Co-authored by Molly Brown
Under the current securities laws, if you are a company in need of capital, you can pursue several legal avenues to raise funds in a private offering exempt from registration. The most well known one, and the most frequently used for the last several decades, is the exemption from registration provided by Rule 506 of Regulation D. Rule 506 generally provides that companies may procure unlimited investments from an unlimited number of “accredited” investors. To be an “accredited” investor, however, potential subscribers have to meet certain high standards promulgated under Rule 501 of Regulation D. For example, persons that have (i) an individual net worth or joint net worth with their spouses in excess of $1,000,000, or (ii) an individual income in excess of $200,000, or joint income with their spouses in excess of $300,000, in each of the two most recent years, are generally considered “accredited” investors.
One of the drawbacks of Rule 506 is that not all companies that want to raise capital have access or are able to procure investments from accredited investors. Regulation Crowdfunding (or Regulation CF), adopted as a result of the Jumpstart Our Business Startups (JOBS) Act of 2012, addresses this concern by allowing anyone to invest, subject to certain limitations. Regulation CF, which became effective on May 16, 2016, enables companies to raise capital across state lines in small amounts from numerous investors through an online platform. Although the new crowdfunding rules provide for “democracy in investing” and remove certain other limitations associated with pre-existing exemptions, they also introduce new restrictions for investors and companies to consider when choosing an exemption, some of which are discussed below in the form of nine questions and answers.
1. Is there a cap on the dollar amount that can be raised from a company relying on the Regulation Crowdfunding exemption?
A company issuing securities in reliance on Regulation CF is permitted to raise a maximum aggregate amount of $1 million in a 12-month period. Amounts raised under other exempt (non-crowdfunding) offerings are not calculated for purposes of determining whether the cap has been reached.
2. Who can invest in a Regulation Crowdfunding offering and are there any limitations that apply?
Anyone may invest in an offering conducted under Regulation CF, subject to the following limitations per investor in all Regulation CF offerings over the course of a 12-month period:
- For investors with annual income or net worth below $100,000, the limit is the greater of (i) $2,000 and (ii) 5 percent of the lesser of annual income or net worth; and
- For investors with both annual income and net worth above $100,000, the limit is 10 percent of the lesser of annual income or net worth.
During the 12-month period, the aggregate amount of securities sold to an investor through Regulation CF offerings may not exceed $100,000, regardless of the investor’s annual income or net worth.
Companies may rely in good faith on an intermediary’s determination that an investor is in compliance with the per-investor investment limit, so long as the company has no knowledge to the contrary. Intermediaries may rely in good faith on an investor’s representation that such investor is in compliance with these requirements.
3. What companies or persons are eligible to rely on the Regulation Crowdfunding exemption?
All U.S. companies may use the Regulation CF exemption to raise money from residents of various states excluding, among others (i) any company that already is a reporting company under the Securities and Exchange Act of 1934, as amended, (ii) certain investment companies, and (iii) companies that have no specific business plan or have indicated that their business plan is to engage in a merger or acquisition with an unidentified company. This last restriction may prevent many search funds or real estate funds from engaging in crowdfunding. In addition, existing securityholders of an eligible company may not rely on this exemption to sell securities.
4. Are there any restrictions on resales of securities sold in a Regulation CF offering?
Resales of securities purchased in a Regulation CF offering are generally prohibited for a period of one year from the date of purchase, subject to certain exceptions when the securities are transferred to an accredited investor or a family member, among others.
5. Is the participation of an intermediary required in a Regulation CF offering?
Yes. According to the "Regulation Crowdfunding: A Small Entity Compliance Guide for Issuers" that the Securities and Exchange Commission (SEC) published on May 13, 2016 (SEC Guidance), each Regulation Crowdfunding offering must be exclusively conducted through one online platform. The intermediary operating the platform must be a broker-dealer or a funding portal that is registered with the SEC and the Financial Industry Regulatory Authority. Such intermediary must, among other things, provide investors with educational materials regarding the company and the offering and provide communication channels to permit discussions about offerings on the platform. However, the intermediary may not offer investment advice or recommendations or hold or manage investor funds or securities.
6. Is general solicitation and advertisement of a Regulation CF offering permitted?
According to the SEC Guidance, a company may not directly advertise the terms of a Regulation CF offering except in a notice that directs investors to the intermediary’s platform and includes only specific limited information about the offering such as (i) the amount and type of securities offered, (ii) the price of securities, (iii) the closing date of the offering period, and (iv) certain factual information about the company and its business. The company, however, may communicate more information about the offering to investors through communication channels provided on the intermediary’s platform.
7. What disclosures or filings must companies relying on the Regulation CF exemption make with the SEC?
The Company must electronically file an offering statement on Form C, which asks for information similar to that required for a Securities Act registration statement. Form C is not subject to SEC review. Amendments to Form C must be filed with the SEC for changes, additions or updates to original Form C that are deemed material. According to the Guidance, unless the intermediary provides frequent updates on its platform regarding the progress of the company in meeting the target offering amount, the company must file a form with the SEC to update the investors on such progress within five business days after reaching 50 percent and 100 percent of its target offering amount.
Form C will contain two years of the company’s financial statements prepared in accordance with generally accepted accounting principles, which must be (i) reviewed by a public accountant for offerings over $100,000, or first-time offerings over $500,000, and (ii) audited for non-first-time offerings over $500,000.
Within 120 days of the end of each fiscal year, the company must post to its website and file with the SEC an annual report, which will require information similar to the offering statement on Form C.
8. Are offerings conducted under Regulation CF subject to the “bad actor” disqualification provisions?
Yes. Regulation CF includes “bad actor” disqualification provisions that generally prohibit a company from conducting the offering if any company director, officer, greater than 20 percent owner or the broker involved in the offering, among others, have been subject to a disqualifying event such as being convicted of, or subject to court or administrative sanctions for, securities fraud or other violations of specified laws.
9. Do state laws apply to Regulation CF interstate offerings?
The general rule is that securities sold in an interstate Regulation CF offering are “covered securities” and, hence, they are not subject to state law registration and qualification requirements. However, companies relying on Regulation CF for an interstate offering must still review the securities laws of the states where they will be selling Regulation CF securities because they may have to comply with certain fee and notice filings provisions contained in those states’ securities laws. In addition, state regulators have the authority to, among other things, investigate and bring enforcement actions for any unlawful conduct of a broker, dealer, or funding portal during the course of a Regulation CF interstate offering.
Note that companies that wish to engage in crowdfunding efforts only within the borders of a certain state must ensure that they comply with that jurisdiction’s intrastate crowdfunding rules, which may have different requirements than SEC’s Regulation CF. The North American Securities Administrators Association has published various resources on its website that track developments in this area of the law on a state-by-state basis. Certain jurisdictions, such as Ohio, have not adopted specific rules related to intrastate crowdfunding. Companies that are seeking to raise capital from a “crowd” comprised exclusively of residents of a state that does not have an intrastate crowdfunding exemption must either register the offering with that state’s securities commission or find another exemption to rely upon, if applicable.
In addition to the traditional rule 506 (or now called rule 506(b)) and Regulation CF, there are other exemptions available that may be a better choice for you depending on the particular needs of your business. These other exemptions include offerings conducted under Rule 504, Rule 505 and Rule 506(c) of Regulation D, or Regulation A or A+, Tier 1 and Tier 2 offerings. Each of these options has its advantages and disadvantages. This is why, if you are trying to raise capital for your business, it is important to consult with legal counsel to make sure that you are relying on the exemption that best meets your business goals.