What Is Crowdfunding?
The term crowdfunding, in its most general sense, means raising money for something from a group of people that is large and relatively undefined: the crowd. Crowdfunding has been around in one form or another since the mid-2000s, but only in late 2015 have crowdfunding techniques been legally approved for companies looking to raise capital.
Crowdfunding offers entrepreneurs who are not yet ready to exploit more traditional avenues of capital raising—such as venture capitalists and angel investors—to tap into their ever-expanding social networks on Facebook, LinkedIn, Twitter, and elsewhere to raise money for their businesses.
It also gives them the limited ability to advertise and promote their offerings, even on television, without violating SEC rules and regulations.
Even more significant, crowdfunding offers investors chances to tap into start-up and early-stage companies that aren’t yet on the radar screens of larger and better- informed investors, and (perhaps) get a piece of the next Facebook before the marketplace finds out about it and media attention drives up the price of the company’s shares.
Of course, whenever the U.S. government loosens the rules in one area of the law, it tightens them somewhere else, and crowdfunding is no exception.
As a condition for allowing entrepreneurs freer access to the capital markets, the SEC has imposed lots of conditions designed to ensure that unsophisticated investors do not lose their shirts buying into companies that aren’t ready for prime time.
Some of these conditions may pose insurmountable barriers to many companies and investors who want to take full advantage of crowdfunded investments.
This blog is a guide for entrepreneurs, investors, and others to the new crowdfunding rules, with tips and advice on how to best take advantage of them.
Most business start-ups have relied on some point on the friends-and-family offering to raise the capital needed to create new businesses—to make the products, provide the services, and launch the innovations that make the global economy exciting and dynamic and provide the foundation for human progress.
Since historically few other people have been willing to risk their hard-earned money on speculative start-ups, most entrepreneurs and company founders, having exhausted their credit cards and personal savings, have been forced to borrow money or seek investment from their friends, college roommates, family members, teachers, mentors, and anyone else who would listen to their pitch.
The near-universal popularity of friends-and-family offerings can be explained by two basic facts of human nature:
1. Friends and family members will frequently offer you money out of love and affection (or, less charitably, to get you out of their hair), not necessarily for the purely economic motive of seeking a return on their investment.
2. Friends and family members are less likely than other people to sue you and force you into bankruptcy if the you-know-what hits the fan and the start-up fails to achieve liftoff.
Historically, the pool of available capital from friends and family has been extremely limited for most entrepreneurs, and the success of these offerings often depended on who your friends and family were.
If they were rich or well connected, you were more likely than not to get the capital you needed to launch your business. If your friends and family were poor, well . . .
But that is about to change. In a big way.
Taking the Friends-and-Family Offering to the Next Level
The past decade has seen an explosive growth in Internet-based social media platforms, such as Facebook, Twitter, Instagram, Pinterest, Snapchat, Google+, and LinkedIn. While these platforms are significantly different from each other, all have one basic thing in common:
They are designed to help people exponentially expand their network of friends and family by building a personal network of followers, fans, hangers-on, groupies, posses, and significant others so that it becomes larger than the friends and family who share entrepreneurs’ DNA or who actually know them in the flesh.
Thanks to these platforms, millions of people throughout the world have discovered that they have more in common with someone in a remote foreign country than they do with their next-door neighbors. The author himself, a relative novice on social media, has about four hundred friends on Facebook and almost two hundred on Twitter.
I admit to knowing personally only a handful of them. Each week I receive invitations to friend other people on Facebook, and I wonder how in the devil these people found me, and why they care about my “friendship.”
I sometimes wonder whether the people who use cartoon caricatures or famous artwork as their Facebook photos are real people or computer algorithms.
It was only a matter of time before entrepreneurs, visionaries, and dreamers started thinking about tapping into these expanded social media networks to raise capital for their projects, their businesses, and other aspects of their lives.
The Different Types of Crowdfunding
There are three basic types of crowdfunding for companies looking to raise capital. With project crowdfunding, those who contribute invest in a specific project (such as a new blog or film) but do not receive securities in a company.
Accredited-investor crowdfunding allows high-net-worth individuals and organizations to invest in a company and receive securities (usually but not always preferred stock or convertible debt) in return.
Title III of the JOBS Act, and the SEC regulations adopted in October 2015 have opened social media crowdfunding or equity crowdfunding to the general public, enabling them to participate in offerings of securities by start-up and early-stage companies as long as their total investments in such securities do not exceed specified amounts.
This blog focuses on social media crowdfunding, but first, a few words to explain the three types.
Project Crowdfunding, Including Gift Crowdfunding
Until now, most crowdfunding activity has been limited to project crowdfunding and gift crowdfunding.
In project crowdfunding, an individual or company solicits money from the crowd for a project of some kind and gives investors something tangible or intangible in return but not securities in a company.
Let’s say I decided to write a blog—a novel, for example, with vampires and zombies competing to have sex with remaining live humans on a reality television show after a nuclear holocaust (yes, yes, I know it’s been done to death, but it’s just an example—please go with it). I submit it to several traditional publishers, but no one is interested.
I get a brilliant idea: I decide to seek crowdfunding for my new blog. I create a crowdfunding campaign on Kickstarter, IndieGoGo, RocketHub, or another crowdfunding platform, describe the blog in detail (perhaps with a sample chapter and other information that would be included in a blog proposal), and ask for money.
For $25, an investor would get an autographed copy of the blog on its release. For $100, an investor gets to participate in a webinar in which I will discuss the blog and my inspiration for it, answer questions, and so forth. For $1,000, an investor gets an invitation to my blog-launch party at an exclusive New York City restaurant or nightclub. You get the idea.
As part of the campaign, I would set a minimum total amount I will accept for the project, for example, $25,000.
If I raise the $25,000 through the crowdfunding campaign, then I accept the investments, write and publish the blog (either in print format or as an e-blog), and fulfill my promises to the investors (send the autographed copies, host the webinar and the launch party).
If my campaign doesn’t reach $25,000 by a certain date, then the investors get their money back (without interest), and I turn to my next project.
This is an example of project crowdfunding. Authors, inventors, other creative types, and companies looking to test-market products have been using this method of crowdfunding for almost a decade.
Because project crowdfunding does not involve investment in a company, or in securities as defined by federal and state securities laws, it has not been regulated by the SEC.
A variation on project crowdfunding is gift crowdfunding, in which the investor doesn’t expect anything in return except for the opportunity to have a positive impact on the world in some way. Examples of gift crowdfunding include:
People without health insurance looking to finance a much-needed surgical procedure
Infertile couples looking to finance in vitro fertilization procedures (in a recent crowdfunding campaign, a couple asked for money to help conceive a baby and gave investors the opportunity to participate in naming the baby by voting from a list developed by the couple and their parents)
Not-for-profit or charitable organizations looking to raise tax-deductible donations for specific projects. In most gift crowdfunding campaigns, investors do not expect to receive anything in return for their money except the opportunity to feel good about themselves and the world in general.
If a gift crowdfunding investor is looking to deduct her investment on her taxes as a charitable contribution, however, she needs to invest in a bona fide public charity registered with the Internal Revenue Service (IRS) under Section 501(c) (3) of the federal Internal Revenue Code. My vampire/zombie novel wouldn’t qualify, nor would the infertile couple seeking to have a baby.
Like project crowdfunding, gift crowdfunding does not involve an investment in a company or securities and accordingly is not regulated (except perhaps by the IRS and state attorneys general, which to some extent regulate fund-raising activities by charitable organizations).
In April 2012, Congress passed the Jumpstart Our Business Startups (JOBS) Act of 2012, which was signed into law by President Barack Obama later in the year.
The overall purpose of the JOBS Act was to ease restrictions on capital raising for early-stage companies. The JOBS Act contained six sections, or titles, making significant changes to the federal securities laws.
Accredited-Investor Crowdfunding (Title II Crowdfunding)
Title II of the JOBS Act created a new exemption for private offerings of securities (those not required to be registered with the SEC) in the United States.
Prior to the JOBS Act, companies were not allowed to advertise or promote private offerings of securities at all, with certain very narrow exceptions. Under Title II (and a follow-up SEC release issued in July 2013), companies were allowed to do so as long as:
They weren’t raising more than $1 million over a twelve-month period. They allowed only accredited investors (extremely sophisticated or rich people who could afford to lose their entire investments in the company) to buy securities in the company
Social Media or Equity Crowdfunding (Title III Crowdfunding)
Title III of the JOBS Act, the primary subject of this blog, allows entrepreneurs and start-up companies to sell securities in their companies using crowdfunding techniques, even if investors who participate in the offering are not accredited, investors.
Title III is the heart of the JOBS Act, containing the provisions that will allow crowdfunded offerings of securities on the Internet. On October 23, 2013, the SEC issued a lengthy release (nearly seven hundred pages) spelling out the rules for how Title III crowdfunded investments can and cannot be accomplished: the proposed Regulation Crowdfunding.
After two years of public comment and debate, the SEC approved the final version of Regulation Crowdfunding on October 30, 2015. The new rules will become effective May 16, 2016.
Under the regulations, it doesn’t matter how many people invest in a Title III crowdfunded offering, or who they are, as long as:
If the investor’s net worth and annual income are both less than $100,000, he or she does not invest more than $2,000 or 5 percent of his or her net worth or income (whichever is greater) in crowdfunded offerings of securities during a rolling twelve-month period
If the investor’s net worth or annual income is $100,000 or more, he or she does not invest more than 10 percent of his or her net worth or income (whichever is less) in crowdfunded offerings of securities during a rolling twelve-month period
The SEC’s goal in drafting this limitation is to ensure that investors in crowdfunded offerings can afford to lose their entire investments if the company they’re investing in collapses, files for bankruptcy, or otherwise fails to live up to its promise.
As a practical matter, this means that most ordinary folks will be legally allowed to participate in only a handful of crowdfunded investments under Title III of the JOBS Act. As has always been the case, wealthy people will be allowed to invest more in these types of offerings.
The regulations also require that Title III crowdfunded offerings be made through a funding portal, not to the securities-issuing companies directly. A funding portal is a financing intermediary that registers with the SEC for the sole purpose of facilitating crowdfunded offerings of securities.
It can be a free-standing company or a division or affiliate of a registered broker-dealer exchanging in a full range of securities-related activities. Brief profiles of several companies that are expected to register as funding portals under Title III appear in the section “Suggestions for Further Reading” near the end of this blog.
The regulations put the burden squarely on the funding portals to ensure that crowdfunded offerings go smoothly and comply with all federal laws and regulations. Among other things, a funding portal must: Be registered with the SEC and be a member of the Financial Industry Regulatory Authority (FINRA)
Handle all documents for each crowdfunded offering and make them available to investors online. Scrutinize all offering statements and other documents submitted by companies to ensure legal compliance. Determine whether investors in crowdfunded offerings are either accredited investors or have satisfied the SEC’s limits on investment in private offerings
Handle all funds received from investors in crowdfunded offerings and make sure the investors get their money back if an offering fails to raise the desired amount of capital
Additionally, a funding portal is liable to investors (along with the portal’s directors, officers, and employees) if it fails to use “reasonable care” in reviewing a company’s offering documents or fails to adopt a “reasonable policy” to avoid false or misleading statements made by companies in those documents.
In this blog, readers will be neither encouraged to seek nor discouraged from seeking crowdfunded investment for their companies. Crowdfunded offerings of securities have advantages and disadvantages, but they require a certain amount of discipline and attention to detail, more so than traditional private offerings of securities.
If managed properly, they can be a wonderful way to raise capital that wouldn’t be available from any other source and can introduce your company to talent and networking opportunities that would not otherwise be possible.
If managed poorly, they can lead to disgruntled investors, class-action lawsuits against your company and its founders (including you), and other unpleasantness.
I have tried throughout this blog to balance the positive and the negative aspects of crowdfunded investments with a focus on teaching readers how to handle them the right way—that is, in such a way as to maximize the chance your company will reap the benefits while doing as much as possible to avoid the pitfalls and dangers.
A Word About Legal and Tax Information
There is a big difference between legal information and legal advice.
While this blog will discuss at length the federal laws and regulations governing crowdfunded offerings of securities, any legal and tax information in this blog is for educational purposes only and is not to be relied on as legal or tax advice, which can only be given by a lawyer or tax professional who is licensed to practice in your state.
A Few Words Before We Launch
The author is an attorney in private practice who has spent most of his career representing business start-ups, early-stage companies, and the people who invest in them.
While I have helped hundreds of clients put together friends-and-family offerings over the years, I have never worked for the SEC or any other government agency and therefore was not privy to any inside information regarding the discussions and debates leading up to the JOBS Act, Regulation Crowdfunding, or any other law governing crowdfunded offerings of securities.
I also confess that I have never launched a funding campaign on Kickstarter, IndieGoGo, RocketHub, or any other crowdfunding website. Although, boy, am I tempted.
The SEC’s Regulation Crowdfunding was finalized in October 2015, shortly before this blog was going into print, and it is possible there have been subsequent developments that are not covered in these pages.
The Evolution of Crowdfunding
According to Wikipedia, the American Committee for the Statue of Liberty in New York Harbor ran out of funds for the statue’s pedestal in 1884. Incensed that the statue might not be completed, newspaper publisher Joseph Pulitzer urged the American public to donate money toward the pedestal in his newspaper the New York World.
Pulitzer raised over $100,000 in six months. More than one hundred twenty-five thousand people contributed to the cause; most donations were one dollar or less.
The Friends-and-Family Offering
In a way, companies looking to raise capital have always relied to some extent on a form of crowdfunding: hitting up friends, family members, neighbors, old college roommates, and people they know for loans, gifts, or contributions to help get their businesses (or their lives) off the ground.
The reward for such investors was frequently intangible (love, affection, helping your slacker kid buy his way into a job, or the right to reserve a restaurant table on New Year’s Eve).
What made such friends-and-family offerings difficult, of course, was that most people’s networks were relatively small and tightly confined. Also, you had to approach each person one on one and establish a personal rapport with each of them.
To network successfully in the pre-Internet world, you had to take time to get to know someone before you asked him for a favor or for money. If your network was rich and well connected, life was good. If it wasn’t, well . . .
The Social Media Revolution
What really made crowdfunding (and crowdlending, for that matter) more viable, of course, was the introduction of social media networks, such as Facebook and Twitter, in the mid-2000s.
Originally viewed as online Rolodexes that would help people keep track of business contacts and far-flung family members, social media platforms have revolutionized the concept of a personal network.
Today it is not uncommon for even relatively unknown entrepreneurs to have hundreds of friends on Facebook or thousands of followers on Twitter.
Social media has, in fact, changed the concept of a personal network from a group of people one knows and stays in frequent contact with to something more akin to a fan club, a “posse,” or—to use a marketing term—an affinity group.
Your social media contacts are not necessarily friends or family; they are just people who, for one reason or another, are interested in you and want to keep up with what you’re doing. But in large enough numbers they can be a rich source for financing projects of all types.
Here’s a mantra I will be repeating throughout this blog: success in crowdfunding (of any kind) depends on your ability to develop, manage, grow, and leverage a large following on social media. Because that’s where your crowd will come from.
Kickstarter.com and Project Crowdfunding
In 2009, Kickstarter launched as a new way to fund creativity. The company also helped bring a new term to the forefront—crowdfunding—which allows a large group of people to pool their money to help fund an idea.
Kickstarter took this concept and built a model that helps creative minds get funding from their peers. Projects range from documentaries to smartwatches.
In project crowdfunding, an individual or company solicits money from the crowd for a project of some kind and gives investors something either tangible or intangible in return but not securities in a company. For example, a rock band might solicit contributions to record its next CD.
In gift crowdfunding, an individual or company makes a donation or gift without any expectation of return, except perhaps for a charitable deduction if the crowdfunding is being done by a charitable organization registered with the IRS under Section 501(c)(3) of the U.S. Internal Revenue Code. For example, a church might use crowdfunding to raise money for a mission overseas.
Angel Investor Social Media Websites
Independent from project and gift crowdfunding, a number of social media sites have cropped up in recent years to help identify angel investor communities and put them in touch with start-up and early-stage companies.
These sites, emboldened by Title II of the JOBS Act and the SEC’s July 2013 release removing the prohibition on “general solicitation” and “general advertising” from offerings to accredited investors, have given life to a new type of venture financing vehicle, called an online syndicate;
which allows angel investors (virtually all of whom are accredited investors under the SEC rules) to quickly assemble a group of investors over the Internet for a targeted start-up company.
Currently, the most prominent website in this field is AngelList (http://angel.co), with 159 investor syndicates and 4,865 early-stage companies looking for capital online. Such websites are ideally positioned to become portals for the facilitation of accredited investor crowdfunding offerings under Title II of the JOBS Act.
Intrastate Crowdfunding Under State Law
It took a long time (from October 2013 to October 2015) for the SEC to finalize its crowdfunding regulations under Title III of the JOBS Act. During that time, a number of U.S. states decided they didn’t want to wait for the final SEC regulations.
Just about every state has some sort of intrastate exemption for securities offerings by local companies. Generally, if your company is organized and located in the state, makes offers and sales only to people who reside in the same state, and complies with other restrictions (which vary from state to state;
for example, limiting the number of purchasers or the dollar amount of the offering), your offering is exempt from federal and state securities laws.
In the two years before final passage of the SEC’s crowdfunding regulations, no less than 29 states—including Alabama, Georgia, Idaho, Indiana, Kansas, Maine, Maryland, Massachusetts, Michigan, Oregon, Texas, Vermont, Washington, and Wisconsin—and the District of Columbia amended their intrastate offering exemptions to allow crowdfunding for offerings of securities that take place within their borders.
In all these states, an intrastate crowdfunded offering would need to comply with all restrictions imposed by the SEC’s Rule 147 relating to intrastate offerings. For example:
The issuer must be organized and located in the state (in Wisconsin, the majority of the issuer’s full-time workers must also work in Wisconsin).
All prospective purchasers must reside in the state (in Texas, the offering must also be completed in Texas). The issuer must file an offering notice with the state securities regulator on a prescribed form. In some states (including Texas and Wisconsin), the offering must also comply with all restrictions in the SEC’s Regulation Crowdfunding.
Small businesses with social media followings that are largely limited to a single state should consider making a crowdfunded offering under their state’s intrastate rules rather than following the cumbersome procedures involved in launching an interstate offering under the SEC’s Regulation Crowdfunding.
The downside? Even one out-of-state purchaser in an intrastate offering can blow the exemption, so issuers will need to make 100 percent sure that all purchasers in the offering are residents of the same state and that all purchases take place within the state.
Making offerings in person at state fairs, chamber of commerce meetings, and other local venues, and making photocopies of people’s driver’s licenses before they buy, may end up being more cumbersome than registering with a funding portal under Regulation Crowdfunding.
Social Media Crowdfunding (Title III Crowdfunding)
The use of crowdfunding platforms to raise money for companies and business projects goes by a number of names, including equity crowdfunding, crowdfunded investing, and social media crowdfunding.
U.S. securities laws closely regulate offerings of securities by privately owned companies. Because those laws traditionally prohibited private offerings made by “general solicitation” or “general advertising” the laws had to be changed to expressly permit crowdfunded offerings of securities.
The federal JOBS Act of 2012 came about because of two things: a major recession and an entrepreneurial effort by three dedicated individuals.
The 2008 financial collapse gave way to the Great Recession, which began to turn around only in 2012. After past recessions, small businesses got the country back on track, but this time around they couldn’t do so because all the typical ways small businesses had traditionally gained access to capital had dried up.
Banks weren’t lending, credit card companies slashed credit limits and hiked interest rates, and private equity and venture capital firms were investing money in fewer than 2 percent of companies that approached them.
Many people and organizations still had cash after the 2008 collapse, but that money wasn’t flowing to the entrepreneurs who could use it to start businesses and to small businesses that could create jobs.
But then three entrepreneurs—Sherwood Neiss, Jason W. Best, and Zak Cassady-Dorion—got creative.
Recognizing the potential of crowdfunding to provide capital not available from traditional sources, the three developed their Start-up Exemption Regulatory Framework and lobbied Congress extensively for what eventually emerged from the legislative process as Title III of the JOBS Act of 2012.
The Start-up Exemption Regulatory Framework contained the following basic elements:
A funding window of up to $1 million for entrepreneurs and small businesses (defined as businesses with average annual gross revenue of less than $5 million during each of the last three years or since incorporation)
Investment from nonaccredited investors capped at $10,000 or 10 percent of their prior year’s adjusted gross income
Elimination of the investor-sophistication requirement in SEC Rule 506 reflects the fact that average investors are a lot smarter today than they were in 1933
Elimination of the five-hundred-investor limit for companies that use crowdfunded investments (this refers to a requirement in the federal Securities and Exchange Act of 1934 that companies with more than five-hundred owners must register with the SEC as “public companies” and file annual and quarterly reports)
Preemption of state securities laws called blue-sky laws that contain contrary requirements
Allowance for “general solicitation” and “general advertising” on registered funding platforms where individuals, companies, and investors can meet virtually and where ideas can be vetted by the community as a sort of peer review
Standardization of the filing process using generic term sheets and subscription agreements based on venture capital industry practices
Neiss, Best, and Cassady-Dorion have gone on to become the founders and principals of Crowdfund Capital Advisors (CCA) (www.crowdfundcapitaladvisors.com), a crowdfunding think tank that, as this blog went to press, was poised to become one of the first SEC-approved funding platforms under Title III.
A number of companies are positioning themselves to play a significant role in Title III crowdfunding. Leading the pack (as of December 2015) was SeedInvest.com, an equity-based crowdfunding platform that connects accredited investors to leading start-ups seeking funding.
Other potential crowdfunded offering platforms (or funding portals), most of which are in the very early stages of development, include:
EquityNet.com (billed as the “original equity crowdfunding platform,” EquityNet boasts a patented software system that streamlines the business planning process)
GrowVC.com (with offices in New York, London, and Hong Kong, it is positioning itself to be a player in international crowdfunded offerings)
Crowdfunder.com (based in Los Angeles, bills itself as “the leading equity crowdfunding platform” as this blog goes to press)
iFunding.com (specializes in crowdfunding of real estate offerings, investments, and syndications)
IPOVillage.com (helped launch Crowdfunding-Website-Reviews.com, one of the Internet’s top sites for getting information on crowdfunding platform websites)
TruCrowd.com (focuses on serving nonaccredited investors)
Sprigster.com (focuses on providing crowdfunded financing for franchised businesses)
SyndicateRoom.com (the United Kingdom’s first crowdfunded offering platform that focuses on the investors and investor returns requires that issuing companies first have a lead investor, or group of lead investors, on board providing a minimum of 25 percent of the funding round out of pocket)
Today there are numerous crowdfunding platforms in the United States, dominated by the big ten:
1. Kickstarter.com (the industry pioneer, accepts creative projects only)
2. IndieGoGo.com (accepts creative, personal, and charitable projects)
3. Gofundme.com (the largest, with more than three hundred thousand campaigns since its inception, accepts personal and charitable projects and local fund-raising efforts)
4. YouCaring.com (personal projects only)
5. Kiva.org (international microloans only)
6. Causes.com (not-for-profit fund-raiser for grassroots campaigns only)
7. GiveForward.com (medical expenses only)
8. CrowdRise.com (charitable projects only)
9. DonorsChoose.org (school donations only)
10. FirstGiving.com (charitable projects only)
Lest anyone still think that crowdfunding is a passing fancy, there are already established in the United States alone are:
The National Crowdfunding Association (www.nlcfa.org)
The Crowdfunding Professional Association (www.cfpa.org)
The Crowdfunding Accreditation for Platform Standards program to promote the adoption of best practices for the operation of crowdfunding platforms globally (www.crowdsourcing.org/caps)
A Brief Overview of Crowdfunding Under Title III of the JOBS Act and Regulation Crowdfunding
Regulation Crowdfunding contains almost seven hundred pages of rules and regulations for companies that want to raise capital via crowdfunding. Here’s an overview of how crowdfunding will work under this regulation.
Rules for Issuers
A company looking to raise money through crowdfunding (called an “issuer” in the securities laws) is limited to raising $1 million through crowdfunded offerings over a rolling twelve-month period.
This limit includes an issuer’s predecessors and affiliates of the issuer (such as any other company run by the same founders as the issuer). Certain companies cannot use crowdfunding, including:
Companies that have committed certain securities law violations
Investment companies such as hedge funds Publicly traded companies
Companies outside the United States (although their U.S.-based subsidiaries can use crowdfunding)
Crowdfunded issuers who fail to file their annual reports with the SEC on Form C-AR
Issuers cannot offer their securities to the public directly but only through a funding portal registered with the SEC. The funding portal must be a website or similar electronic medium, and the issuer is limited to only one funding portal per offering.
Before launching a crowdfunded offering, the issuer must file electronically with the SEC and post on the funding portal an “offering statement” on the SEC’s new Form C, containing much the same information as has always been required of companies in private offerings.
During the offering, the issuer is required to file progress updates five business days after the offering has reached 50 percent and 100 percent of the targeted amount, as well as a final Form C-U to disclose the total amount of securities issued as part of the offering.
These offering documents may be viewed by the general public—anyone who visits the site—but investments and communications with issuers may be made only by people who open accounts with the funding portal.
As part of its offering documents, the issuer must include financial statements covering the shorter of the two most recently completed fiscal years or the period since the issuer’s inception, the nature of which will depend on the amount the issuer is trying to raise:
If the offering amount is $100,000 or less, disclosure of the amount of total income, taxable income, total tax as reflected in the issuer’s federal income tax returns certified by the principal executive officer to reflect accurately the information in the issuer’s federal income tax returns (in lieu of filing a copy of the tax returns), and financial statements certified by the principal executive officer to be true and complete in all material respects;
if, however, financial statements of the issuer are available that have either been reviewed or audited by a public accountant that is independent of the issuer, the issuer must provide those financial statements instead and need not include the information reported on the federal income tax returns or the certification of the principal executive officer.
If the offering amount is more than $100,000 but less than $500,000, the financial statements must be reviewed by an independent certified public accountant (CPA), using the Statements on Standards for Accounting and Review Services issued by the Accounting and Review Services Committee of the American Institute of CPAS (AICPA);
If however, financial statements of the issuer are available that have been audited by a public accountant that is independent of the issuer, the issuer must provide those financial statements instead and need not include the reviewed financial statements.
If the offering amount is more than $500,000 but not more than $1 million of securities in reliance on Regulation Crowdfunding for the first time: financial statements must be reviewed by a public accountant that is independent of the issuer;
If however, financial statements of the issuer are available that have been audited by a public accountant that is independent of the issuer, the issuer must provide those financial statements instead and need not include the reviewed financial statements.
If the offering amount is more than $500,000 and the issuer has previously sold securities in reliance on Regulation Crowdfunding, the financial statements must be audited by an independent CPA using generally accepted U.S. auditing standards (GAAS) or any other standard adopted by the Public Company Accounting Oversight Board (pcaob.org).
Any unaudited financial statements submitted as part of a Regulation Crowdfunding offering must be labeled as such. Issuers seeking to raise up to $100,000 are not required to submit copies of their actual tax returns, due to the risk of disclosing private or personally identifiable information about the company’s founders and early investors.
During the offering, the issuer cannot advertise the terms of the offering except for a short public notice (similar in form and content to the “tombstone ads” used by underwriters in public offerings) directing readers to the funding portal where the offering is conducted.
These notices may, however, be disseminated broadly through general solicitation in all media channels, online and off-line, and the issuer is allowed to communicate directly with investors using communications media (such as chat rooms) furnished by the funding portal.
An offering must be posted for at least twenty-one days, but after that, the offering can last as long as an issuer likes, provided the offering documents are kept up to date.
If the issuer raises the targeted amount before the offering ends, the issuer can terminate the offering early (but not until twenty-one days after the offering commences) as long as it gives investors five business days’ notice of the new closing date.
It allows investors to cancel their investments up to forty-eight hours before the new closing dates, it notifies investors whether or not the issuer will accept investments during the final forty-eight hours, and the issuer continues to exceed the target on the new closing date.
If the issuer fails to raise the targeted minimum amount of capital before the offering expires, any investments made during the offering are returned to the investors. If the issuer raises the targeted minimum amount of capital, the offering closes—investors’ funds are released to the issuer, and the issuer delivers securities to the investors.
After an offering is completed, the issuer must file annual reports with the SEC on Form C-AR; failure to do so on time disqualifies the issuer from future crowdfunded offerings.
Issuers, including their directors and officers, are liable to investors for “untrue or materially misleading statements” in their offering documents unless they can prove they did not know, and in the exercise of reasonable care could not have known, of the untruth or omission.
Rules for Investors
An individual investor is limited in the amount he or she can invest in crowdfunded offerings each year. If the investor’s net worth or annual income (whichever is greater) is $100,000 or less, the investor cannot purchase more than $2,000 or 5 percent of the net worth or annual income (whichever is greater) in crowdfunded securities.
If the investor’s net worth or annual income (whichever is greater) is more than $100,000, the investor may purchase up to 10 percent of the net worth or annual income (whichever is lesser).
Purchases of other types of securities are not included when calculating these limits.
An investor may cancel an investment up to forty-eight hours before the offering closes but is barred from doing so after that time.
Investors are entitled to progress reports while the offering is pending and to certain statements when an offering closes.
Investors may communicate directly with issuers and other investors during the offering process but only through the communications channels maintained by the funding portal. These communications can be viewed publicly only by participants in the offering.
After an offering closes, crowdfunded securities cannot be resold by anyone for a period of one year except to the issuer, as part of a registered public offering of the issuer’s securities (an IPO), or for estate planning or divorce purposes. After the one-year period, crowdfunded securities can be freely sold—if, of course, the investor can find a buyer for them.
Rules for Funding Portals
All crowdfunded offerings must take place through an intermediary, called a funding portal, which must be a website or other electronic medium.
Unless it is operated by broker-dealers who are already registered with the SEC, a funding portal must be registered with the SEC, be a member of FINRA, and maintain in place a $100,000 fidelity bond.
A funding portal is required to review all offering documents submitted to it by issuers and may deny access to the portal if it believes there is the potential for fraud or the issuer is not eligible for crowdfunding under Regulation Crowdfunding.
It is also required to make a reasonable effort to vet investors to make sure they haven’t exceeded their investment limits in crowdfunded securities.
In operating its business, a funding portal must operate by numerous rules, including:
It cannot offer investment advice or recommendations, or solicit purchases, sales, or offers (although it can advertise its services generally).
It cannot be compensated based on the number of sales it achieves or charges a contingency fee.
It cannot hold, manage, possess, or otherwise handle investor funds or securities (it must establish accounts with banks and securities depositories to hold these).
It can limit companies from accessing its portal using objective criteria (for example, a portal can limit offerings to just one industry or a certain type of security) but cannot deny access based on “the advisability of investing in the issuer” (that is, the portal cannot pick favorites).
It can highlight offerings using objective criteria, but cannot highlight offerings based on “the advisability of investing in the issuer” and cannot be compensated for highlighting an offering.
It can provide search functions to sort by objective criteria.
It can provide communication channels by which investors can communicate with one another and with issuers but cannot participate in discussions except as a moderator.
It can advise issuers about the structure or content of the issuer’s offering, including assisting the issuer in preparing the offering documents.
It can compensate a third party for referring people to the funding portal as long as no personally identifiable information is given.
It can cancel an offering if the portal believes there is a potential for fraud.
The funding portal must preserve records of all offerings and communications for five years.
A funding portal, including its directors and officers, has the same liability as an issuer if fraud occurs, although it has a defense if it can prove that it used reasonable care in reviewing an issuer’s offering documents and established a reasonable policy for avoiding misstatements and untruths in crowdfunded offerings.
Is Crowdfunding Right for Your Company?
Generally, if you want to engage in traditional project crowdfunding (raising money for a specific project as opposed to raising money for a company), there isn’t much preparation involved. All you have to do is:
Select the right crowdfunding portal (one that specializes in the type of project you want to launch)
Develop a short description of the project, how much money you need, why you deserve it, and the minimum amount you want to raise within a specific timeframe
Post the description online
Wait for the money to roll in
There is no requirement that you have expertise or experience in the type of project (although as a practical matter it is difficult to obtain financing online without that) or even that you have a clear vision or prototype of the project once it’s developed. All you need is an idea or even just a dream, and if you catch the imagination of enough people online, you can get crowdfunded.
However, that will not be the case with crowdfunding under Title III of the JOBS Act.
Crowdfunding Is Not for Everyone
Although theoretically any type of company, at any stage of development, can seek crowdfunding under Title III, as a practical matter only select companies will be able to do so effectively.
If you are thinking about launching a crowdfunding campaign under Title III, you will need to ask yourself three specific questions:
1. Is my company the right type of company to receive investments through crowdfunding?
2. Does my company meet the requirements of the JOBS Act and Regulation Crowdfunding?
3. Am I willing to put up with dozens, if not hundreds, of demanding, immature, possibly crazy individual investors with unrealistic expectations if our Title III crowdfunded offering is successful?
Let’s take a closer look at each of these questions so you can figure out if Title III crowdfunding is right for you.
Is Your Company Right for Crowdfunding?
The good news is that Title III crowdfunding opens the private equity markets to companies that traditionally have had trouble finding early-stage investors in the past. For example:
Companies organized as LLCs or other pass-through legal entities
Companies engaged in retail, service, or other industries that don’t involve high technology
Companies that are looking to franchise their concepts
Companies whose business models are not scalable, such that each dollar of investment produces only a limited amount of revenue or profit
The bad news is that only a relatively small number of companies will be able to qualify for crowdfunded offerings of their securities under Regulation Crowdfunding. There are two primary reasons for this.
First, the cost of putting together the offering statement, financial statements, and other documents required by the SEC and the funding portals that will manage the offerings will probably be beyond the reach of most start-ups or concept companies that haven’t yet put together a solid business plan.
Second, because of the tremendous liability Regulation Crowdfunding imposes on funding portals, most of these portals will be extremely nervous about dealing with a company that they suspect doesn’t have its act together yet.
As an accountant friend of the author put it, “No one will want to be the first portal that gets sued or prosecuted by the SEC because they were negligent in picking the right issuers or reviewing their offering materials.”
As an issuer, you can expect that most funding portals will be looking at your company and your written documents with an electron microscope, looking for even the tiniest flaws that may expose them to liability.
That said, if your management team is disciplined and willing to put in long hours on legal and accounting paperwork, there is no reason why even a concept company (one with little more than an idea, although a well-articulated one with a high likelihood of success if proper funding is obtained) cannot obtain crowdfunded capital under Title III.
Before you consider seeking Title III crowdfunded money, your company needs to put together a solid business plan.
Hundreds of blogs have been written on the subject of business plans, a few of which are listed in the “Suggestions for Further Reading” section near the end of this blog, but putting together a solid business plan boils down to answering twelve specific questions:
1. What is the product or service we are looking to develop?
2. Who are the customers for our product or service, and what needs and wants do they have that our product or service will answer?
3. Why will customers buy our product or service (in other words, how will our product or service appeal to the fears and passions of the targeted markets)?
4. How will we get our message across to our targeted markets and get the product or service into people’s hands (in other words, what advertising and promotion tools will be used to market and distribute our product or service)?
5. Who are our competitors, both direct (people and companies doing the exact same thing) and indirect (people and companies doing a different type of thing that solves the same customer problems our product and service does or that renders our product and service obsolete)?
6. Why is our product or service better than any competing product or service on the market or soon to be on the market?
7. Do we have the right people on our management team to develop our product or service and get it into the market in a reasonable amount of time?
8. Are the people on our management team and advisory board (an informal collection of business mentors) likely to impress potential investors with their credentials and expertise?
9. What are the resources (money, office space, equipment, people,
professional services, time) we will need to launch this product or service, and how much will we have to spend on each resource during the first one to two years of our operations?
10. When will this company break even (generate enough revenue from sales to cover basic operating expenses on an ongoing basis) and thereby become self-sustaining?
11. If our company is successful, what will our exit strategy be (launch an IPO or sell out to a large public corporation interested in acquiring our product or service)?
12. What are the legal and economic risks involved in this business, can we ensure against them, and if so, how much will that insurance cost?
Okay, that’s probably about fifteen or sixteen questions, and other, more-specific subquestions fall under each of the ones above, but you get a general idea.
If you and your company don’t have compelling answers to each of these questions and cannot articulate them in a written business plan, your company is not ready for Title III crowdfunding. It’s that simple.
Qualifying Under the JOBS Act and Regulation Crowdfunding
To qualify for crowdfunding under Regulation Crowdfunding, the issuing company must be incorporated or organized under the laws of a U.S. state or territory. Unincorporated businesses cannot qualify for Title III crowdfunding.
The vast majority of Title III issuers will be C corporations and LLCs.
Public companies do not qualify for Title III crowdfunding under Regulation Crowdfunding, nor do companies based in foreign countries (although foreign companies can invest in U.S.-based crowdfunded offerings).
Companies that have engaged in any of the “bad acts” described in Rule 506(d) of Regulation D and companies whose principals have engaged in any bad acts are disqualified from Title III crowdfunding.
As are issuers who concluded successful Title III crowdfunded offerings in the past but failed to file the required annual reports and other documents required to be delivered to crowdfunded investors on an ongoing basis.
Investment companies (such as mutual funds and hedge funds) do not qualify for Title III crowdfunding, as otherwise there is a risk Wall Street firms would form crowdfunded pools of crowdfunded companies, or create holding companies that would invest in dozens if not hundreds of crowdfunded companies.
This is unfortunate in some respects, as enabling investors to pool their investments in a single entity that would coordinate communications between a crowdfunded company and its investors would probably be a beneficial thing and would eliminate many of the “time vampire” issues of investor communications.
But as this prohibition is contained in Title III of the JOBS Act itself (not Regulation Crowdfunding), there is probably nothing the SEC can do to correct that as this blog goes to press.
Blank-check or shell companies formed for unspecified purposes or to acquire other companies cannot make offerings under Title III.
Any company seeking crowdfunding under Title III must have an actual business plan, not a speculative one or one couched in alternative terms (for example, “if we raise $100,000 we will do X, but if we raise $250,000 we will do Y instead”).
However, it is possible that Title III crowdfunded offerings may be tiered based on the amount of money raised and the planned use of proceeds at different levels of investment (for example, “if we raise $100,000 we will do X, but if we raise $250,000 we will be able to do Y and Z as well”).
Foreign companies cannot take advantage of Title III crowdfunded offerings. Regulation Crowdfunding is not clear on this point, but that may include U.S.-based subsidiaries of overseas companies.
Finally, public companies cannot make Title III crowdfunded offerings. If they could, there would be no need for SEC registration of public offerings, would there?
Handling Your Crowd of Investors If the Offering Is Successful
This biggest challenge in Title III crowdfunded offerings of securities and the biggest potential obstacle to the development of a viable crowdfunded securities market have nothing to do with the offering process itself but rather what happens after a successful crowdfunded offering is completed.
Once your company successfully completes a Title III crowdfunded offering, it can’t just pocket the money and say “See ya!” to the dozens or perhaps hundreds of individuals and companies that invested in the offering.
Once you sell a piece or percentage of your company to an investor (voting common or preferred stock for a corporation, voting membership interests for an LLC), they have the right to receive notice of investor meetings and vote on any matter for which investor approval is required by state law where the company is incorporated or organized.
Even if a company’s crowdfunded investors are issued nonvoting securities (non-voting common or preferred stock for a corporation, nonvoting membership interests for an LLC), Regulation Crowdfunding requires they be given annual reports and other financial statements, and state corporation and LLC law often requires they be given advance notice of certain major decisions affecting the company.
If you fail to give them the required notice, that failure may invalidate the decision, even though the holders of your voting securities voted overwhelmingly in favor of the measure you proposed to them.
Even if your crowdfunded investors have no rights at all under your state corporation or LLC law, there is nothing to prevent them from calling your office day and night asking silly questions, making unrealistic or inappropriate demands on your company, or offering unsolicited (and sometimes stupid) advice.
That is the price of having an outside investor in your company, of course, but that price is a lot higher in a crowdfunded offering of securities, for two reasons:
1. There are an awful lot more of them.
2. They are less sophisticated than investors in traditional accredited-investor private offerings of securities and therefore more likely to act unpredictably, irresponsibly, or unprofessionally.
Investors can be time vampires, requiring an inordinate amount of your management time that is much better spent developing and launching your company’s products and services.
Most public companies have several employees devoted exclusively to shareholder communications or investor relations. As a start-up or early-stage company, you cannot afford to dedicate employees to those tasks.
Yet if you ignore your investors, even if Regulation Crowdfunding technically allows you to do so, you do that at your peril.
It’s no secret that the Internet can sometimes be a very volatile, nasty, and dangerous place, where little problems and hiccups can be blown quickly and exponentially out of proportion by a negative, viral campaign on social media launched by one angry, self-appointed vigilante or a handful of them.
Probably the worst thing that can happen to a company that has successfully raised money via Title III crowdfunding is to see its crowdfunded investors turn into a disgruntled lynch mob that says nasty things about the company and its management online.
If you do decide to launch a Title III crowdfunding campaign for your start-up or early-stage company, you will have to decide if you are willing to put procedures in place to manage and communicate with your crowd after the offering is over. If you are not, then Title III crowdfunding is not for you.
Stick with accredited investors or traditional friends-and-family offerings. Your elderly Aunt Irma who loaned you $5,000 isn’t likely to go viral on Yelp.com because she wasn’t invited to your company picnic.
Preparing Your Company for a Crowdfunded Offering
Having decided that your company is a good candidate for a Title III crowdfunded offering, you will need to do several things before you begin drafting your offering statement, contacting funding portals.
Choose the Right Legal Entity
Regulation Crowdfunding requires that an issuer of crowdfunded securities be “incorporated or organized.” Unincorporated businesses such as sole proprietorships and partnerships do not qualify for crowdfunding.
That leaves only three types of legal entities that legally qualify for Title III crowdfunding:
1.Regular or C corporations
2.Subchapter S corporations
3.Limited liability companies
Regular or C Corporations
A corporation is a taxable entity; when you form a corporation it is as if you have had a baby and the baby pays taxes from the day it’s born. It’s called a C corporation because it is taxed under Subchapter C of the Internal Revenue Code of 1986.
What’s Good About a C Corporation? In two words: limited liability. Generally, the owners of a C corporation (called shareholders or stockholders) are liable only for the amounts they contribute (or agree to contribute) as capital to the corporation but will still be liable for their own negligence or stupidity.
EXAMPLE 1: A and B are shareholders of ABC Corporation. A runs over someone with his car while on the corporation’s business. The injured party may sue the corporation and win a judgment up to the number of the corporation’s assets (because that’s all it has).
The injured party may sue A in his individual capacity and take A’s house away. But the injured party cannot sue B in any way unless it can be shown that B contributed actively in some way to the injury (for example, B served A too much liquor, which caused A to be intoxicated at the wheel).
EXAMPLE 2: A and B are shareholders of ABC Corporation. ABC Corporation enters into a contract with a supplier to buy ten thousand widgets and then discovers that it doesn’t have enough money to pay for the widgets.
ABC Corporation breaches the contract, and the supplier uses. The supplier may sue the corporation and win a judgment up to the number of the corporation’s assets, but the supplier cannot sue A or B, even if A or B actually signed the contract as an officer or employee of ABC Corporation.
What’s Bad About a C Corporation? C corporations are expensive to form. Legal expenses and filing fees are usually between $1,000 and $1,500 to form a corporation in most states.
They are also expensive to keep alive: if a corporation fails to pay taxes for X consecutive years or fails to file a report (and pay a fee) every Y years with the secretary of state's office, the attorney general comes along and dissolves the corporation (and your limited liability along with it).
To add insult to injury, you are not informed that this has been done, so you continue blissfully doing business, thinking you have a corporation when you really don’t.
If you don’t use the corporation and treat it with respect, you lose the corporation. People suing you for something your corporation did will always try to argue they didn’t know they were dealing with a corporation.
If you conducted business in your own name, wrote checks from your own checking account, and accepted money in your own name that should have gone to the corporation, you can’t argue it was really the corporation that should be sued and not you personally. Lawyers call this piercing the corporate veil.
C corporations involve lots of paperwork. When you have a corporation, you don’t do anything; the corporation does everything. This means that for a corporation to do anything, the shareholders (that’s you) have to prepare written documents (called resolutions or minutes) authorizing the directors of the corporation (again, that’s you) to do the thing, and the directors have to prepare written documents authorizing the officers of the corporation (again, that’s you) to do the thing.
Resolutions are a pain in the neck, but if you don’t do them you will be tempting the courts to say you didn’t treat your corporation with the proper respect so creditors are allowed to get at your personal assets.
Dealing with taxes is somewhat complicated when you have a C corporation. Because corporations are taxable entities, they file their own returns (IRS Form 1120, due March 15 of each year for a calendar year corporation) and pay taxes separately from the owners (albeit at a lower rate than you do, in most cases). This means that any income a corporation earns is taxed twice.
EXAMPLE: XYZ Corporation has two stockholders, A and B, and makes $100 in net income for a particular year. The corporation pays 15 percent to Uncle Sam as federal income tax and blogs the remaining $85 as net after-tax earnings.
XYZ Corporation then resolves (remember those minutes?) to pay A and B the $85 in the form of a dividend, and distributes $42.50 to each of A and B.
A and B each has to report that $42.50 as income on Form 1040 for the year and pay taxes on that $42.50 at his or her individual rate.
The result? If A and B are in the top tax bracket, that $100 in corporate income has dwindled to about $26 in each of A’s and B’s hands after federal income taxes. Add state and local taxes to this calculation, and the tax bite becomes much larger.
The C Corporation as a Crowdfunding Vehicle. If you are planning to raise capital in an accredited-investors-only offering under SEC Rule 506(c) and Title II of the JOBS Act, you are almost certainly going to have to organize your company as a C corporation. Why? There are two basic reasons:
1. Professional investors and angel investors normally like to receive preferred stock in the companies they invest in, and S corporations, as we can see below, cannot issue preferred stock. While LLCs can legally issue preferred membership interests, the mechanics are quite cumbersome and awkward to draft in legal language.
2. When sophisticated or professional investors see the LLC designation after a company name, they tend to think “small-time, mom-and-pop, will never grow big.”
This is a false view, as there is nothing in the law to prevent an LLC from growing big or even eventually going public. The bias against LLCs, however irrational, is strongly felt within the investment community.
Accordingly, a new business that plans to seek venture capital or private equity funding (angel money) within the first one to two years of its existence should be set up as a corporation, preferably in a state like Delaware that offers a number of advantages to venture-capital-backed companies.
C corporations are also an ideal vehicle for a Title III crowdfunded offering because of the limited liability they offer and the opportunity to create a special class of securities for your crowdfunded investors. Also, as a matter of optics, many people in the investing community take corporations more seriously than they do LLCs.
Subchapter S Corporations
An S corporation is the same as a regular or C corporation with one important difference: it is not taxed by the federal government. This means that the S corporation is taxed just like a general partnership: profits, losses, and other tax benefits flow through to the corporation’s shareholders and are taxed on their individual Form 1040 tax returns.
But with the powerful advantage that stockholders in an S corporation have limited liability, unlike partners in a general partnership, who are personally liable for everything that happens in the partnership business.
However, some state and local governments (including New York City) do not recognize S corporations. This means that S corporations with offices in such states or municipalities are taxed twice at the state or local level.
What’s Good About an S Corporation? Like a C corporation, there is a limited liability: shareholders are not personally liable for the debts and obligations of the corporation.
Moreover, the corporation is not taxed by the federal government, although it does file its own tax return (Form 1120-S, due on March 15 each year; virtually all S corporations are required to use the calendar year for accounting purposes).
Taxation is also favorable. Because the S corporation does not pay taxes, profits, losses, and other tax benefits flow through to the corporation’s shareholders, who report these on their personal Form 1040 federal income tax returns.
What’s Bad About an S Corporation? Because S corporations are taxed like partnerships, S corporations have what is called a phantom income problem.
This means that, unlike C corporation shareholders, who are taxed only on amounts the corporation distributes or pays out to them, S corporation shareholders must also pay taxes on their pro rata (proportionate) share of the corporation’s profits and losses that were not distributed to them.
EXAMPLE: XYZ Corporation, a subchapter S corporation, had $100,000 in taxable income this year. The corporation has two shareholders, A and B. A owns 60 percent of the corporation’s shares, and B owns 40 percent.
The corporation did not distribute any cash or dividends to either shareholder. At the end of the year, A must report $60,000 as income on his federal income tax return (60 percent of $100,000), and B must report $40,000 (40 percent of $100,000) as income on his federal income tax return.
Subchapter S corporations were originally designed only for small businesses; they were never intended to go big or launch an IPO. Accordingly, S corporations have lots of icky little rules to comply with if they don’t want to be taxed as a regular or C corporation.
(Note: if the IRS takes away your S corporation status you don’t—repeat, don’t—lose your limited liability; the worst thing that happens is that you’re taxed as a regular or C corporation).
Only natural human beings can be stockholders in an S corporation (no corporations, LLCs, or trusts, with only one or two limited exceptions). S corporations can’t have more than one hundred stockholders (that alone puts Title III crowdfunding out of reach for S corporations).
S corporations can have only one class of common stock (no preferred stock, which alone puts Title II accredited-investor-only financing out of reach for S corporations).
The shareholders of an S corporation must be U.S. citizens or green card holders (permanent resident aliens of the United States).
The S Corporation as a Crowdfunding Vehicle. Generally, it’s a bad idea. Most accredited investors involved in a Title II private placement under Rule 506(c) want to receive preferred stock or some other form of senior security, which S corporations cannot issue as they are limited to a single class of security.
The one-hundred-investor limit and the prohibition on foreign and corporate shareholders will also put Title III crowdfunding out of reach for S corporations.
If your business is currently organized as an S corporation, you should discuss with your accountant or tax adviser the possibility of opting out of an S corporation and becoming a C corporation before launching any sort of crowdfunded offering.
Keep in mind; however, that if you do convert to C corporation status and the crowdfunded offering goes nowhere, you will not be able to elect to be taxed again as an S corporation for three consecutive tax years.
Limited Liability Companies (LLCs)
Since the early 1990s, the LLC has become the legal entity of choice for many small businesses and early-stage technology start-ups. What is an LLC? Well, it’s basically an S corporation without all the icky little rules that make S corporations unattractive for a lot of folks.
What’s Good About an LLC? Owners of an LLC (called members) have limited liability. If A and B are members of an LLC and B runs someone over with her car while on LLC business, B may lose her house, but A will not lose his house unless A actively contributed to the injury.
Like partnerships, LLCs are simple to operate. There is no need to prepare resolutions or minutes to authorize people to do things (although banks and some other folks may still require you to do resolutions because they haven’t gotten the idea yet)—they just do them. If the idea of doing legal paperwork makes you want to gag, the LLC is the legal entity for you.
The costs of starting up an LLC are likely to be much less than forming a C corporation or an S corporation—$400 to $600 in most states.
LLCs are taxed like partnerships, so there is no double taxation of an LLC’s income. Everything flows through to the owners of the LLC, who report their shares of the LLC’s income on their personal federal income tax returns, the same as shareholders in an S corporation.
However, as was the case with S corporations, owners of an LLC must pay taxes on phantom income the LLC earns that is not distributed to them in the form of cash.
If you are doing a lot of overseas business, the LLC format may give you an edge on your competition. Most foreign business organizations (such as the German GmbH and the Italian S.r.l.) are a lot closer in structure to an LLC than they are to a partnership or corporation;
With an LLC, you can give your managers the same titles as their European or Asian counterparts (Europeans especially cannot understand that in America one can be a “director” of a corporation and have absolutely no power to bind the corporation; in Europe, business organizations are managed by their “directors,” not by officers or mere employees).
What’s Bad About an LLC? Really not a lot. While not actually flawless, LLCs are the closest thing to a perfect business organization the law has come up with to date. Limited liability, favorable tax treatment, and easy to operate: who could ask for more?
There are a few negatives, however.
It may be difficult for existing businesses to convert to LLC status: corporations and their shareholders incur double taxation upon liquidation, while general and limited partnerships formed to acquire or hold title to real estate (as many are) may incur transfer taxes and other fees on converting to an LLC.
If your business is high tech or will seek outside capital within the first twelve to eighteen months of operations, be aware that many investors (wrongly) associate LLCs with small business, mom-and-pop, no growth potential.
While this perception is unfair, it is widespread, and you may want to consider becoming a C corporation instead (preferably in a high-visibility state like Delaware).
LLCs are not recommended for businesses that will have physical locations in New York State. When New York adopted its LLC statute in 1994, it included a burdensome publication requirement that drives up the costs of forming a New York LLC.
LLCs in New York are required to publish a legal notice in two newspapers—one daily and one weekly—in each county in New York where the LLC maintains an office of the business.
In most upstate counties, the cost of doing this publication is in the $200 to $300 range. In New York City, however, the cost can be upward of $2,000 to $3,000.
Also, LLCs located in New York City are subject to that city’s unincorporated business tax. Overall, it may be less expensive to form a corporation or S corporation in New York State than an LLC.
A growing number of states are imposing special taxes or minimum taxes on LLCs and other unincorporated business organizations. For example:
California and Rhode Island have a minimum $800 income tax on LLC profits, payable even if the LLC had no profits.
Connecticut requires domestic and foreign LLCs to pay a business entity tax of $250 every two years whether or not they make money.
The LLC as a Crowdfunding Vehicle. One of the main goals of the JOBS Act was to expand the private equity market to companies that could not obtain financial support under the previous rules. The vast majority of issuers seeking traditional venture capital were high-tech ventures organized as corporations.
But in theory, there is no reason why an LLC couldn’t raise capital under either Title II or Title III of the JOBS Act. In recent years, some attorneys have pioneered the creation of corporate mimic LLCs for their clients.
These LLCs continue to be taxed as if they were partnerships and are otherwise subject to the LLC statutes, which generally are more flexible and less restrictive than the corporation laws, but they are structured to look exactly like corporations. For example:
The corporate mimic LLC would be structured with “units of membership interest” (think shares of stock), which could be voting or nonvoting. The LLC could be authorized to issue “preferred” units of membership interest with terms and provisions identical to those of preferred stock in a corporation.
The LLC would be managed by a board of managers (think the board of directors).
The board of managers could delegate some of its responsibilities to officers with specific job titles and duties, just as in a corporation.
The LLC’s organizational document, called an operating agreement, could provide that the LLC could incorporate any time the board of managers felt it was appropriate by merely swapping each unit of membership interest for one share of stock of the same class in the new corporation.
If you are organized as an LLC or desire the flexibility and informality of the LLC way of life, speak to your attorney about setting up a corporate mimic LLC that walks, talks, and swims like a corporation but isn’t really (or legally) one.
The Bottom Line on Legal Entities
If you and your advisers cannot decide on the best form of legal entity to engage in a Title II accredited-investor-only offering or a Title III crowdfunded offering, form your company as a C corporation. That structure gives you the most flexibility in putting together the offering and limiting the rights of your investor crowd once the offering is completed.
It is also what most sophisticated investors expect, and you will spend less time explaining the finer points of “Series B preferred equity units of membership interest” in an LLC.
If your company is currently organized as an S corporation, convert to a C corporation prior to launching the offering, as it will be virtually impossible for your company to maintain its S corporation status unless you restrict your crowd to fewer than one hundred individual investors who are U.S. citizens or green card holders.
Even then, you may have to give these folks voting shares of common stock in your corporation, which will not only dilute your ownership of the corporation but also your ability to manage the corporation’s business without outside interference from the crowd.
Still Have Questions?
For a more thorough discussion of each of these entities and the advantages and disadvantages of each, consult the detailed outline titled “Demystifying the Business Organization” available as a free download from the author’s website at www.cliffennico.com.
This document will answer almost all of the legal and tax questions you should be asking when forming a legal entity for your business.
Decide Where to Incorporate, or Consider Reincorporating Somewhere Else
Generally, corporations and LLCs are best advised to incorporate in the state where their physical offices are located or where the business activities will actually be conducted. There is usually no point in incorporating in another state.
If your business is located in state X and you incorporate in state Y, your income will still be subject to state X taxes, so the state Y corporation or LLC will have to register as a foreign corporation or foreign LLC in state X and so end up being taxed by two states instead of one.
A corporation or LLC that wishes to take advantage of Title III crowdfunding may wish to reconsider that decision, however. Bringing on board dozens if not hundreds of crowdfunded investors changes the way corporations are governed, for better or worse, and it helps to be incorporated or organized in a state that has the most conducive rules for crowdfunded offerings of securities.
Here are some of the legal issues you will need to think of when selecting the right state of incorporation prior to launching a crowdfunded offering.
Franchise Taxes on Authorized Shares
When forming a corporation in virtually any state, you will be required to pay a tax (commonly called a franchise tax—on the permission, or franchise, of doing business with limited liability) when filing your articles of incorporation with the state.
This tax is based on the number of authorized shares of stock you designate in your articles of incorporation.
So, for example, in a particular state the tax could be one cent per share for the first ten thousand shares, one-half of one cent for the next ninety thousand shares, one-quarter of one cent for the next four hundred thousand shares, and one-tenth of one cent thereafter.
There is almost always a minimum franchise tax that must be paid, and sometimes (in nicer states) a maximum franchise tax as well.
This is traditionally one of the main reasons entrepreneurs like to incorporate their businesses in Delaware. Like virtually all states, Delaware has a franchise tax, but it allows corporations to calculate the tax in two different ways and pay only the lower amount of tax.
The two methods are known as the authorized shares method and the assumed par value capital method. Almost always, the assumed par value capital method results in a much lower tax than the authorized shares method.
Using the authorized shares method, a corporation would pay $35 up to the first three thousand shares, then $62.50 for the next two thousand shares, then $112.50 for the next five thousand shares, then $62.50 for each additional ten thousand shares, up to a maximum of $165,000.
To use the assumed par value capital method, you begin by determining your corporation’s total gross assets (basically the corporation’s total assets as reported on its Form 1120 federal income tax return) for the fiscal year. The calculation is fairly involved and is easier to illustrate that it is to explain in words.
So here’s an example: Let’s say a Delaware corporation with one million shares of stock with a par value of $1, and two hundred fifty thousand shares of stock with a par value of $5, has gross assets of $1 million and issued shares totaling four hundred eighty-five thousand. Here’s how you would calculate the corporation’s Delaware franchise tax:
1. Divide the corporation’s total gross assets by its total issued shares carried to six decimal places. The result is the corporation’s assumed par. So: $1,000,000 assets ÷ 485,000 issued shares = $2.061856 assumed par.
2. Multiply the assumed par by the number of authorized shares having a par value of less than the assumed par. So: $2.061856 assumed par x 1,000,000 shares = $2,061,856.
3. Multiply the number of authorized shares with a par value greater than the assumed par by their respective par value. So: 250,000 shares x $5 par value = $1,250,000.
4. Add the results of 2 and 3 above. The result is the corporation’s assumed par value capital. Example: $2,061,856 + $1,250,000 = $3,311,956 assumed par value capital.
5. Figure the franchise tax due by dividing the assumed par value capital, rounded up to the next million if it is over $1,000,000, by 1,000,000 and then multiply by $250. So: 4 x $250 = $1,000.
Corporations that plan to engage in Title III crowdfunded offerings will need to have lots of authorized shares: at least one million and possibly as many as ten million.
Choosing the state with the lowest franchise tax for a large number of authorized shares will be critical to many start-up companies, especially those on extremely limited budgets.
One way to avoid the whole franchise tax issue, believe it or not, is to form a corporate mimic LLC and authorize it to issue voting and nonvoting units of membership interest. An interesting loophole in the law is that in virtually all states, franchise taxes are limited only to shares of stock in corporations.
The idea that LLCs could be set up to mimic the capital structure of corporations using units of membership interest did not occur to state legislatures when they drafted their LLC statutes in the 1990s.
They probably assumed that LLCs would be used only by small businesses managed by their owners and accordingly, would operate as partnerships in which owners have percentage interests in the LLC’s profits and losses rather than shares.
If that was the case, they certainly underestimated the creativity and shrewdness of your average corporate attorney.
As a result of this discrepancy between the two statutes, in virtually every state I’m aware of:
A corporation with one million authorized shares of common stock would have to pay a hefty franchise tax upon incorporation.
An LLC with one million authorized units of membership interest would not.
That loophole may well be closed in future years.
Until that happens, however, many companies seeking to avail themselves of Title III crowdfunding that does not want to (or cannot afford to) reincorporates in another state with a lower franchise tax may want to consider forming an LLC, at least temporarily, to eliminate their franchise tax exposure.
If the crowdfunded offering is successful, the LLC will then have plenty of money to convert into a C corporation and pay the franchise tax at that time.
Next, look at the rights granted to shareholders in your state corporation statute. Generally, you want to be able to limit your crowdfunded investors’ rights as much as possible without jeopardizing the success of the offering.
You want (and need) their money, but you do not want their unsolicited advice, and you certainly do not want them to have the right to tell you how to run your company. Yet if these rights are granted by your state corporation law, you must honor them in your dealings with investors.
LLC statutes in virtually all states are much more flexible—the rights of LLC owners (called members) are generally not set out in the statute but rather in an operating agreement (similar to a partnership agreement) that you would prepare as one of your crowdfunded offering documents.
You or your legal counsel would set out the rights your investors would have when becoming members of your LLC and any limits on those rights. As part of the offering terms, investors would be required to agree to be bound by the terms and conditions of the LLC operating agreement.
Here are some basic rights state corporation laws grant to shareholders of corporations (both C and S).
Voting Rights. Virtually all state corporation laws grant shareholders the right to vote at meetings of shareholders and participate in the management of the corporation’s business unless these rights are denied in the articles of incorporation.
Most corporations have two classes of common stock, one of which (sometimes called Class A) carries with it the right to vote, while the other one (sometimes called Class B) does not.
The rights of each class of shares would be spelled out in the corporation’s articles of incorporation. The company founders and key executives would own the voting shares, while investors would own the nonvoting shares.
Inspection Rights. Virtually all state corporation laws grant shareholders the right to inspect and review the blogs and records of the corporation at reasonable times and on advance notice to the corporation.
Antidilution Rights. There are two types of antidilution rights shareholders can have:
1. Price based antidilution protection: the right to acquire additional shares (without paying for them) in the event the company makes a subsequent offering of securities at a lower valuation than the offering the shareholder subscribed to;
the number of shares would be enough so the shareholder would maintain its original percentage ownership of the corporation’s shares.
2. Structural antidilution protection: the right to acquire additional shares (again without paying for them) in the event of a stock split, stock dividend, or another event that increases the number of the corporation’s issued and outstanding shares other than a public or private offering of those shares.
Virtually all state corporation laws deny these rights to holders of a corporation’s common stock. These rights are almost certain to be included, however, in offerings of preferred stock, by agreement between the corporation and the investors.
As will be seen later in this blog, it wouldn’t make much sense to launch a crowdfunded offering of preferred stock, although an accredited-investor-only offering under Title II of the JOBS Act could easily be structured that way.
A shareholder with a preemptive right has the right to acquire additional shares (and pay for them, at the same price per share offered to subsequent investors) in the event the company makes a subsequent offering of securities at a higher valuation than the offering the shareholder subscribed to;
The number of shares would be enough so the shareholder would maintain its original percentage ownership of the corporation’s shares.
Right of Nonvoting Shareholders to Receive Notice of Shareholder Meetings. Even if shareholders in a corporation are denied the right to vote, they still may have rights under the state corporation statute.
For example, do they have the right to receive notice of meetings of the voting shareholders, even though they have no legal ability to influence the decisions made at those meetings?
In many states, the answer is yes, especially if the matter being voted on is a major change, such as a merger or acquisition, the sale of all or substantially all of the corporation’s assets, the amendment of the corporation’s articles of incorporation, or the corporation’s dissolution or liquidation (including a filing in bankruptcy).
The failure to give notice to your nonvoting shareholders within the time frame required by the statute (usually ten days before the meeting is held) could void any decision made at that meeting.
Shareholder Rights to Compel Dissolution of the Company. A handful of states allow owners of a significant minority percentage of a corporation’s shares (usually 10 or 20 percent) to petition a court to dissolve the corporation or force the majority shareholders to buy out their interest at fair market value.
If they can demonstrate they were “oppressed” by the majority shareholders. The definition of “oppressed” in these states is left up to the courts to decide.
What Type of Security Will You Be Offering?
There are three types of securities you would consider for a crowdfunded offering: notes (or promissory notes), common stock, or preferred stock.
Notes or Promissory Notes
These are debt instruments. The investor in a note agrees to make a loan to the corporation or LLC at a set rate of interest. The loan is repaid with interest over a period of months or years, in monthly or quarterly installments. The investor’s return on the investment is limited to the amount of interest set forth in the note.
Convertible notes may be exchanged for shares of common or preferred stock in the corporation at the option of the investor and may also be convertible on demand of the corporation immediately prior to an IPO or a merger or acquisition transaction.
Notes may also be issued with warrants attached—these are like options to acquire shares of the corporation’s common or preferred stock in the future and are in addition to the note. An investor exercising a warrant to acquire shares in the issuing company still has the right to receive interest on the note until it is paid in full.
Common Stock and Preferred Stock
These are equity instruments, representing ownership of a percentage of the corporation’s total issued and outstanding shares.
Investors in common stock are entitled to all the rights granted to common stockholders in the state corporation statute and the corporation’s articles of incorporation, while investors in preferred stock receive the rights granted to them in a purchase agreement with the corporation that is usually the subject of some negotiation.
Unlike common stockholders, preferred stockholders are entitled to a liquidation preference. If the corporation is dissolved or otherwise goes out of business, preferred stockholders get their money out before the common stockholders get a penny.
Preferred stock may be voting or nonvoting, convertible into common stock or not, as the corporation’s board of directors determines, and may afford the investor the right to receive preferred distributions of cash, known as cumulative dividends before dividends are paid to the common stockholders.
LLC Membership Interests
If you are planning to launch a crowdfunded offering of equity securities in an LLC, you will be issuing membership interests or units of membership interest in the LLC to investors.
Like shares of a corporation’s stock, units of membership interest in an LLC can be voting or nonvoting and can grant investors whatever rights are spelled out in the LLC’s operating agreement.
You can even grant investors preferred membership interests containing many of the same terms and conditions as would apply to preferred stock in a corporation.
Which Security Is Best for a Crowdfunded Offering?
Most early-stage companies want to avoid debt like the plague, especially if the debt is being held by dozens or possibly hundreds of individual lenders.
It is unlikely that a company will want to offer notes in a Title III crowdfunded offering, but one of the most common private placement structures under SEC Rule 506 is the offering of convertible promissory notes, and an offering of debt securities in an accredited-investor-only offering under Title II may make sense for a more seasoned company.
Similarly, it would make little sense for a company to issue preferred stock in a Title III crowdfunded offering because the sheer number of investors having the right to a liquidation preference upon the dissolution or liquidation of the company may discourage anyone from investing in the corporation’s common stock in subsequent offerings because they would fear being wiped out in that event.
Because most accredited investors will want preferred stock in your company, you may want to consider convertible preferred stock as the vehicle for a Title II accredited-investors-only offering, or indeed any other offering under the SEC’s Rule 506.
Accordingly, it is anticipated that the vast majority of Title III crowdfunded offerings will involve common equity securities: voting or nonvoting common stock in a corporation, or membership interests in an LLC.
Amend Your Articles of Incorporation to Create a Separate Class of Shares for Your Crowdfunded Offering
Most early-stage companies launch multiple offerings of securities over time —a friends-and-family or crowdfunded offering, to begin with, followed by subsequent offerings of notes, preferred stock, or common stock to angel investors and other accredited investors, followed by one or more so-called mezzanine offerings to venture capital firms, followed (it is hoped) by an initial public offering.
Many companies, for example, may want to launch an “upstairs-downstairs” offering—a Title II offering of preferred stock to accredited investors, together with a Title III crowdfunded offering of common stock to non-accredited investors.
Create Multiple Classes of Stock
It is therefore important to prepare and file articles of incorporation with several different classes of stock, allowing for maximum flexibility in structuring future offerings.
Because this is seldom done when a corporation is first incorporated, it is customary for the corporation to “amend and restate” its articles of incorporation to spell out the rights, privileges, and limitations for each class of its common and preferred stock.
Create a Class of Convertible Preferred Stock. If your company is considering a private placement to accredited investors under Title II of the JOBS Act, you will need to create at least one class of preferred stock.
Investors like preferred stock because if hedges their bets on a start-up company: if the company crashes and burns, preferred stockholders get their money before common stockholders get a penny.
Also, preferred stock can be structured so the investors get cumulative dividends—a guaranteed return on their investments that accrue over time (albeit without interest) if the company fails to pay dividends on time.
Accredited investors will want your preferred stock to be convertible into common stock at the investor’s option. That way, if the company takes off and becomes wildly successful, the investor can convert preferred into common stock and participate in the rapid growth of the company.
Keep in mind that you must be a C corporation in order to have one or more classes of preferred stock; S corporations are prohibited by law from having more than one class of stock.
Create Voting and Nonvoting Classes of Common Stock. Now let’s look at your company’s common stock—the security you are most likely to offer to your crowdfunded investors in a Title III offering.
Generally, it’s a bad idea to give crowdfunded investors voting common stock. Holders of voting common stock are granted extensive rights under state corporation laws, including the right to vote on matters affecting the company’s business and operations, the right to participate in the company’s management, (sometimes) the right to appoint members of the company’s board of directors, and in general the right to make themselves into time vampires if they so choose.
You want to keep those rights in as few (and trusted) hands as possible: yourself, the other company founders, the key members of your management team, and perhaps one or two angel investors who provide the seed capital that gets the company off the ground.
Simply put, everyone else should get nonvoting common stock: not just your crowdfunded investors but employees, consultants, advisers, and other people who are not essential to the success of your company or its business plan.
Now, I realize that may sound a bit nondemocratic to some readers and not consistent with the spirit of crowdfunding, which is to open start-up investment opportunities to the masses.
But as someone who has advised hundreds of start-up companies in my career, I can tell you that having too many powerful investors too early in a company’s life cycle is more likely than not to crush a company’s prospects. Investors can be (and frequently are) demanding.
They ask lots of questions (facilitated by the ease of using email, instant messaging, and texting), they expect prompt response from management, and if they don’t like what’s happening, they can turn into hostile and unruly whistle-blowers who post unfavorable, unfair, possibly incorrect, and overly critical information about your company on social media.
But giving investors voting stock creates the possibility of a hostile voting bloc that will attempt to take over your company, or at least act collectively as a roadblock to important business decisions that must be made as quickly and efficiently as possible.
Even if your voting shareholders are as quiet as mice and complacent as lambs, you must give them notice and explain to them in detail what’s going on before making important decisions.
While it may seem unfair, undemocratic, or downright Neanderthal to offer crowdfunded investors nonvoting common stock, I think you will find most of them understand that for an investment of $2,000 or less they cannot, and should not, have the right to tell management what to do.
If they really feel your company is headed in the wrong direction, they should take that $2,000 and start companies of their own rather than invest in yours. Those who don’t understand that should be investing in your competition.
Consider Making Your Nonvoting Common Stock Redeemable. Virtually all state corporation laws give corporations the right to make one or more classes of their stock redeemable, thereby allowing the corporation to repurchase those shares for cash under certain circumstances.
Frequently, corporations will make one or more of their classes of preferred stock redeemable so they can remove that class at the demand of subsequent investors (or investment bankers as part of an initial public offering) or otherwise due to market conditions.
Historically, corporations have not chosen to make classes of their common stock redeemable, although state corporation laws do not prohibit them from doing so.
The reason has more to do with marketing than the securities laws: many investors will, in theory, be reluctant to buy shares in a company if those shares can be repurchased out from under their noses days, weeks, or months after the investment is made—especially if the shares are nonvoting common stock that doesn’t give them the right to complain about that decision.
Title III crowdfunding may, however, lead more corporations to conclude that having redeemable common stock—which would enable them to buy out overly difficult or needy shareholders and otherwise help them cull the herd whenever necessary—outweighs the possible negative impact on the company’s ability to market the offering.
You should discuss with your attorney the relative advantages and disadvantages of redeemable nonvoting common stock. If you do decide to offer redeemable shares as part of your Title III crowdfunded offering, make sure.
The repurchase price is at least 120 percent of the price per share you are asking for in the offering (this gives the investor a guaranteed return if the shares are repurchased)
You stipulate that you are not allowed to redeem any shares in the offering for a period of at least one year after the closing date of the offering. These provisions will make the idea of redemption more palatable to your crowdfunded investors and make it easier for you to make a successful offering.
Can LLCs Have Multiple Classes of “Stock”? LLCs can be structured the same way as corporations, with common and preferred, voting and nonvoting units of membership interest. The rights, privileges, and limitations of each class of units are normally spelled out in the operating agreement of the LLC rather than by amending the LLC’s articles of organization.
Set Your Offering Amount and Determine the Dilution for Existing Investors
Now is the time to make two key determinations:
1. How much money do you plan to raise in the offering?
2. How much of your company do you want to give up?
Before you determine this, it is a good idea to put together a use-of-proceeds chart or Excel spreadsheet with the help of your accountant listing exactly what you will do with the proceeds of the offering if it is successful.
Under the Title III regulations for crowdfunded offerings, you will be required to spell this out in some detail, and one of the most common entrepreneurial mistakes is to underestimate how much capital will be needed to fulfill specific purposes.
The more capital you wish to raise, the more investors will have to participate. The Title III crowdfunding regulations require that you set the amount of capital you wish to raise at the beginning of the offering; fail to hit that target and you have to give all the investors their money back. The more money you ask for, the less likely you will be able to hit your funding target.
Accordingly, it will be difficult for start-up companies to raise more than a couple of hundred thousand dollars in a Title III crowdfunded offering.
Concept companies probably should not ask for more than $50,000. More established private companies will be able to raise more significant sums under Title III, but after a certain point, it will be much more cost-effective to raise money via a traditional Rule 506 private placement, or an accredited-investors-only offering under Title II.
Dilution: How Much Equity Do You Want to Give Up?
When issuing debt securities such as notes, you do not give up any equity in your company.
Because equity securities involve owning a percentage of your company’s shares, by issuing new common or preferred stock (or membership interests in an LLC) to anyone, you end up owning a lower percentage of your company than you did previously.
To use the simplest possible example, if you and your founders own 100 percent of your company today and you sell common stock for 20 percent of your company to crowdfunded investors, you and your founders will end up owning 80 percent of the company when the offering closes.
You and your co-founders continue to have the same number of shares as previously, but because your company has issued additional shares, your shares constitute a lower percentage of your company’s total issued and outstanding shares after the offering is completed.
You cannot issue more than 100 percent of a company’s shares, so each new issue of equity securities dilutes the percentage owned by the founders and the previous investors. How much dilution are you and the other founders willing to tolerate each time you launch an offering of securities, crowdfunded or otherwise?
As an attorney who has represented start-ups for more than thirty years, I can tell you that these can be extremely difficult conversations for entrepreneurs.
Larger corporations make this decision by hiring experts to perform a valuation of what the company is worth. Once the valuation has been determined, the company determines how much money it needs and how much of the current valuation that amount constitutes.
For example, if a corporation is worth $500,000 and needs to raise $100,000, it would issue stock constituting 20 percent of the total issued and outstanding equity in the company after the investment is completed.
For a start-up company that is still trying to develop or perfect its products or services (or concept companies that are little more than an idea), valuation is pretty much impossible. Any valuation you put on your company is mostly guesswork because the company has no revenue and no tangible assets.
Here are some basic rules of thumb:
Don’t even attempt to project revenues or profits—focus instead on the things you need to do to make your product or service a reality and get it into the marketplace, and on how much each of those things will cost.
Always ask for more (120 percent to 150 percent) of what you think you will need—there are always hidden costs you fail to foresee, and it’s helpful to have the money readily available when you realize that’s the case (just keep in mind that you will have to explain to your funding portal and the SEC what you will do with any excess proceeds of your offering).
Do not give up more than 10 percent of your company in your initial offering, especially a crowdfunded one.
The last point is by far the most important one. If your company has an exciting product with huge market potential, you are likely to get some investors in your crowdfunded offering no matter how many risks you disclose in your offering statement.
Under no circumstances do you want a crowd (or mob) of people owning a significant percentage of your company, especially if they have the right to vote on matters affecting the company’s business. There are three reasons for this:
1. The more equity investors own in your company, the more power they have to influence your decision making (and may have legal rights under your state corporation laws).
2. Future investors will not like your having a significant percentage of minority owners to deal with.
3. The more equity you give away early on, the less you will have for yourself and the other founders later.
Unlike the title characters in the famous Mel Brooks movie (and Broadway show) The Producers, you can’t sell more than 100 percent of your stock.
I have personally seen companies give away so much of their equity during the first two years of operations that the founders ended up owning less than 10 percent of their companies when the big venture capital firms started knocking on their doors wanting a 40 or 50 percent equity stake.
Prepare a Term Sheet for the Offering
Once you have determined the rights you want your investors to have, the amount of money you need, and the percentage of your company you wish to give up, it is time to put together a term sheet and begin looking for funding portals to manage and handle your Title III crowdfunded offering.
As opposed to a traditional private offering, in a Title III crowdfunded offering you must make two sales pitches: first, you must sell the funding portal; second, once accepted by a portal, you must sell prospective investors. The term sheet is the document that will help you sell the funding portal.
A term sheet is not a legal document and is therefore not binding on your company as a contract or legal obligation. It does not commit your company to follow through on the offering; it merely indicates your interest in launching an offering of securities on those terms.
Your term sheet should be as detailed as possible, but be sure to leave room for some negotiation, as funding portals, accredited investors, and others will surely comment on your terms and try to change them more to their advantage.
In structuring your offering, you should look closely at the terms and conditions of other offerings involving similar companies in your industry offering comparable products and services.
Get Your Management Team and Initial Investors On Board
State corporation laws require any offering of securities to be authorized by resolution of the corporation’s board of directors and (often) its shareholders. Similarly, state LLC laws require any offering of membership interests or units to be authorized by the LLC’s members.
This must be done at a special meeting called for the express purpose of approving the offering and must be documented (minutes must be taken). Advance notice of the meeting must be given to all shareholders or LLC members as required by the statute. Failure to conduct this meeting may void the offering as being not properly authorized under state law.
Once your Title III crowdfunded offering has received all required internal approvals, you are ready to launch.
Launching Your Crowdfunded Offering
If your company has offered securities in the past, you will probably be able to launch a Title III crowdfunded offering with little assistance from outsiders. Start-up companies, first-time issuers, and concept companies will have a tougher time.
Regulation Crowdfunding contains dozens of rules issuers have to comply with when offering securities under Title III, and it is relatively easy to make mistakes if you don’t have at least some professional help.
Finding the Help You Need
Companies making Title III crowdfunded offerings for the first time will need help from at least three, and possibly four, professionals:
A good accountant
A good lawyer who is experienced in private offerings of securities and familiar with the Title III and Regulation Crowdfunding rules for crowdfunded offerings
A business mentor or adviser who can coach the company founders throughout the offering process (Perhaps) a social media marketing expert who is familiar with crowdfunded marketing campaigns under Kickstarter, Indiegogo, RocketHub, and other project crowdfunding platforms
The accountant will be necessary to put together the financial statements, cash-flow projections, and other financial information in the offering documents.
The lawyer will be responsible primarily for drafting the disclosure documents required by Regulation Crowdfunding but also for coaching the company founders on what they cannot do or say during the offering process.
As Title III crowdfunding becomes a reality, there will be an explosion in the number of people offering advice to entrepreneurs on structuring and managing their crowdfunded offerings (including, perhaps, the person whose blog you are reading).
Like all business mentors, many of these will know what they’re talking about and many won’t. The ideal mentor for a start-up company contemplating a Title III offer is someone who:
“Gets” social media and the triggers that make successful social media marketing campaigns work
Understands the industry your company is in and the factors that make for success in that industry
Has successfully managed Title III crowdfunded offerings for at least one or two other companies
Has the honesty, integrity, and reputation for fairly dealing with clients who you and your cofounder's trust
Of course, at the time this blog was being written, virtually no one met all those criteria because no Title III crowdfunded offerings had taken place yet.
Do you need to work with a social media marketing expert when launching a Title III crowdfunded offering? I’m frankly of two minds on this. On the one hand, success in marketing a Title III offering will depend on your ability to leverage your social networks effectively.
If you do not live on social media every day, you probably do not know what works and what doesn’t on each of the most popular social media platforms, and any help in this area will likely improve your batting average with prospective investors, especially those younger people (and they seem to be legion) who trust their Facebook friends’ recommendations more than anyone else’s.
On the other hand, many social media marketing consultants may not be familiar with Title III and the many detailed rules and regulations for crowdfunded offerings of securities.
Reaching out to people you don’t know my work on Kickstarter and help you raise money for an invention or a charitable fund-raising campaign, but it almost certainly will shut down your Title III offering if the SEC finds out you’re doing it.
If you have to choose between a brilliant marketing expert who doesn’t understand Title III and a halfway decent lawyer who does, choose the latter, at least until you know what you are doing.
Preparing Your Disclosure Documents
Before you begin approaching funding portals to launch your offering, you will need to put together a term sheet—a nonbinding summary, often in bullet form, of the principal terms and conditions of the offering you propose to make.
Most funding portals will not accept your offering on the basis of a term sheet, however. They will want to see the actual documents you will be used to solicit investors through the portal. These documents fall into two categories:
1. The disclosures you are required to make to investors under Regulation Crowdfunding, in an offering statement using the SEC’s new Form C (from now on we will call these Form C disclosures)
2. Any other materials—such as PowerPoint slide shows, video presentations, detailed business plans, online product reviews, newspaper/magazine articles and blog postings, and advertisements and marketing materials you plan to use when selling products and services to customers.
You think investors should see in order to fall in love with your company, its mission, its products, its services, and its good-looking-enough-for-Hollywood management team, as long as they don’t violate Regulation Crowdfunding (from now on we will call these the supplemental materials)
Becoming Familiar with Form C
Before you begin working on your crowdfunded offering, it’s a good idea to become familiar with the SEC’s Form C. A copy of the current text, as issued by the SEC on October 30, 2015.
The SEC requires issuers to use an XML-based fillable form to input Form C and discourages the submission of paper filings. Information not required to be provided in text boxes in the XML-based fillable form would be filed as attachments to Form C.
Form C is used for all of an issuer’s filings with the SEC related to the offering made in reliance on Regulation Crowdfunding. The issuer checks one of the following boxes on the cover of Form C to indicate the purpose of the Form C filing:
“Form C: Offering Statement” for issuers filing the initial disclosures required for an offering
“Form C-A: Amendment” for issuers seeking to amend a previously filed
Form C for an offering
“Form C-U: Progress Update” for issuers filing a progress update
“Form C-AR: Annual Report” for issuers filing the annual report
“Form C-TR: Termination of Reporting” for issuers terminating their reporting obligations
The SEC’s data-handling system—Electronic Data Gathering, Analysis, and Retrieval (EDGAR)—would automatically provide each filing with an appropriate tag depending on which box the issuer checked so investors could distinguish among the different filings.
An issuer who did not already have EDGAR filing codes and to which the SEC had not previously assigned a user identification number, called a Central Index Key (CIK) code, would need to obtain the codes by filing electronically a Form ID at www.filermanagement.edgarfiling.sec.gov.
An issuer is permitted to submit exhibits to Form C in Portable Document Format (PDF) as official filings.
Because the prospect of filling out an SEC form can be quite daunting, especially for a first-time issuer, the SEC gives issuers the option of submitting some of the required information in a question-and-answer format.
Issuers opting to use this format would prepare their disclosures by answering the questions provided and filing that disclosure as an exhibit to the Form C filed electronically in XML format. The text of the question-and-answer version of Form C, as issued by the SEC on October 30, 2015.
The Form C Disclosures
The SEC requires issuers to provide certain information to investors through the funding portals and to the SEC directly via an electronic filing of SEC Form C on EDGAR. While some of the Form C disclosures will be included in the itemized fields of Form C, other information will be included as attachments to Form C.
The Form C disclosures for each issuer are:
The name, legal status (whether a corporation or LLC), state of organization, date of organization, physical address, and Uniform Resource Locator (URL), or website address
The names of the directors and officers, the positions and offices held by those people, how long they have served in those positions, and the business experience of those people over the past three years
The name of each person who is (as of the most recent practicable date but not earlier than 120 days prior to the date the offering statement is filed) a beneficial owner of 20 percent or more of the issuer’s outstanding voting equity securities
A description of the business of the issuer and anticipated plan of business (merely a short description of the business and its plan going forward, not a detailed business plan, although this may and probably should be included in the supplemental materials)
The current number of employees of the issuer
A discussion of the material risk factors that make an investment in the issuer speculative (see Appendix 9 for a sample risk-factors disclosure for an issuer creating a mobile smartphone app)
The target offering amount and the deadline, or closing date, to reach the target amount
A statement with respect to whether the issuer will accept investment in excess of the target amount and the maximum amount it will accept (if the issuer accepts investments above the stated target, it must state the method it will use to allocate oversubscriptions), and a description of how the issuer will use any excess funds
A description of the purpose and intended use of the offering proceeds or, if an issuer is uncertain how the proceeds will be used, a statement of the probable uses and the factors impacting the selection of each use.
(these descriptions must be fairly detailed and include what proceeds will be used to compensate the funding portal, salaries to the company founders and others, repurchase shares issued to previous investors, and so forth— a mere statement that proceeds will be used for “working capital” or “general corporate purposes” will not suffice)
A statement of how long the issuer expects the proceeds to last
A description of the process to complete the transaction or to cancel an investment commitment as prescribed by Regulation Crowdfunding
The price of the securities or the method for determining the price (if the issuer has not set a price at the start of the campaign—not recommended —it must provide a final price prior to any sale of securities)
A description of the owner and capital structure of the issuer
The terms of the securities being offered as well as each other class of security of the issuer
Any rights held by the company founders or other principal shareholders
How the securities being offered are valued and how the securities may be valued in the future
The risks to investors relating to minority ownership and the risks associated with corporate actions like the additional issuance of shares, issuer repurchases, and the sale of the issuer or issuer assets to related parties
A description of any restrictions on the transfer of the securities (for example, any buy-sell provision that might appear in the issuer’s shareholders’ agreement or LLC operating agreement). The name, SEC file number, and Central Registration Depository (CRD) number of the funding portal that will conduct the offering
The amount of compensation paid to the funding portal for conducting the offering and the amount of any referral or other fees associated with the offering (which can be disclosed either as a dollar amount or percentage of the offering amount or as a good faith estimate if the exact amount is not available at the time of the filing)
Any other direct or indirect interest in the issuer held by the funding portal, or any arrangement for the funding portal to acquire such an interest A description of the material terms of any indebtedness of the issuer (if the issuer has debt, it will need to disclose all material terms, including the principal amount, interest rate, maturity date, and any other terms an investor would deem material)
A description of any exempt offering under Regulation D, Regulation A, or Section 4(a)(2) of the 1933 Securities Act conducted within the past three years (the description should include the date of the offering, the offering exemption relied on, the type of securities offered, the number of securities sold, and the use of proceeds)
A description of any completed or proposed transaction by the issuer or any affiliated company for value exceeding 5 percent of the amount being raised in the Title III offering since the beginning of the issuer’s last fiscal year, including the current offering, when a control person, promoter, or “member of the family”
(defined as a 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 of any such control person or promoter) had a direct or indirect material interest
A description of the financial condition of the issuer (which must include, to the extent material, a discussion of liquidity, capital resources, and historical results of operations)
The tax returns, reviewed financial statements, or audited financial statements of the issuer, depending on the level of the offering and other offerings within the previous twelve months.
A description of any events that would have triggered disqualification under the “bad actor” disqualification rules in the SEC’s Rule 506(d) had they occurred after the effective date of Regulation Crowdfunding
A statement that the issuer will file annual reports on EDGAR within 120 days after the end of each fiscal year
The location on the issuer’s website where investors will be able to find the issuer’s annual report and the date by which such report will be available on the issuer’s website. Whether the issuer or any of its predecessors previously has failed to comply with the ongoing reporting requirements of Regulation Crowdfunding
Any material information necessary in order to make the statements made, in light of the circumstances under which they were made, not misleading
By far the most important Form C disclosure—which should appear in as many places as possible not only in the Form C disclosure but also in your supplemental materials, in your Regulation Crowdfunding offering announcement.
And in every communication, you make to investors during the offering period, and in capital letters—is the simple statement,
“INVESTMENT IN THESE SECURITIES IS HIGHLY RISKY, AND THERE IS A CHANCE YOU MAY LOSE YOUR ENTIRE INVESTMENT.”
The SEC does not specify the format in which the Supplementary
Materials must be presented, leaving some flexibility for issuers to present some information in written offering documents, some in videos and other information by graphic means.
While the SEC does not review, comment on, or in any way approve the Form C disclosures, it would be foolish to assume that the SEC will not read information that is on EDGAR.
When preparing your Form C disclosures and supplemental materials, you should assume that if and when they suspect problems, the SEC staff, and the state regulatory authorities will thoroughly review the Form C disclosures for potentially misleading statements and also review the supplemental materials on the funding portal’s platform.
The Form C disclosures may include screenshots and other visual aids, such as tables and charts, but cannot be submitted in the form of a PowerPoint presentation.
In order to file the Form C disclosures on EDGAR, your company will need to have EDGAR filing codes and a CIK code. If an issuer does not already have these codes, it can obtain them from the SEC.
Since virtually all funding portals will already have these codes and will be experienced in filing documents on EDGAR, it may be best to have the funding portal file your company’s Form C disclosures on EDGAR. Just don’t be surprised if the portal charges an additional fee for that service.
Your Supplemental Materials
Only the Form C disclosures are required to be filed with the SEC. Regulation Crowdfunding does not, however, limit your offering documents to the Form C disclosures.
Issuers in crowdfunded offerings are not only allowed but encouraged to post a wealth of information about themselves and the offering on the funding portal that is listing the offering, by way of supplemental materials that go beyond the Form C disclosures.
This is a departure from prior law, in which investors were allowed to see only the statutory prospectus for an offering.
Your supplemental materials may include, among other things:
PowerPoint presentations about your company and its products and services
Audio and video presentations by the company founders Screenshots of the company’s website
Sample marketing materials your company will use to promote its products and services once funding has been successfully raised
A detailed written plan of the sort venture capitalists, angel investors, and other traditional players in the venture capital market are accustomed to seeing (I would venture to say that posting such a plan on the funding portal is essential if you are looking to raise money from accredited investors)
Regulation Crowdfunding does not limit the form or content of your supplemental materials in any way. You are, however, liable for any misstatements or omissions in the supplemental materials.
The one rigid, inflexible rule in Regulation Crowdfunding is that the supplemental materials must be posted only on the funding portal while your Title III crowdfunded offering is in progress. You cannot post them on your website or social media pages during the offering period, and you cannot send them directly to investors as part of a direct pitch.
While the SEC and state securities regulators are unlikely to plow through your supplemental materials looking for problems, the funding portal may well do so in order to protect itself against legal liability for any false or misleading claims you may make there.
Also, keep in mind that if the SEC, in reviewing your Form C disclosures, suspects there may be compliance problems with your offering, it is not prevented from looking at your supplemental materials, and it will almost certainly do so.
Your Financial Statements
Issuers of securities under Regulation Crowdfunding are required to provide financial statements prepared in accordance with the U.S. generally accepted accounting principles (GAAP) covering the two most recently completed fiscal years (or since inception if the company is less than two years old).
The financial statements cannot be more than eighteen months old. If more than 120 days have passed since the end of the issuer’s most recently ended fiscal year, the issuer will have to produce financial statements for that most recent year but until that point can use financial statements from the preceding year.
The extent to which an issuer’s financial statements will need to be reviewed by an independent accountant or accounting firm will depend on (1) the amount of money you are seeking to raise and (2) the number of securities your company has already sold under Regulation Crowdfunding during the preceding twelve months. Here are the rules:
If your current crowdfunded offering plus previous Regulation Crowdfunding offerings were for $100,000 or less, the financial statements must be certified by your company’s “principal executive officer” or founder and accompanied by the company’s tax returns (if any).
Basically, the founder(s) will need to include a sworn statement that everything in the financial statements is “true, correct, and complete in all material respects” (Regulation Crowdfunding is not clear, but I doubt the SEC will allow company founders to qualify that statement by saying the financial statements are true and correct “to the best of their knowledge and belief”).
If your current crowdfunded offering plus previous Regulation Crowdfunding offerings were for more than $100,000 but less than $500,000 in total, the financial statements must be reviewed by an independent CPA.
If your current crowdfunded offering plus previous Regulation Crowdfunding offerings were for $500,000 or more, your financial statements must be audited by a CPA unless this is your first crowdfunded offering and you are raising less than $1 million, in which case only reviewed financial statements are required.
Reviewed Financial Statements. Reviewed financial statements provide the investor with the comfort that based on the accountant’s review, the accountant is not aware of any material modifications that should be made to the financial statements in order for the statements to be in conformity with GAAP.
A review engagement involves the CPA performing procedures (primarily analytical procedures and inquiries) that will provide a reasonable basis for obtaining limited assurance that there are no material modifications that should be made to the financial statements in order for them to be in conformity with GAAP.
In a review, the CPA designs and performs analytical procedures, inquiries, and other procedures, as appropriate, based on the accountant’s understanding of the industry, knowledge of the client, and awareness of the risk that he or she may unknowingly fail to modify the accountant’s review report on financial statements that are materially misstated.
A review does not contemplate obtaining an understanding of the entity’s internal control, assessing fraud risk, testing accounting records, or other procedures ordinarily performed in an audit.
The CPA then issues a report stating that the review was performed in accordance with Statements on Standards for Accounting and Review
Services; that management is responsible for the preparation and fair presentation of the financial statements in accordance with the applicable financial reporting framework and for designing, implementing, and maintaining internal control relevant to the preparation and fair presentation of the financial statements;
That a review includes primarily applying analytical procedures to management’s financial data and making inquiries of management; that a review is substantially less in scope than an audit;
And that the CPA is not aware of any material modifications that should be made to the financial statements in order for them to be in conformity with the applicable financial reporting framework.
Audited Financial Statements. Audited financial statements provide the user with the auditor’s opinion that the financial statements are presented fairly, in all material respects, in conformity with GAAP. In an audit, the auditor is required to use GAAS to obtain an understanding of the entity’s internal controls and assess fraud risk.
The auditor is also required to corroborate the amounts and disclosures included in the financial statements by obtaining audit evidence through inquiry, physical inspection, observation, third-party confirmations, examination, analytical procedures, and other procedures.
The auditor issues a report that states the audit was conducted in accordance with GAAP and the financial statements are the responsibility of management, and provides an opinion that the financial statements present fairly, in all material respects.
The financial position of the company and the results of operations in conformity with GAAP, or the auditor issues a qualified opinion if the financial statements are not in conformity with GAAP. The auditor may also issue a disclaimer of opinion or an adverse opinion if appropriate.
As initially proposed, Regulation Crowdfunding required all issuers raising $500,000 or more to provide audited financial statements to prospective investors.
This requirement was hotly debated during the comment period leading up to the adoption of Regulation Crowdfunding in October 2015, with most commentators insisting that the high cost of an audited financial statement would effectively prohibit early-stage companies from launching crowdfunded offerings under Title III.
The SEC backed down on this requirement in the final version of Regulation Crowdfunding, but only for first-time issuers raising between $500,000 and $1 million. After that, audited financial statements are required.
The SEC defended its position on audited financial statements on the grounds that financial statements prepared in accordance with GAAP generally are “self-scaling to the size and complexity of the issuer.”
Or, to put it in plain English, start-ups and concept companies that need $500,000 or more in upfront money to launch their business plans are much more likely to fail and thus pose a bigger threat to investors than start-ups and concept companies that need only $50,000 to get up and running.
If a start-up or concept company needs $500,000 or more to launch its business plan, then its CPA better be willing to back that up in writing, even if it means putting his or her license at risk.
Needless to say, few CPAs will be willing to take that risk for anyone but their largest clients unless they cover their rear ends ten times over to avoid liability if the company fails.
The requirement of reviewed and audited financial statements may well mean that, as a practical matter, only companies with significant track records and a product or service that is well on its way to being marketed will qualify to raise more than $100,000 using Title III crowdfunded offerings.
Finding the Right Funding Portal for Your Offering
Prior to January 26, 2016, the earliest date on which funding portals were allowed to register with the SEC, there were no Title III crowdfunding portals operating anywhere in the United States because the final version of Regulation Crowdfunding authorizing the existence of funding portals wasn’t released until October 30, 2015.
By the time you read this, there still may not be any Title III crowdfunding portals in existence. Before a company can operate as a funding portal under Title III, it must:
Register as a funding portal with SEC Register with FINRA
(Possibly) have its principals take examinations in order to qualify under SEC and FINRA requirements
Hire and train the many people that will be necessary to comply with Regulation Crowdfunding’s many requirements for funding portals
It’s a fair bet that funding portals will need to charge high fees for their services in order to cover their high start-up and operating costs. While it is anticipated that most of these fees will be charged in the form of commissions (that is, a percentage of the amount successfully raised in each crowdfunded offering), the SEC does not prohibit funding portals from charging flat upfront fees for their services.
This, in fact, is how most funding portals will probably charge for handling offerings of $100,000 or less. Also, it is almost certain that funding portals will charge fixed breakage fees for crowdfunded offerings that fail to raise the minimum amount of capital on or before the scheduled closing date.
Your company will not be able to make a Title III crowdfunded offering of its securities except through a funding portal. How do you find the right portal for your specific offering? Generally, you want to work with the funding portal that is likeliest to get a successful result for your crowdfunded offering. Here are the questions to ask:
Does the Portal Handle My Type of Company?
Most funding portals will be focused on technology-related companies, for three reasons:
1. That’s what the funding portal’s founders know and understand (keep in mind always that funding portal executives are entrepreneurs just like yourself. Most will be coming from venture capital backgrounds and accordingly will be more familiar with tech companies than other issuers).
2. Tech companies generally have higher valuations and therefore higher offering amounts (leading to greater commissions for the funding portal) than other issuers.
3. Most serious investors (angels and venture capitalists) will be focused on tech companies and other scalable businesses to the exclusion of everyone else.
However, one of the great selling points of Title III crowdfunding is that it opens up the securities markets to retail, service, distribution, franchise, and other companies that have not historically had an easy time attracting investors. It is not inconceivable that specialized funding portals may emerge to focus on these nontraditional issuers.
Is the Portal Handling Other Issuers in the Same Industry (Is It Vertical)?
Generally, you want to work with a funding portal that understands your industry and is handling offerings for other companies in your industry, for two reasons:
1. They are in a better position to vet your offering and point out areas where your offering documents may need improvement.
2. They are more likely to attract investors who are interested in your specific industry.
The downside, of course, is that you may find your offering being listed shoulder to shoulder with an offering by one of your competitors. That is great for investors, of course, as it permits side-by-side comparison of different offerings by similar companies, but is highly stressful for the participating issuers, who may find themselves in a beauty contest to attract the best investors.
In such a situation, competing issuers will be under pressure to outdo the others in their offering terms and conditions (because your offerings are publicly available for view online, they can see yours and you can see theirs), with a greater risk of fraud or misstatement if one or the other competitors promote its offering too aggressively.
It can be a difficult decision to make: is your company better off being the only one in its industry listed with a particular portal (and therefore more likely to stand out) or being one of many similar companies handled by a portal known for its expertise in that industry (and therefore more likely to attract the best and most knowledgeable investors in that industry)?
Does the Funding Portal Have Lots of Investors On Board?
Not only issuers but investors are required to list with funding portals. The difference is that while investors may register with more than one portal, issuers are limited to one portal for their crowdfunded offering.
While funding portals will be prohibited from providing you with personally identifiable information about their investors—for fear you will try to contact them directly and circumvent the portal’s role as intermediary.
They probably will offer aggregate information about the number of investors that have registered with them, the percentage of accredited investors, and other statistical information that may help you make a more informed portal selection decision.
Is Portal Marketing Itself Aggressively?
Remember that funding portals are start-up companies just like yours, competing with other portals for business and that just like your company, they have to market themselves to attract issuers and investors to the portal.
Maybe—just maybe—some funding portals themselves use Title III crowdfunding to raise capital for their business operations (which raises the question of who would be acting as their funding portal?)
Regulation Crowdfunding specifically allows portals to advertise themselves and to seek brand recognition from broker-dealers, investment banks, and other players who may recommend investors to the portal. Your company should be looking for funding portals that are marketing themselves aggressively and securing the capital they need to grow their operations.
As in all industries, aggressive competition among funding portals will lead eventually to a handful of companies dominating the industry. Your company should be listed with a winner in that competition, not an also-ran.
Will the Portal Coach My Company Through the Process?
Regulation Crowdfunding allows funding portals to advise an issuer about the structure or content of the offering, to a limited extent. For example, a portal can:
Provide pre-drafted templates or form documents to the issuer
Provide advice on the types of securities the issuer can offer and the terms of those securities
Provide advice on compliance with crowdfunding regulations (including advice on correcting mistakes in the Form C disclosures)
Obviously, the line between telling an issuer what it did wrong in its offering documents and coaching an issuer on the right way to do its offering documents can be a very thin one, and funding portals will have to train their employees dealing with issuers carefully to make sure no one crosses a line that might invalidate an offering or (worse) put the funding portal’s SEC or FINRA registration in jeopardy.
Just as obviously, your company will probably have to pay a bit extra for any hand-holding services a funding portal believes it is safe to provide. What a funding portal cannot do, under any circumstances, is play favorites or discriminate between your company and other issuers. This would include giving you advice that would give you a leg up over any issuers competing for the same investors.
Should I Use a Matchmaker?
Because under Regulation Crowdfunding issuers are required to work with only one portal when launching a Title III crowdfunded offering, the selection of that portal will become mission critical to the offering’s success.
To avoid mistakes in the portal selection, it may be worth getting professional help in making that decision. It is almost certain that some individuals and companies will set themselves up as matchmakers who will help link issuers and funding portals online.
Regulation Crowdfunding allows you to use a matchmaker to find the right portal, as long as you disclose the amount of its compensation in the Form C disclosures.
Unless the matchmaker is a registered broker-dealer, it cannot accept a percentage of your successful offering as compensation: it must charge a flat fee, hourly rate, or other compensation that is not tied to the amount or success of your offering.
Setting the Offering Schedule and the Minimum/Maximum Amounts
The last question you need to ask before launching a Title III crowdfunded offering is: when do we really need the money?
Setting the Offering Closing Date
You must first set a closing date for your crowdfunded offering. Crowdfunded offerings are not open-ended; they must close at a specific date and time set forth in the Form C disclosures.
Regulation Crowdfunding requires that crowdfunded offerings last a minimum of 21 days. Even if it takes only two or three days to raise your minimum offering amount, you cannot grab the cash until 21 days have passed.
This is a cooling-off period required by the SEC to give investors more time to study your company and possibly withdraw their investments if they get cold feet or a better opportunity comes along, and give you time to fine-tune and update your offering documents to reflect the latest changes,.
You can set as long a period as you like for your crowdfunded offerings, although periods of 90 to 180 days will be commonplace, and periods of more than a year probably will be discouraged.
You may be able to extend the closing date of your offering if you find yourself close to achieving your minimum offering amount, but you will have to give the portal at least five business days before the scheduled closing date to process and post the extended closing date.
And the portal will be required to give existing investors five days in which to reconfirm their investments. If an investor fails to reconfirm an investment within the five-day period, the investment is canceled and the investor gets the money back.
An extended closing date may give your investors additional time to get cold feet and pull the plug on their investments, as they will be able (as they always were) to withdraw their investments up to forty-eight hours before the extended closing date.
Also, the funding portal is almost certain to charge your company an additional fee for keeping the offering documents posted for an extended period of time. All in all, if your offering has generated lots of investments within the scheduled offering period, it may be advisable to take the money and run.
Setting a Minimum Offering Amount
Regulation Crowdfunding allows you to set a single target amount for your crowdfunded offering, but most issuers will opt for the so-called min/max offering, with a minimum offering amount they will accept and (sometimes) a maximum offering amount.
Even without a maximum offering amount, it is recommended that you set a minimum offering amount to hedge your bets in case your target amount proves unrealistic.
So, for example, you can stipulate in your Form C disclosures that you are seeking to raise $500,000, but with a minimum offering amount of $200,000. If at least $200,000 is raised by the scheduled closing date, the offering is successful and will close even though you didn’t raise the full $500,000.
Keep in mind, though, that crowdfunded offerings are all or nothing: if the minimum offering amount you set has not been raised by the scheduled closing date, the offering has failed and your funding portal will be required to return any investments that have been made to the investors.
Setting a Maximum Offering Amount
You also have the option under Regulation Crowdfunding to set a maximum offering amount for your crowdfunded offering, such that the offering automatically closes if the maximum is reached prior to the scheduled closing date.
If your crowdfunded offering is wildly successful, and you raise the full amount of capital you need in twenty-one days or less, why would you want to shut off the spigots?
The only requirement in Regulation Crowdfunding is that you state in your Form C disclosures what you will do with any excess proceeds of your offering.
Also, by setting a maximum offering amount, if your offering is oversubscribed, you will be forced to decide which investors you will accept and which you will reject (or accept only a percentage of each investor’s subscription to keep everyone happy), and describe in your Form C disclosures how you will handle the oversubscription.
Managing and Marketing Your Crowdfunded Offering
You have prepared the offering documents for your Title III crowdfunded offering and found the perfect funding portal to handle the offering.
You have posted your offering documents to the portal, and either you or the portal has filed the Form C disclosures with the SEC. The portal has listed your offering on its website.
Congratulations! You have now reached the starting gate.
To get to the finish line, you now have to raise the money within your scheduled offering period.
While your funding portal has helped you get to the starting gate (indeed, you could not have gotten there without it), there are only a limited number of things the portal can legally do to help you get to the finish line.
At the end of the day, a successful crowdfunded offering depends entirely on you—the strength and sex appeal of your business plan, the extent, and depth of your social networks, and your ability to persuade prospective investors that you and your co-founders have a winner on your hands.
Your Offering Announcement: Where It Should Go, Where It Can’t Go
The success of any crowdfunded offering depends on your company’s ability (and its founders’ ability) to leverage its networks—on social media and otherwise—to find investors willing to shell out their hard-earned money in exchange for a piece of your company.
But you cannot—cannot—send these materials to your website, your social media pages, or anyone else. They exist only on the funding portal, and that is the only place online where people should be able to find them.
What you can send to your social networks—once and once only—is a notice, in the form prescribed by Regulation Crowdfunding, directing investors to the funding portal that is handling your offering.
Under Regulation Crowdfunding, the notice may contain no more than the following:
A statement that the issuer is conducting an offering, the name of the funding portal conducting the offering, and a link to the portal’s website.
The terms of the offering, including the number of securities being offered, the nature of the securities, the price of the securities, and the closing date of the offering period.
Factual information about the legal identity and the business location of the issuer limited to the name of the issuer, the address, the phone number, the website URL of the issuer, an email address for a representative of the issuer, and a brief description of the issuer’s business.
The notice would be similar in appearance to tombstone ads for initial public offerings permitted by the SEC’s Rule 134, except that the Regulation Crowdfunding notice must direct potential investors to the funding portal.
One of the guiding rules of Regulation Crowdfunding is that all communications between an issuer and investors during the offering period must take place not directly but only through the funding portal to ensure that all investors receive the same information at the same time and that all communications are available for public scrutiny in one place only.
Regulation Crowdfunding does not place restrictions on how the issuer distributes these notices. An issuer could place these notices on its own website, on various social media websites, or in newspaper and magazine ads (theoretically, the notice could be given over radio and television as well.
But the cost is likely prohibitive to most issuers), and the notice would direct those interested to the funding portal page, where they could access the Form C disclosures and supplemental materials necessary to make informed investment decisions.
Posts on Facebook, tweets on Twitter, LinkedIn updates, and the like that do not follow these limitations would violate Regulation Crowdfunding and legally disqualify your crowdfunded offering.
The prohibition on advertising the terms of the offering and related requirements apply to people acting on behalf of the issuer. For example, those acting on behalf of the issuer are required to identify their affiliation with the issuer in all communications on the funding portal’s platform.
Note also that if an issuer is offering securities under another SEC exemption at the same time as it is offering securities under Regulation Crowdfunding, the other offering might have to limit its advertising activities in order to avoid being integrated with the crowdfunded offering.
Advertising and Promoting Your Offering on the Funding Portal
Regulation Crowdfunding requires funding portals to maintain communications channels enabling issuers and investors to communicate directly with each other; such channels include chat rooms, discussion threads, frequently-asked-questions pages, webcasts, podcasts, and webinars.
Issuers are not only allowed but encouraged to communicate about the terms of the offering through these channels, as such communications will be publicly available for view by all potential investors.
Regulation Crowdfunding requires that any communication from the issuing company, its founders, or other management team members be clearly identified as such.
Also, any communications made on the portal by someone who has received compensation or a gift from the issuing company, its founders, or other management team members must state clearly the compensation or gift received by the person making the communication (for example, in paid reviews or testimonials by celebrities who receive gifts in exchange for their endorsement).
The downside, of course, is that funding portal channels may be used by people—such as competitors—who masquerade as investors in an effort to solicit confidential information about your company or post negative comments designed to frighten investors away from your offering.
Regulation Crowdfunding allows communications on funding portals only by investors who have opened accounts with the portal, and presumably, the portal will conduct the necessary due diligence to ensure that those claiming to be investors are indeed who they say they are. Still, despite a portal’s best efforts, a few bogus email accounts are likely to find their way over the threshold.
The only remedy offered for such activities is to do the same thing you would do if the posting appeared elsewhere on the Internet: find out who the posting is from and then out them publicly on the funding portal. Issuers should also notify the funding portal of any such activities in the hopes it may take action to ban offenders from the portal.
Advertising and Promoting Your Offering Elsewhere
In two words, you can’t. Other than posting or sending the Regulation Crowdfunding notice to folks, you cannot advertise or promote your offering other than through the funding portal.
Each member of your management team will need to be made aware of this requirement, as each no doubt will send emails, post on his social media pages, and generally do everything he can to get the word out about your offering to the maximum number of potential investors.
What you and your management team need to understand is that even a single communication in violation or Regulation Crowdfunding may disqualify the entire offering and force you to withdraw it from the funding portal, at great cost and potential embarrassment in the marketplace.
Can the Funding Portal Help You Advertise Your Offering?
In a word, no. A cryptic statement in Regulation Crowdfunding says that a funding portal is permitted to “highlight issuers or offerings based on objective criteria that would identify a large selection of issuers.”
The criteria used, however, cannot implicitly endorse one issuer or offering over others, and the criteria must be consistently applied to all issuers and offerings.
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.
Similarly, a funding portal is permitted to provide search functions or other tools that allow investors and potential investors to search and categorize the offerings on the portal based on objective criteria.
In addition, Regulation Crowdfunding allows a funding portal to (1) categorize its offerings into general subject areas so a potential investor can find an offering, and (2) give potential investors the ability to create automated email notifications about offerings on the portal.
A funding portal is prohibited from endorsing specific offerings or receiving special or additional compensation for identifying or highlighting an issuer or offering on the platform. So, for example, promotions such as Kickstarter’s “Deals We Love!” highlights on its homepage would violate Regulation Crowdfunding.
Updating or Changing Your Offering Documents Midoffering
Time does not stand still once an issuer’s offering documents are filed with the funding portal and the SEC. Change happens, and an issuer will want to keep its offering materials as up to date as possible to reflect changes such as:
The addition of new members to the management team The withdrawal of any member of the management team
News articles and media coverage about the company that appear during the offering period
Changes in the company’s product and service offerings
News that may negatively impact the company’s success, such as a competitor’s introduction of a similar or identical product, or a regulatory change making the company’s service less desirable
Issuers are not only allowed but encouraged to update their offering documents. The supplemental materials may be updated at any time by posting them to the funding portal (and, perhaps, paying an additional fee—this will be up to each individual portal).
What If You Made a Mistake in Your Offering Documents?
Despite your best efforts to get everything right when filing your initial offering documents, you may find out later that something in the offering documents is wrong when you or a member of your management team discovers the error or when someone responding to your offering on the funding portal points it out to you.
When it comes to offering document mistakes, there are three levels of concern.
Under Regulation Crowdfunding, “insignificant deviations” do not affect a crowdfunded offering’s exemption under Title III. In order for a mistake to qualify as an insignificant deviation, an issuer must show that:
The failure to comply with a term, condition, or requirement of Regulation Crowdfunding was “insignificant with respect to the offering as a whole”
The issuer made a reasonable and good faith effort to comply with all terms, conditions, and requirements of Regulation Crowdfunding
The issuer did not know of the failure to comply, where the failure to comply with a term, condition, or requirement was the result of the failure of the funding portal to comply with the requirements of Regulation Crowdfunding, or such failure by the funding portal occurred solely in offerings other than the issuer’s offering
The SEC acknowledges that whether a deviation from the requirements would be “significant to the offering as a whole” will depend on the facts and circumstances of the offering and the deviation.
Given the serious penalties that could attach to a mistake in crowdfunded offering documents (including loss of the Title III exemption, liability to investors in a class-action lawsuit, action by state and federal regulators, and possibly personal liability for the offending company’s founders and management team members).
An issuer should never assume that a mistake is an insignificant deviation from the Regulation Crowdfunding rules. If the issuer can correct the mistake in time, it should.
A material mistake—any error that could potentially mislead an investor into making the wrong investment decision—should be corrected as soon as possible on the funding portal, and an announcement should be made on the portal’s communications channels.
If the mistake affected the issuer’s Form C disclosures, a formal Amendment to Offering Statement, using Form C-U, should also be filed on EDGAR.
When a material change to an issuer’s offering documents is announced, the following actions must take place:
The funding portal must send notice to committed investors that their investments will be canceled unless reconfirmed within five business days.
Investments that are not reconfirmed by their investors must be canceled.
Upon canceling an investor’s investment, the portal must send notice of cancellation to the investor, together with the reason for cancellation and a statement of the investor’s refund amount.
If the material change occurs within five business days of the offering’s scheduled closing date, the offering period must be extended for five business days to give investors sufficient time to reconfirm their investments.
If the mistake is so serious as to render the offering documents meaningless, seriously misleading, or in material violation of Regulation Crowdfunding, the issuer will need to consult with the funding portal and decide if the offering should be withdrawn.
Regulation Crowdfunding permits the issuer to withdraw an offering at any time and for any reason prior to the scheduled offering date. The issuer cannot, however, accept any money from investors (even if the offering has reached the minimum offering amount), and the portal must return all investor funds to investors.
Either the issuer or the portal would file Form C-TR on EDGAR announcing the withdrawal of the offering. It is also advised that the issuer and portal agree on a statement to be made to investors explaining the reason for the offering’s withdrawal so the issue is not precluded from making a subsequent crowdfunded offering with improved and compliant offering documents.
Closing Your Offering Early, or Quitting While You’re Ahead
Regulation Crowdfunding allows issuers to terminate their offerings before the scheduled closing date and take whatever money has been invested up to that point, as long as:
At least twenty-one days have elapsed since the offering commenced
Investors are given five business days’ notice of the new closing date
Investors are allowed to cancel their investments up to forty-eight hours prior to the new closing date
The issuer notifies investors whether or not it will continue to accept investments during the final forty-eight hours
At the time of the new deadline, the issuer has exceeded its target offering amount or minimum offering amount
Filing Progress Reports with the SEC: Form C-U
While an offering is pending, issuers (or the portals acting on their behalf) must file the following documents on EDGAR:
Any changes to the Form C Disclosures on Form C-A
A progress update on Form C-U within five business days after reaching 50 percent of the target offering amount
Another progress update within five business days after reaching 100 percent of the target offering amount
A final Form C-U to disclose the total amount of securities sold in the offering and the total amount of investment, among other things
Issuers may rely on a funding portal to make publicly available on the offering platform frequent updates about the issuer’s progress toward meeting the target offering amount, but an issuer relying on the portal’s progress reports must still file a Form C-U at the end of the offering to disclose the total amount of securities sold in the offering.
After Your Successful Crowdfunded Offering Is Completed
If your offering fails to reach its target amount (or the minimum offering amount you specified in your offering documents) by the scheduled closing date, the ball game’s over. The funding portal takes down your listing, those who invested in your offering get their money back, and you and your management team go back to square one.
If your offering reaches its target amount within the specified offering period, congratulations! I predict you and your co-founders will be enjoying a very wild (and well deserved) celebration indeed. Just make sure you don’t use any of your investors’ money to fund the party (they really, really don’t like that).
And don’t celebrate for too long. You and your management team have lots more work to do.