals are required by Title III of the JOBS Act to provide disclosures and investor educational materials at the time you open your account. These materials must be in plain English and include information about:

  • The process for investing on the funding portal
  • The risks associated with crowdfunded offerings of securities
  • The types of securities that may be offered on the funding portal and the risks associated with each, including dilution


Restrictions on the resale of crowdfunded securities


The type of information an issuer is required to deliver annually, including a statement that such information may cease to be provided in the future:

  • Investor limit amounts
  • The circumstances in which an investor may cancel an investment commitment
  • Limitations on the investor’s right to cancel an investment commitment
  • The need for an investor to consider whether crowdfunded securities are appropriate for him or her
  • The possibility that at the end of the offering, there might not be an ongoing relationship between the issuer and the funding portal
  • Each time you express a desire to make an investment in the funding portal, it is required to send you these educational materials.


Satisfying the Portal’s Investor Due Diligence

Regulation Crowdfunding

Regulation Crowdfunding requires not only that the funding portal provides you with educational materials but that it receive “positive affirmation” from you that you have reviewed and understood the materials, that you understand you can lose the entire amount of your investment, and that you are in a financial position to absorb that loss.


There is no required form for the positive affirmation document. Funding portals are permitted to create a process—whether a multiple-choice quiz, a yes/no or true/false question-and-answer document, or another format—that is suited to its particular business model and types of offerings as long as that process is reasonably designed to demonstrate your receipt and understanding of the information.


Each time you make an investment on a funding portal, you will be required to go through the positive affirmation process.


Now, here’s where things get interesting.


The scope of a funding portal’s obligation to verify that you are qualified to invest in crowdfunded offerings is not specified in Regulation Crowdfunding.


The funding portal must have a “reasonable basis” for believing that you have not exceeded your investment limit across all funding portals on which you may be investing and is entitled to rely on your representations with respect to your annual income, your net worth, and the amount of other crowdfunded investments you may have made on other funding portals.


As discussed, there is no specific penalty or liability for funding portals under Regulation Crowdfunding if an investor decides to submit a false written representation.


This means that funding portals will have a wide range of discretion as to how much information to request from you in support of your positive affirmation document. 


In the absence of an express requirement on investors to perform due diligence, many funding portals unquestionably will choose not to do so, to avoid offending potential investors and ensure that they will build as large a database of investors as possible.


Some funding portals, however, may request that you show them copies of tax returns, brokerage or bank statements, or other information supporting your statements in the portal’s positive affirmation document, especially if you are making an extremely large investment constituting a large percentage of your investment limit.


In such a case, you will need information about the funding portal’s privacy policy and what it is prepared to do to keep your sensitive financial information private and secure. You will also need to know whether, and how frequently, you will need to update the information it has on file as long as you maintain your account with the portal.


Communicating with Issuers and the Portal During the Offering Process

Issuers Portal

You will not be allowed to communicate directly with the issuer and its personnel while the crowdfunded offering is pending. All communications between you, the issuer, and its personnel (or with other investors) must be conducted on the communications channels provided by the funding portal, such as chat rooms, webinars, recorded conference calls, and the like.


Keep in mind that:

The funding portal must permit public access to all discussions made in the communications channels.


The funding portal must restrict the posting of comments in the communications channels to those people who have opened an account with the funding portal.


The funding portal must require that any person posting a comment in the communications channels clearly and prominently disclose with each posting whether he or she is a founder or an employee of the issuer or of someone engaging in promotional activities on behalf of the issuer, or is otherwise being compensated, whether in the past or prospectively, by anyone to promote the issuer’s offering.


There is no expectation of privacy here, so be careful what you say.


Funding portal personnel may not participate in these communications (unless they are registered as broker-dealers with the SEC), and the portal may establish guidelines for communications and for removing abusive or potentially fraudulent communications.


For example, funding portals can decide whether their registered users must post under their real names or may do so under aliases (this is a difficult decision: requiring investors to use their real names might limit participation, but aliases could encourage inaccurate or abusive posts).


Making Your Investment

Making Your Investment

You can make your investment at any time while the offering is pending by sending notice to the funding portal and wiring or otherwise transmitting the amount of your investment to a separate bank account maintained by the funding portal for that particular offering with a bank or financial institution;


where it stays until the close of the offering (when it is promptly transmitted to the issuer) or you cancel your investment (when it is promptly transmitted to you).


Funding portals are prohibited from handling funds or securities; they must direct your funds to the qualified bank that has agreed to hold the funds in escrow. Any funding portal that asks you to transfer the funds directly to it is a fraud and is operating in violation of Regulation Crowdfunding.


You cannot use a credit card to make an investment in a crowdfunded offering. While Regulation Crowdfunding does not expressly prohibit payment by credit card, federal banking regulations prohibiting the purchase of securities on credit, the complexities of credit card chargebacks, and the economics of credit card transactions have made the use of credit cards unworkable, at least for now.


As this blog goes to print, investors may make their investments by bank wire transfer or debit card, from amounts on deposit in a PayPal account, or from PayPal accounts linked to bank accounts or debit cards (not credit cards).


In addition to sending money, you may also be required to sign some of the offering documents that appear on the portal. These may include:

A subscription agreement (by which you agree formally to the terms and conditions of the offering)


A signature page to the company’s shareholders’ agreement (for a corporation) or operating agreement (for an LLC) agreeing to be bound by the terms and conditions of that document, including (possibly) some restrictions on your ability to transfer shares to others without first giving the company a right of first refusal to repurchase them


A confidentiality and nondisclosure agreement preventing you from discussing any inside information you may receive about the company, its products, services, and management


On receipt of your funds, the funding portal is required to promptly give you a written record confirming the dollar amount of the commitment, the price of the securities, the name of the issuer, and the date up to which you may cancel your investment commitment.


It is not clear under Regulation Crowdfunding if the issuer will receive a copy of this information prior to the closing of the offering or if it will be permitted to thank you on the funding portal’s communications channels for making your investment.


Withdrawing Your Investment Before the Scheduled Closing Date


You may withdraw your investment at any time, and for any reason, up to forty-eight hours before the offering closes.


If the issuer chooses to close the offering early, as is permitted by Regulation Crowdfunding under certain circumstances once the minimum offering amount has been raised you still have forty-eight hours before the revised closing date.


If the issuer makes a material change in the offering, you will be given notice of the change and five business days to reconfirm your investment by email to the funding portal.


If you fail to reconfirm your investment within that five-day period, your investment will be deemed withdrawn, and you will get your money back promptly from the bank or financial institution acting as an escrow agent.


When You Get Your Money Back Unexpectedly

You may receive your investment back from the funding portal unexpectedly because of certain conditions, including:


The scheduled closing date has come and gone, and the issuer has failed to raise the target offering amount (or the minimum offering amount if there was one).


The issuer made a material change to the offering, and you did not reconfirm your investment within five business days after receiving notice of the change.


The issuer withdrew the offering because of a change in its business plan or because it discovered serious mistakes in its offering documents.


The funding portal discovered false or misleading statements in the issuer’s offering documents and pulled the plug on the offering. In the latter two scenarios, you should receive some sort of explanation, either from the issuer or the funding portal.


Bringing in Other Investors


During the offering process, the issuer will encourage you (possibly ad nauseam) to forward its offering announcement to your friends and social media contacts and encourage them to view the issuer’s offering materials on the funding portal.


The issuer is looking to reach as many people as possible, and one of the benefits of a crowdfunded offering is the ability to tap into not only the issuer’s own social networks but those of its early investors as well.


You are certainly free to do so if you wish (although if you truly believe you have uncovered the next Facebook, why would you shout about it to the entire world?).


There is only one important rule: you cannot accept any form of compensation or finder’s fee from the issuer or from the people you bring in. If you do, the entire offering may be disqualified under the JOBS Act, and any compensation you receive from third parties will need to be disclosed publicly on the funding portal.


Selling Your Crowdfunded Securities

Under the JOBS Act, you must hold on to your crowdfunded securities for one year. Prior to that time, you can sell your securities only to: The issuer (that is, it repurchases its shares)


An accredited investor

A member of your family (your child, stepchild, grandchild, parent, stepparent, grandparent, spouse or spousal equivalent, sibling, mother-in-law, father-in-law, son-in-law, daughter-in-law, brother-in-law, or sister-in-law, including adoptive relationships) or to a trust, for bona fide estate-planning purposes


Your ex-spouse as part of a divorce decree or separation agreement.

The one-year resale restriction applies to any purchaser during the year beginning when the securities were first issued, not just the initial purchaser, so if you acquired the securities from another investor during the one-year period, you are required (among other things) to have a “reasonable belief” that any subsequent purchaser during the one-year period is an accredited investor.


At the end of the one-year holding period, you may sell your crowdfunded securities to anyone you like, without restriction, under Regulation Crowdfunding. There are only two small problems:


There may not be a market for such securities, meaning you will have to negotiate the terms of sale one-on-one with your purchaser, providing all of the company’s current information available online and on EDGAR.


State securities laws may prohibit you from reselling the securities under certain circumstances (these aspects of state blue-sky laws were not preempted by the JOBS Act). 


Generally, at least until some enterprising people create a new securities market expressly for crowdfunded securities (don’t hold your breath, as it would take years to register a new stock market with the SEC, the National Association of Securities Dealers, and other regulators), your crowdfunded securities will be highly illiquid, and you must expect to hold on to them for the long term.


Getting Involved in Your Crowdfunded Company

Crowdfunded Company

One of the nice things about investing in a small company is that you are not just a number—you are family.


If you buy one hundred shares of stock in Microsoft Corporation, you don’t get a telephone call from Bill Gates thanking you for your investment. When you invest in a small company, your investment counts.


Not only do you get a telephone call from the company’s CEO thanking you for your investment, but you may also get periodic calls for help in building the business. In some cases, there may be too much communication with the issuer’s management team.


As an investor, you are entitled to information about the company from time to time. You probably will receive monthly e-newsletters from the company highlighting its progress and quarterly emails with copies of the progress reports crowdfunded companies are required to file with the SEC every three months.


When there’s bad news, a reputable company will inform you about the problem before you read about it elsewhere.


You are also entitled to ask questions via email of the company’s management from time to time and offer comments and suggestions if you think you have something to contribute.


You should strive not to become a time vampire, however. If you find yourself sending emails to the crowdfunded company more than once or twice a month, that’s probably too much.


Remember that this investment is supposed to be “play money”—your retirement doesn’t depend on the success or failure of this company. If you are losing sleep over your crowdfunded investment, you probably never should have made it in the first place. As Bob Dylan once sang, “It’s all over now, baby blue.”


If you have particular expertise in the company’s market, business, or industry, or are well connected within that industry, don’t be surprised if company management reaches out to you after you invest and offers you a more involved role in the company.


If you are such a person, you may want to volunteer yourself as a mentor or adviser to the company—nothing in the JOBS Act or Regulation Crowdfunding prohibits you from doing so.


Most start-up companies have informal boards of advisers consisting of their mentors, professional advisers, and industry or marketplace players. The author himself serves on several advisory boards established by his law clients. There are four things you need to know about serving on advisory boards:


1. You will be required to participate in quarterly conference calls to discuss issues facing the company; to be an effective advisory board member, you will need to commit the time to be available for those calls.

2. You will not be paid for your services.

3. You are not a part of the company’s management team, and any advice you give the company is completely nonbinding.

4. Advisory board members are customarily expected to assist management in its future fund-raising efforts.


The good news is that as a member of a company’s advisory board you have no legal liability if the company issued.


If you truly are a player, you may be invited to join the company’s board of directors or become employed by the company in a senior management capacity. You will need to consult with your attorney before doing so. Officers and directors of a privately owned company are exposed to a lot of legal risk under state corporation statutes and federal securities laws.


When such a company experiences trouble, shareholders frequently sue the company’s officers and directors for fraud, breach of fiduciary duty, misappropriation of corporate funds, and other nasty things, whether or not there is any legal basis for the claim.


The good news is that most small companies will indemnify you and hold you harmless in the event you are sued because of your role as an officer or director of the company. The bad news is that if the company is broke, its indemnity will be worthless, and you will have to defend the lawsuit at your own expense.

management team

Before joining the management team of a small company, you should ask if it provides its directors and officers with liability coverage known as D&O insurance. This is similar to the malpractice or “errors and omissions” coverage a doctor, lawyer, or another professional would maintain.


If the company is unable to provide such coverage, do not join the management team unless you have deep enough pockets to defend yourself if the company issued.


Note to issuers: you should consider using some of the proceeds of your crowdfunded offering to buy a D&O insurance policy. This will make it much easier for your company to attract industry leaders, experts, and other highly desirable players to serve as officers or outside directors of your company.


When Can You Write Off Your Worthless Investment in a Crowdfunded Company on Your Taxes?

If your investment in a crowdfunded offering turns out to be a total loss, you may—may—be able to write it off as a worthless investment. But, as always with tax deductions, there are rules and exceptions.


In order to write off an investment, there has to be a total loss. As long as the issuer is in business or is going through bankruptcy proceedings, there is always hope (however slim) that things may turn around.


Until the company is 100 percent dead and gone, with no hope of resurrection (even as a zombie), you cannot write off any portion of your investment.


When you are finally able to write off your investment, you and your accountant will need to determine whether you can write it off as an ordinary loss or a capital loss.


In order to write off your investment as a total loss, the shares you purchased may have to qualify as Section 1244 stock. Section 1244 of the Internal Revenue Code allows losses from the sale of shares of small, domestic corporations to be deducted as ordinary losses instead of as capital losses up to a maximum of $50,000 for individual tax returns or $100,000 for joint returns.


To qualify for Section 1244 treatment, the corporation, the stock, and you must meet certain requirements. The corporation’s aggregate capital must not have exceeded $1 million when the stock was issued, and the corporation must not derive more than 50 percent of its income from passive investments.


You must have paid for the stock and not received it as compensation, and only individual shareholders who purchase the stock directly from the company qualify for the special tax treatment.


This is a simplified overview of section 1244 rules; because the rules are complex, investors in crowdfunded offerings are advised to consult a tax professional for assistance.


Even if your crowdfunded investment does not qualify for Section 1244 treatment, you may be able to deduct your loss under Section 165 of the Internal Revenue Code.


But your deduction will be a capital loss, which in general is not as valuable as the ordinary loss you would receive had your investment qualified for Section 1244 treatment, because of the difference in tax rates between ordinary income and capital gains under the federal tax laws.


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Should You Set Up a Funding Portal?

Set Up a Funding Portal

Throughout this blog we have looked at the role funding portals will play in the crowdfunding process and the responsibilities they have for ensuring that crowdfunded offerings of securities go smoothly and legally.


In fact, both the JOBS Act and Regulation Crowdfunding put the burden squarely on funding portals to make sure the crowdfunding systems work—most of Regulation Crowdfunding’s nearly seven hundred pages are devoted to rules and regulations governing funding portals.


A few enterprising readers may be thinking to themselves, “Hey, the money in crowdfunding is with the funding portals! I should be thinking about starting up a funding portal!” This blog will discuss funding portals, the advantages, and disadvantages of getting involved in the funding portal business, and the right way to set up a funding portal operation.


It May Be Too Late for the Early Money

As this blog goes into print, about a dozen companies are positioning themselves to open funding portals under the JOBS Act. By the time you read this blog, at least some of those portals will have registered with the SEC and FINRA and will have opened their doors for business.


In addition, the JOBS Act and Regulation Crowdfunding not only allow but appear to encourage investment banking firms, brokerage houses, and other registered broker-dealers to get into the funding portal game, and it may be expected that at least some of these firms will consider opening crowdfunding divisions in coming months.


Any such firms would, of course, be extremely powerful competitors in an early-stage market because of their extensive experience in the securities industry and because of the huge amounts of capital they already have available for building a successful portal business.


It may therefore already be too late to get into the funding portal game in a big way and become a key player.


Picking a Crowdfunding Niche

Crowdfunding Niche

There may, however, be opportunities to develop funding portals that focus on specific industries or verticals, specific types of companies, and specific types of offerings.


Regulation Crowdfunding expressly permits such specialization as long as it is based on objective criteria that are designed to result in a broad selection of offerings, are applied consistently, and are clearly displayed on the portal website.

Examples of such specialized portals are:

  • Energy-related companies
  • Start-up fast-food franchises
  • LLC securities
  • Issuers located in a particular state or region


Offerings of less than $50,000

Focusing on a niche may well reduce the costs of setting up a funding portal and get you into the market more quickly than offering a broad range of crowdfunding services. In looking for the right niche, however, it is important to ask:


Is the niche big enough to generate substantial revenue in the first few years of operations?

Is the niche small enough to be unattractive to the large investment banks, brokerage firms, and early-stage portals that may come to dominate the industry?


Do issuers in the particular niche have enough money to pay decent commissions and the add-on fees the portal will need to stay afloat?

Are there enough investors interested in the niche to justify an exclusive portal?


Setting Up a Funding Portal

Funding Portal

There are five basic steps in setting up a funding portal:


1. The founders must form a corporation for the funding portal (due to the high degree of liability imposed on funding portals, an LLC would not provide enough protection to the portal’s shareholders).


2. The portal is then required to register with the SEC as either a funding portal or a broker, using the SEC’s new Form Funding Portal (the text of which can be found at SEC Release No. 33-9974, www.sec.gov/rules/final/2015/33-9974.pdf, beginning on page 21).


3. The portal is then required to register with FINRA and pay a fee of $2,700 (the text of the FINRA application form is at www.finra.org/industry/rule-filings/sr-finra-2015-040).


4. The portal must obtain a $100,000 fidelity bond.


5. The portal must hire the staff necessary to provide all the services and perform all the obligations imposed on funding portals by Regulation Crowdfunding.


It will likely take at least a year, and possibly longer, to complete all these steps.

The cost of setting up a funding portal is likely to be prohibitive for many start-up companies. Operating a funding portal is also likely to be extremely labor-intensive: reviewing offering documents from dozens or perhaps hundreds of issuers, furnishing them with advice on putting together their offerings.


Dealing with dozens or perhaps hundreds of investors, and keeping track of dozens of crowdfunded offerings at the same time, without making mistakes that could subject the portal to liability—performing these functions will require many, many warm bodies sitting at computer terminals.


Many funding portals are likely to try to minimize these costs by outsourcing their internal operations to a location in India or another country in the developing world—a highly ironic outcome, to say the least, for a statute designed to create jobs in the United States.

Before launching a portal, each of its founding executives must understand that they cannot:

  • Have a financial interest in any issuer
  • Participate in offerings either as an issuer or investor


Engage in any activity that might constitute a conflict of interest with an issuer, investor, or any other third party (for example, by referring the portal’s business to another company in which the executive has a financial interest)


The Portal’s Obligations to Vet Issuers

The JOBS Act and Regulation Crowdfunding impose somewhat inconsistent obligations on funding portals in their dealings with issuers.


When reviewing an issuer’s offering documents, funding portals must have a “reasonable basis for believing” that the issuer (1) has met the disclosure and other requirements of Regulation Crowdfunding and (2) has the means to keep accurate records of investors once an offering is completed.


Regulation Crowdfunding provides that funding portals may rely on representations to that effect by the issuer, absent any indication that the representation is not true.


On the other hand, Regulation Crowdfunding states that funding portals must be able to “adequately and effectively assess the risk of fraud from the issuer or its offering.”


Funding portals are also required to investigate whether any of an issuer’s directors, officers, or other key executives have committed “bad acts” sufficient to disqualify the issuer’s offering under Regulation Crowdfunding.


If it cannot do so (for example, because an issuer’s directors are foreign nationals whose country of origin does not allow for third parties to review criminal or regulatory enforcement background information), the funding portal must deny access to its platform.


If a funding portal becomes aware that any crowdfunded offering “presents the potential for fraud or otherwise raises concerns regarding investor protection,” it must deny the issuer access to the portal.


If a funding portal becomes aware that there is the potential for fraud after an offering has commenced, or that one or more of the issuer’s principals is disqualified as a bad actor, it must cancel the offering and return any investors’ money.


Can an issuer sue a funding portal if the portal mistakenly rejects its offering or denies it access to the portal? That is an interesting question, the answer to which will hinge on how the issuer would calculate damages for not having access to that particular portal.


Given these heavy obligations, to what extent must a funding portal conduct due diligence on issuers before accepting their offerings? Regulation Crowdfunding isn’t clear, and each funding portal will need to determine how closely and aggressively to review offering documents.


While Regulation Crowdfunding allows a funding portal to rely on an “issuer representation” that all rules have been complied with.


I don’t think many portals will feel comfortable that their obligation to prevent fraud can be satisfied by having the issuer click “I agree” to accept terms and conditions that it has never read—and I strongly doubt that legal counsel representing a portal will sanction such an informal approach.


On the other hand, the need to generate a high volume of issuer offerings during the early years of a portal’s operation may lead it to go easy on issuers in an effort to gain a competitive advantage.


The Portal’s Obligations to Investors

Obligations to Investors

Funding portals are required to develop educational materials for each offering it handles and to deliver them to each investor who opens an account and expresses a desire to participate in a particular offering.


It must also develop a means of confirming that the investor understands the information in the educational materials and agrees to play by the rules. This send-out-materials-and-obtain-confirmation procedure must be repeated each time an investor indicates an interest in a particular offering.


Funding portals are not, however, required to investigate or do background checks on investors to make sure they legally can participate in crowdfunded offerings.


While a funding portal can check its records to see if the total amount of an investor’s commitments exceeds her investment limit, there is no practical way for a portal to confirm if she has exceeded her limit by reason of investments with other portals.


Accordingly, Regulation Crowdfunding provides that a funding portal may rely on an investor’s representations concerning the investment limits that apply to the investor and the number of the investor’s investments in crowdfunded securities through other portals.


That said, funding portals will be best advised to make each investor focus hard and long on his other crowdfunded investments when completing the affirmation documents for each offering by asking as many focused, specific questions as possible and requiring the investor to respond to each one.


That way, there will be little likelihood an investor can claim he wasn’t sure what the portal was getting at if he is later found not to have been qualified to invest in a crowdfunded offering.


Can a funding portal bar access to an investor who is found to have lied in his statements to the portal? Perhaps. If the investor is a heavy hitter who participates in lots of offerings and has an otherwise decent track record, I have a suspicion most funding portals will find a way to deal with the problem discreetly.


What is clear from Regulation Crowdfunding is that a funding portal may not reject an investor because it feels a particular investment isn’t suitable for the investor.


Funding portals must provide to investors all information about an offering by one of three methods: via email, via a link to the portal’s website, or via a notice on the portal website as to where such information can be found. Investors must be allowed to save, store, or download the information.


When an investor commits to an offering, the funding portal must accept the investment on the issuer’s behalf but must direct funds to the qualified bank that has agreed to hold them in escrow for that offering. Funding portals are expressly prohibited from holding investor funds or issuer securities.


The portal must also ensure that an investor fills out and signs any and all subscription documents the issuer has required for the offering, and issue a “notice of investment commitment” to both the issuer and the investor.


If an investor cancels an investment commitment up to forty-eight hours before the offering closes, the portal must refund the investor’s money promptly.


When an offering closes, the portal must issue a confirmation statement to the investor detailing the amount of the investment, the number of securities purchased, and other information required by Regulation Crowdfunding.


The Portal’s Obligations to the SEC

Portal’s Obligations

Funding portals are not required to file documents periodically with the SEC the way issuers are. Funding portals are, however, required to maintain extensive blogs and records, subject to examination by the SEC at any time. These records include:


Records related to an investor who purchases or attempts to purchase securities through the portal Records related to issuers who offer and sell or attempt to offer and sell securities through the funding portal and the people who “control” such issuers (for example, people who own a majority of the issuer’s shares, or an affiliated company that is owned by the same company that owns the issuer);


  • Records of all communications occurring on or through the portal Records relating to promoters
  • Records required to demonstrate compliance with Regulation Crowdfunding
  • Notices provided by funding portals
  • Written agreements entered into by the funding portal


Daily, monthly, and quarterly summaries of transactions effected through the portal, including successful issuers, amounts distributed, and transaction volume (number of transactions, number of securities involved, total amounts raised by and distributed to issuers, and total dollar amounts raised across all issuers on the portal)


A log reflecting the progress of each issuer toward achieving its target offering amounts

The organizational documents of the funding portal Funding portals are required to preserve all records for five years. During the first two years, records are required to be kept in an easily accessible place.


While the SEC does not require funding portals to register as broker-dealers, funding portals are not exempt from the compliance requirements that apply to registered brokers.


These compliance requirements include the SEC’s anti-money-laundering regulations, customer-privacy protections, and the provisions relating to examination and inspection of blogs and records and facilities by the SEC and FINRA.


The Portal’s Obligations to Market and Grow Its Business

Grow Its Business

Funding portals are allowed to advertise their own existence, and (with some limitations) to pay third parties for referring issuers and investors to the portal. For example:


A portal can pay a third party for referring potential investors to the portal so long as the third party does not provide the portal with any personally identifiable information about any of the potential investors (information that can be used to distinguish or trace an individual’s identity), as long as the payment is not based on the number of investments made by those investors on the portal.


A portal can enter into agreements with registered broker-dealers by which they can pay each other for services.


Funding portals cannot, however, charge issuers for a special place for their offerings on the portal, or for recommendations or endorsements of specific offerings. Funding portals also cannot solicit offers or sales to buy securities offered on the portal.


The Portal’s Obligations in Managing Offerings

Managing Offerings

A funding portal is a platform only, a “program or application accessible via the Internet or another similar electronic medium” as defined in Regulation Crowdfunding, designed to facilitate interactions between issuers and investors but without itself getting involved in the offering process.


In many ways, funding portals are intended to be set up the same way as eBay is: buyers and sellers interact with each other without any intervention from eBay (except, of course, for the collection of fees from buyers and sellers).


Funding portals are obligated to ensure public access to all offering documents posted to the portal and to all communications taking place on the portal, including search functions to enable issuers and investors to find each other.


Funding portals are obligated to set up communications channels by which issuers and investors communicate with each other, such as chat rooms, discussion threads, webinars, and telephone conference calls.


Funding portals may not, however, participate in any discussions other than to establish guidelines, to moderate, and to remove postings that violate the rules or their own communications guidelines.


What happens if the portal website goes down and issuers and investors cannot communicate for a period of time? Regulation Crowdfunding does not provide specific liability for such a situation, and presumably, funding portals will do everything possible to limit their liability for such outages in their published terms and conditions.


A more significant question, however, is what happens if an offering closes during a portal outage, such that investors are prevented from making last-minute investments during the outage period?


To avoid liability to the issuer in such a situation, I suspect most funding portals will develop a policy of automatically extending the offering period for the same amount of time that the portal site was down or five business days, whichever is longer.


Such a policy would not be prohibited by Regulation Crowdfunding as long as the portal follows the rules for extending an offering (giving investors notice of the extended period and five business days within which to reconfirm their investments).


Of course, issuers won’t be too happy if investors fail to reconfirm their investments during the five-business-day period and the funding portal is required to give them back their money because of something that wasn’t the issuer’s fault.


During the offering period, funding portals are also obligated to:

  • Maintain accounts with banks or other financial institutions to hold investors’ money until an offering closes
  • Accept investment commitments on behalf of issuers and ensure that investors fill out and sign all subscription documents required for the offering
  • Release funds to the issuer when the offering closes (or the minimum offering amount has been reached)
  • Deliver confirmations of investment to the issuer and each investor when the offering closes


The Portal’s Liability for Mistakes

Portal’s Liability

Issuers, including their directors and officers, are liable under the JOBS Act to investors for “untrue or materially misleading statements” in their offering documents.


Funding portals, their directors and officers, and lower-level employees who are “involved in the offering” are also liable to investors for “untrue or materially misleading statements” in an issuer’s offering documents, unless they or the issuer can prove they did not know, and in the exercise of reasonable care could not have known, of the untruth or omission.


The good news is that a funding portal’s liability is limited to the amount paid by each investor affected by the mistake, plus interest. The bad news is that investors can sue the funding portal even after they have sold their investments.


Funding portals are, however, permitted to exercise discretion in limiting the offerings and issuers they allow on their platforms, which may give them some ability to limit their liability to investors under Regulation Crowdfunding.


Funding portals will also have liability to the SEC for, among other things, failing to maintain all required logs and records relating to the offerings it handles, and for a funding portal’s own breach of the requirements of the JOBS Act and Regulation Crowdfunding (for example, by advertising a particular offering or highlighting one offering over another in violation of the rules).


Funding portals that violate specific provisions of the JOBS Act and Regulation Crowdfunding will be subject to the same civil and criminal penalties as are imposed for violations of the Securities Exchange Act of 1934.


How a Funding Portal Makes Money

 Funding Portal

As this blog is going into print prior to January 26, 2016 (the date funding portals are first allowed to register with the SEC), no funding portals have been approved by the SEC. It is therefore difficult to predict the revenue model most funding portals will adapt over time.


Funding portals are prohibited from taking a “carried interest” (a piece of the action) in the crowdfunded offerings they manage. But there is nothing in the JOBS Act or Regulation Crowdfunding preventing funding portals from charging issuers and investors a commission or other fee for their services at both ends of the transaction.


Accordingly, it may be anticipated that most early funding portals will charge issuers a flat fee or commission for handling their offerings, which may be tiered based on the amount of the offering, the timing of the offering, and/or the amount of offering documentation the funding portal will be expected to process for a particular issuer.


In addition, funding portals are almost certain to charge extra for such add-on services as helping issuers prepare their offering documents or managing their shareholder lists and capitalization tables after an offering is completed.


While funding portals are prohibited from endorsing or promoting specific offerings in their communications with the outside world, the rules are a bit fuzzy when it comes to allowing issuers to add bells and whistles to their online presence so as to stand out from other offerings on the portal.


Regulation Crowdfunding allows funding portals to “highlight and display” offerings on the portal based on “objective criteria that would identify a large selection of issuers.”


Some of the objective criteria noted by the SEC are the type of securities being offered, the geographic location of the issuer, and the number or amount of investment commitments made.


Funding portals are prohibited, however, from receiving special or additional compensation for identifying or highlighting an issuer or offering on the portal.


To the extent permitted by the rules, funding portals will almost certainly charge add-on fees for such bells and whistles as an issuer may request and are consistent with Regulation Crowdfunding, similar to the way eBay charges its sellers for using different colors, visuals, or graphics when listing items for sale on the site.


Given the high start-up and operating costs of running a funding portal business, the many responsibilities funding portals have under the JOBS Act, and the high degree of liability to which they are subject, portal fees may be expected to be quite high.


At least during the early years of the portal’s operations, in amounts comparable to what an investment bank or brokerage firm would charge for handling a similar offering.


Funding portals may also charge fees to investors, although at least initially most funding portals will probably keep these as low as possible in order to maximize investor interest and participation.


Creating a Stock Transfer Ledger

Stock Transfer Ledger

There is one other section of your corporate minute blog you need to look at: the “Stock Transfer Record” or “Stock Transfer Ledger,” which usually appears at the end of the blog.


As anyone who has ever written or self-published a newsletter can tell you, the hardest part of the job is keeping track of your mailing list.


It’s the same with investors: you need to keep track of every outstanding share in your company at all times.


If you ever decide to solicit large investments from venture capitalists or accredited investors under Title II or Regulation D, launch a mezzanine offering with institutional investors, or (from my lips to God’s ears) decide to make an initial public offering of your shares, your underwriters or venture capital investors will want to see this information on demand.


This means keeping track of the name, address, telephone number, and email address of each investor and updating that information every time the investor:


Changes her address or email address

  • Adds a cell phone or other telephone number as a secondary number
  • Dies, so that his shares are transferred to someone else (hopefully just one) as part of probating his will Sells her shares to someone else after the one-year holding period required by Regulation Crowdfunding


  • Gets divorced, so that some of his shares are transferred to his ex-spouse by court order
  • Files for bankruptcy, so that her shares are transferred to a creditor by court order


Updates his will and transfers the shares to a trust benefiting his descendants in perpetuity (called a dynasty trust; this is becoming an increasingly popular tool in estate planning). Has any other change that may prevent you from getting hold of her when you really need to do so.


Traditionally, companies kept track of this information in the “Stock Transfer Record” at the end of their corporate minute blog. Today, an Excel spreadsheet is probably a more efficient way to keep track of this information, or, for email communications especially, an account with Constant Contact or another website that facilitates email newsletters.


If you do use a spreadsheet, I recommend that you print it out periodically, make two copies, put the original in your corporate minute blog, and send the copies to your accountant and your lawyer. This is information you absolutely, positively cannot afford to lose.


I always advise that companies maintain their own shareholder lists. If this is a task you really don’t feel comfortable doing yourself, I’m sure some funding portals will offer this as an additional service to their issuers—for a hefty fee, of course.


Updating Your Capitalization Table

Capitalization Table

The last thing you should do before you start spending your crowdfunded cash is updated your capitalization table (cap table), a chart that shows:


Each class of your company’s securities

  • The number of issued and outstanding shares of each class
  • The number of options and warrants you have granted to people to acquire shares of each class in the future
  • The percentage ownership of each class

A brief summary of the principal terms and conditions of each class of securities


If you don’t already have a cap table for your company, now is the time to create one, as this will be one of the first things venture capitalists and other professional investors will ask for when considering your company for a follow-up offering.


Filing Your Annual Reports and Holding Your Annual Shareholders Meeting

Your company will be required to file an annual report with the SEC on Form C-AR (basically an update of the information submitted on your initial Form C) within 120 days after the end of your company’s fiscal year. You will also be required to post a copy of each annual report on your company website.


Failure to file the annual report on time will, among other things, disqualify your company from future offerings under Regulation Crowdfunding, which requires that any ongoing annual report that was due during the two years immediately preceding the currently contemplated offering must be filed before an issuer can make an offering under Regulation Crowdfunding.


Your company will be required to file the annual report until the earliest of the following events occurs:

  • Your company is required to file periodic reports under the Securities and Exchange Act of 1934.
  • Your company has filed at least one annual report and has fewer than three hundred holders of record.
  • Your company has filed at least three annual reports and has total assets that do not exceed $10 million.

Your company or another party purchases or repurchases all the securities issued pursuant to Regulation Crowdfunding, including any payment in full of debt securities or any complete redemption of redeemable securities.


Your company liquidates or dissolves in accordance with state law.

Virtually every state corporation law requires companies to hold an annual meeting of shareholders and special meetings of shareholders to approve particular matters. For most start-up companies, these are relatively informal affairs, which may take the form of conference calls or casual meetings over lunch.

No more.


If your crowdfunded investors have voting rights (not recommended), you will have to involve them in these meetings. Depending on your state’s corporation laws, you will be required to give notice of each meeting to all your investors at least ten days prior to the meeting date and confirm that they received the notice.


You must also allow your investors to be physically present during the meeting, either in person or by telephone conference call (in a handful of extremely forward-thinking states, meetings can take place via webinar or other electronic means).


Even if your crowdfunded investors do not have voting rights (highly recommended), you may be required by your state corporation law to give them advance notice of shareholder meetings if particular items are on the agenda (such as mergers, acquisitions, or amendments of your company’s charter documents affecting their rights as shareholders).


You may also be prohibited from dealing with your nonvoting shareholders in a harsh and oppressive manner in some states. Talk to your attorney to learn more about your state’s specific rules for dealing with nonvoting shareholders.


Making Sure Your Company Doesn’t Get Too Big

Generally, a company that has more than two thousand total investors or more than five hundred investors who are not accredited investors is required to register its securities and file periodic reports with the SEC under the Securities and Exchange Act of 1934, just like a public company is required to do. Regulation Crowdfunding exempts a crowdfunded issuer from this requirement as long as it:

  1. Files its annual reports promptly and on time
  2. Has $25 million in total assets or less
  3. Appoints an SEC-registered transfer agent for its securities
  4. An issuer that exceeds these thresholds will be granted a two-year transition period before it will be required to start filing periodic reports under the 1934 act, provided it timely files all its ongoing reports pursuant to Regulation Crowdfunding during the two-year period.


Crowdfunding Rules

Federal Regulation of Private Offerings of Securities Prior to the JOBS Act

Prior to the twentieth century, offerings of securities in the United States were not regulated by government at any level. The prevailing laissez-faire philosophy of the time dictated that the government should interfere with commercial activities only when absolutely necessary to protect the public interest.


Investors were held strictly accountable for their own mistakes, negligence, and bad investment choices under the maxim of caveat emptor, or “buyer beware.”


The early 1900s: The States Get the Ball Rolling with Blue-Sky Laws

That changed in the early twentieth century, largely as the result of several waves of panic (today we call them recessions) in which many investors lost their shirts by putting money into thinly capitalized start-up companies launched by promoters who in many cases were little better than thieves.


During the Progressive Era of the early 1900s, a number of states, including New York, enacted securities laws designed to protect investors against these unscrupulous promoters. These were called blue-sky laws in a 1917 U.S. Supreme Court opinion, which described the purpose of these laws as preventing “speculative schemes that have no more basis than so many feet of ‘blue sky.’”


Blue-sky laws vary from state to state but have traditionally focused on the registration of broker-dealers and securities offerings. With respect to the registration of private offerings, most states impose some sort of merit review (state regulators tear apart the offering documents, offer comments, and suggestions, and generally make a nuisance of themselves).


States also typically have in place antifraud provisions that make actionable false statements made in connection with securities offerings. These antifraud provisions apply regardless of whether registration is required.


Absent an exemption, blue-sky statutes typically require registration in each state where the offering occurs. Registration, therefore, may be required in multiple states. Researching each individual law and completing the registration process can add delay and cost to an offering and discourage capital raising.


State blue-sky laws still play an important role in the regulation of private offerings. Under the U.S. Constitution, the states and the federal government have concurrent power to regulate offerings of securities. That means the federal government and the states can pass laws affecting private offerings.


Unless the federal government expressly preempts or prohibits the states from passing laws in a particular area, the states are free to pass laws of their own as long as they are at least as restrictive as federal law and do not allow behavior that is prohibited by federal law.


So, for example, if federal law says you can’t have more than thirty-five nonaccredited investors in a private offering of securities, State X is free to pass a law saying;

“Yes, but for this type of offering you can’t have more than ten nonaccredited investors who are residents of this State without filing an offering statement with the State X Department of Securities.”


A number of states have such rules, and companies planning offerings of securities need to be aware of the limitations that apply in the states where their investors reside.


While Title III of the JOBS Act expressly prohibits (or preempts) states from passing laws to regulate Title III crowdfunded offerings, there is no such blanket preemption for Title II accredited investor offerings, which may still require notice filings in some states.


Also, a number of states have amended their intrastate offering rules (for offerings of securities that take place entirely within state borders) to allow for limited crowdfunding of these offerings.


Therefore, companies looking to make Title II crowdfunded offerings (offerings to accredited investors only) or intrastate offerings (offerings of securities that take place entirely within state borders) may still have to comply with blue-sky laws in the states where they are physically located or where their investors live.


1933: The Federal Government Wades into the Securities Markets


Fast-forward to the early 1930s, after the 1929 stock market crash, followed by the Great Depression, followed by President Franklin D. Roosevelt and his New Deal.


One of the most important pieces of New Deal legislation Congress passed during this period was the Securities Act of 1933, the first federal statute regulating the offerings of securities.


The Securities Act imposed rules for offerings of several types of securities: stocks, bonds, notes, debentures, certificates of interest, participation in profit-sharing agreements, preorganization certificates, preorganization subscriptions, voting trust certificates, and investment contracts.


A piece of paper may be a security, even if not denominated as a share of stock or note if it is deemed to fit within one of a group of other less clear-cut categories such as “investment contract.”


In a 1946 opinion, the U.S. Supreme Court defined security, subject to regulation under the Securities Act, as “an investment of money in a common enterprise with the profits to come solely from the efforts of others.”


The heart of the Securities Act is Section 5, which prohibits the offer of securities to anyone unless a “registration statement” (including a prospectus or business plan describing the securities and the company issuing them) is on file with and has been declared “effective” by the SEC.


Section 5 also prohibits the delivery of the securities to a purchaser or investor unless accompanied or preceded by a prospectus that complies with the requirements of the Securities Act.


The Securities Act, like all securities laws, is basically a consumer protection law. The idea is that securities should not be sold to anyone unless the company issuing them educates the purchaser about the company, the business, the securities, and the risks involved in an investment.


Failure to do so, or false or misleading statements in the offering documents, are severely punished under the Securities Act. The investor, of course, does not have to read all the documentation but must be given a reasonable opportunity to do so before the rule of caveat emptor kicks in and he is faulted for making a bad investment.


Section 5 basically says that if you want to make a public offering of securities in the United States, you must—must—go through the public offering process: you must prepare a registration statement and prospectus, file it, have it approved (or “declared effective”) by the SEC, and deliver it to prospective investors.


The size of the offering or the company issuing the securities does not matter. Under the Securities Act, every offering of securities is a “public” offering unless it is specifically exempted from the registration requirements of Section 5.


From the beginning, it was recognized that the requirements of Section 5 would be too onerous for many small companies making small or limited offerings of securities to people they knew well who could handle the risks of investing in an unproven, early-stage company.


Thus the Securities Act contains several exemptions from the Section 5 registration requirement, two of which are especially important when dealing with crowdfunded offerings:


1. Section 3(b) of the Securities Act gives the SEC authority to exempt small offerings of securities (defined by the SEC as offerings that do not exceed $1 million during a rolling twelve-month period, less other offerings by that same company during the same period).


2. Section 4(a)(2) of the Securities Act, which exempts from Section 5 “any transaction by an issuer not involving any public offering.”

In determining whether an offering is nonpublic under Section 4(a)(2), the Supreme Court has looked at whether the class of people being offered the securities needs the protection of the Securities Act or otherwise is sophisticated and has access to the type of information that would be contained in a registration statement filed with the SEC.


Thus, for an offering of securities to be other than a public offering requiring compliance with the Securities Act’s registration requirements, the offering must:


  1. Not be made “publicly” or in a public manner (for example, by a general solicitation or general advertising)
  2. Not be made “to the public” (that is, the crowd, the hoi polloi, aka “the great unwashed”) indiscriminately but only to selected people who by virtue of their sophistication and wealth do not need the protection of the federal securities laws


In 1934, Congress passed the Securities and Exchange Act of 1934, containing rules for companies that have registered one or more public offerings with the SEC and have thereby become “public companies.”


Various sections of the 1934 act require public companies to file annual and quarterly financial reports with the SEC, regulate how public companies can be governed, describe illegal “market manipulation” activities, and contain detailed rules for broker-dealers and other players in the securities markets.


Section 12 of the 1934 act provided that even if a company had not registered a public offering with the SEC, it could become a public company subject to the Act's requirements if it had more than five hundred shareholders or more than $10 million in total assets at the end of its last fiscal year.


Title V of the JOBS Act raised those limits to two thousand shareholders, five hundred shareholders who are not accredited investors, and $25 million in total assets.


1964: The SEC Adopts Regulation A

Fast-forward to 1964, the era of Camelot, the rise of Madison Avenue, and colossal tail fins (on automobiles). In that year, the SEC issued Regulation A, consisting of thirteen rules that make up, in effect, a shortened form of registration for a securities offering.


Regulation A exempts from Section 5 of the Securities Act an offering of securities in an aggregate amount of $1,500,000 in any twelve-month period, reduced by the amount of any other securities that the issuer sold during that period under any other exemption.


Relatively few companies over the years have taken advantage of a Regulation A offering, but two aspects of Regulation A are still relevant for crowdfunded offerings:


1. Regulation A contains provisions disqualifying “bad” companies from using the regulation; these are basically companies whose owners, key executives, or promoters have been convicted of securities offenses, been subject to SEC disciplinary proceedings, or been involved in certain other types of proceedings.


2. Compliance with Regulation A requires the filing, generally in the regional SEC office where the issuer has its principal place of business, of notification and an offering circular on SEC Form 1-A, which must be approved by the SEC prior to the offering.


Also, companies that are subject to the bad boy disqualification rules are not eligible to make crowdfunded offerings under Title III.


Title IV of the JOBS Act and SEC Release No. 33-9741, adopted March 25, 2015, made numerous amendments to Regulation A designed to make it a more attractive option for early-stage companies than previously, with mixed results.


1970: The SEC Adopts Rule 146 for Private Placements

Fast-forward to 1970: Richard Nixon, tie-dyed shirts, Vietnam, and “All you need is love.” In that year, the SEC adopted Rule 146 in an attempt to create a “safe harbor” under Section 4(a)(2).


Safe harbor means that if a company issuing securities complied with all of the rule’s requirements, it was engaged in a “private placement” that did not have to be registered with the SEC under Section 5 of the Securities Act.


If a company substantially complies with the safe harbor rules in Rule 146 but fails to nail them 100 percent, it might still be exempt from registration under the Securities Act by virtue of Section 4(a)(2) private placement exemption, but it might have to prove it in court if challenged by angry investors, the SEC, or state securities regulators.


Securities lawyers refer to this as the “residual” Section 4(a)(2) exemption. Of course, whether a company has “substantially complied” with a rule is often a matter for the courts to decide, an expensive and time-consuming proposition for any early-stage company.


Rule 146 imposed a number of hoops for companies to jump through in order to qualify for the safe harbor, but three species are relevant to crowdfunded offerings:


1. The offering must be limited to thirty-five purchasers overall.

2. The offering must not be made by “general solicitation” or “general advertising.”


3. The company must have “reasonable grounds to believe” prior to making an offer that (1) either the offeree or her investment representative has such knowledge and experience in financial and business matters that she is capable of using the information contained in the company’s offering statement to evaluate the risks of the prospective investment and of making an informed investment decision, and (2) the offeree is a person who is able to bear the economic risks of investment.


In other words, for an offering to qualify as a private placement under Rule 146, it must be made discreetly to a limited number of people who are both sophisticated and rich—people who do not need the protection of the federal securities laws because they can fend for themselves.


1982: The SEC Adopts Regulation D, Adding More Exemptions

Fast-forward to the early 1980s: Ronald Reagan, Michael Jackson, Madonna, MTV, big hair for men, and bigger shoulder pads for women. After a decade of wrestling with the “sophistication” and “rich” definitions to determine which investors qualify as offerees under Rule 146, the SEC decided to throw the rule out and start from scratch.


Also, there was a growing consensus in the securities industry and the SEC that exemptions from the Securities Act’s registration requirement should be available for offerings under $1 million that don’t deserve the federal government’s time and attention (and/or which could be more easily regulated by state governments under their blue-sky laws).


What emerged was Regulation D, containing three separate exemptions from the registration requirements in Section 5 of the Securities Act: two (Rules 504 and 505) under Section 3(b) of the Securities Act dealing with small offerings, and one (Rule 506) under Section 4(a)(2) of the Securities Act dealing with private placements to accredited investors (and some others).


Rule 504 exempts an offering of securities not in excess of $1 million in any twelve-month period (less all other exempt offerings during that period by the same company).


Rule 505 exempts an offering of securities not in excess of $5 million in any twelve-month period (less all other exempt offerings during that period by the same company).


Rule 506 exempts the sale of an unlimited amount of the securities if the company issuing them reasonably believes the sale is being made to not more than thirty-five nonaccredited investors. Sales under Rule 506 may also be made to an unlimited number of people whom the issuer reasonably believes are accredited, investors.


In addition, the issuer must reasonably believe that each non-accredited investor, alone or with a purchaser representative, has such knowledge and experience in financial and business matters as to be capable of evaluating the merits and risk of the investment (in other words, is a sophisticated investor).


Rule 501 of Regulation D defined “accredited investors” as:


Certain institutional investors, such as banks, employee benefit plans, and venture capital firms

Insiders, such as directors, executive officers, or general partners of the issuing company Wealthy individuals—people who have a net worth, or a joint net worth with a spouse, in excess of $1 million, or who had an individual income in excess of $200,000, or a joint income with a spouse in excess of $300,000, in each of the last two years and anticipated in the current year


Entities—all of whose beneficial owners meet the above three criteria of “accredited investors”


Whether an offering of securities is made under Rule 504, 505, or 506, it must also meet a number of other conditions under Regulation D. For example:


Rule 502(b) requires that specific information be made available to non-accredited investors in Rule 505 or 506 offering (for offerings up to $2 million, the information required is the same as would be required by Part II of SEC Form 1-A), and copies of that information be given as well to all accredited investors in the offering.


Rule 502(c) requires that a Regulation D offering is made with no “general solicitation” or “general advertising.”


Rule 502(d) requires the issuing company to make reasonable inquiry to determine if the purchaser is acquiring the securities for his or her own account, generally by requiring the investor to sign an investment-intent letter.


Subscription agreement that contains a representation that the purchaser is buying for his or her own account for investment and not with a view to distribution or for resale to others.


Rule 503 specifies that five copies, one manually signed, of a notice of sale on SEC Form D be filed with the SEC not later than fifteen days after the first sale of the securities.


Although issuers may be disqualified from using Rule 505 if there is a violation of the bad actor disqualification provisions set forth in Regulation A, there is no such disqualification procedure in connection with Rule 504 or 506 offerings.


Regulation D is still the dominant rule for determining whether an offering of securities is exempt from the registration requirements of Section 5 of the Securities Act.


If an offering qualifies for exemption under Title II or Title III of the federal JOBS Act of 2012 and the SEC regulations contained in Regulation Crowdfunding, it does not have to qualify separately for exemption under Regulation D.


An offering that does not meet all of the conditions of Title II or Title III may, however, still be exempt from registration under the Securities Act if it separately meets the conditions of Rule 504, 505, or 506 of Regulation D.


Thus a Title III crowdfunded offering that closes with twenty-five accredited investors and five nonaccredited investors, all of whom had access to the offering documents prepared by the issuing company and posted to the funding portal.


But one of whom invested more than $2,000 in private offerings of securities during the past year, may still qualify for exemption under Rule 506 if all the nonaccredited investors who purchased securities in the offering meet the “sophistication” criteria of that rule.


Of course, the offering of the securities via a crowdfunding portal constituted a general solicitation or general advertising that might deny the offering exemption under the Rule 506 safe harbor, but the offering may still qualify under the residual exemption in Section 4(a)(2) of the Securities Act. That will be a case for the courts to decide if and when the time comes.


1996: The National Securities Markets Improvement Act

Fast-forward to 1996: Bill and Hillary Clinton, corduroys and grunge music, and the dawn of the Internet. Congress passes the National Securities Markets Improvement Act (NSMIA), which eliminates state registration requirements for “covered securities,” including shares sold in a private placement under Rule 506 of Regulation D.


The NSMIA, however, left the other exemptions untouched. Offerings relying on Regulation A, Rules 504 and 505 of Regulation D, and private placements under Section 4(a)(2) of the Securities Act that does not meet the requirements of Rule 506 safe harbor remained subject to state registration requirements.


The states also retained the power to enforce the antifraud provisions in their blue-sky laws, bringing actions against fraudulent offerings and establishing registration violations for offerings improperly made under Rule 506.


2012: The Jumpstart Our Business Startups Act

Fast-forward to today: Barack Obama, Lady Gaga, the Great Recession, social media networks, reality television, and Kickstarter. And the Jumpstart Our Business Startups (JOBS) Act of 2012.