Types of Crowdfunding and Regulations

There’s more to the story than just Regulation Crowdfunding when it comes to new rules and regulations from the SEC. We go into detail here on what crowdfunding is and what startups need to know ahead of time.

Not all (crowd)funding is the same

There are three types of crowdfunding: rewards, debt, and equity.

  • Rewards crowdfunding is what you see on Kickstarter or Indiegogo: in exchange for a small amount of support, people are given rewards (pre-orders, services, recognition/swag). Equity crowdfunding is not Kickstarter: if you are interested in selling equity in your startup or borrowing money from the customers of your small business, you must realize you are selling securities in your business and that this is a highly regulated activity.
  • Debt crowdfunding encompasses several different types of lending. These include mini-bonds, peer-to-peer lending and invoice financing. Some of VentureWell’s Powering Agriculture Xcelerator Innovator teams have benefited from Kiva, a debt crowdfunding platform, as a way to provide their end-users with crowdsourced loans from around the world.
  • Equity crowdfunding is what we’re talking about here: it is a mechanism that enables investors to fund startup companies and small businesses in return for equity. Investors give money to a business and receive ownership of a small piece of that business.

Equity crowdfunding is a new–and highly regulated–ball game. There is more work involved than putting together an amazing video, great rewards, and photos of your community for a Kickstarter campaign.

The regulations

In order to fully address the impacts of the new rules, we need to understand all of the rules related to crowdfunding that have rolled out in recent years through President Obama’s 2009 Jumpstart Our Business Startups Act (JOBS Act).

Every time a startup raises capital in exchange for shares of its company, the transaction must be registered with the Securities and Exchange Commission (SEC), unless an exemption applies. The JOBS Act added two new, critical exemptions for startups to broaden their fundraising options: Rule 506(c) of Regulation D and Regulation Crowdfunding.

These exemptions are a big deal, because registering securities with the SEC without an exemption involves hundreds of hours of paperwork (the required Form S-1 has an estimated time burden of 972.32 hours) followed by required public financial reporting annually and quarterly. Through the new exemptions, the JOBS Act greatly reduces the amount of paperwork required and accommodates for “the power of the Internet” to create a wider pool of investors. Startups need to make sure they understand the exemptions in order to abide by them appropriately.

Title II
The first change the JOBS Act introduced was to allow startups to publicly fundraise for the first time. This was done through Title II of the JOBS Act in September 2013, which lifted the longstanding ban on general solicitation by splitting the previously existing Rule 506 of Regulation D into 506(b) and 506(c).

506(b)
Rule 506(b), the original exemption, allows startups to:

  • Raise an unlimited amount of money
  • Raise money from accredited investors and 35 non-accredited investors
  • Rely on an investor’s word that they are accredited

The key benefit here is a reduction in paperwork: since you can rely on an investor’s word that they’re accredited, the average time it takes to fill out the form (Form D) is four hours. This is the old, reliable exemption that most seed-stage startups have used for decades.

One caveat is that is that if you want to use 506(b) you cannot speak publicly about selling stock in your company. You can’t present the offering in any seminar or meeting where attendees have been invited by any general solicitation or general advertising. If you do so without realizing it, you could end up needing to use 506(c).

506(c)
Rule 506(c) was the new addition. Now if a startup wants to advertise the sale of its shares publicly (websites, public events, billboards, TV, etc.) it can use rule 506(c):

  • Raise money through general solicitation
  • Cannot raise money from unaccredited investors
  • Must take “reasonable steps” to confirm that all investors are accredited (meaning reviewing income statement, tax returns, etc.)

While 506(c) allows startups to raise money publicly, the investors have to be accredited (i.e., they have to meet certain wealth or income requirements) and the burden is on the entrepreneur to verify that they’re accredited. This is important to do correctly, since making a mistake can result in the cancellation of your round. We have seen this happen before: a team raised money using 506(c), but did not verify that investors were accredited. It turned out that the investors were not accredited and the startup had to return the funds. The consequences can be worse: failure to get verification could also freeze the company out of doing any offerings for a full year.

Our advice to startups is to make sure to work with a good lawyer who can recommend the appropriate exemption and take the right steps to ensure that you comply.

Title III: Regulation Crowdfunding
The newest legislation from Title III of the JOBS Act–Regulation Crowdfunding, which went into effect on May 16–opens up the playing field to allow non-accredited investors to participate in publicly advertised financings. Here’s how this one works:

  • Non-accredited investors can now participate in equity investing transactions in a limited way. People can invest:
    • The greater of $2,000 or 5 percent of their annual income or net worth, if annual income or net worth of the investor is less than $100,000;
    • 10 percent of their annual income or net worth (not to exceed an amount sold of $100,000), if annual income or net worth of the investor is $100,000 or more
  • A startup can raise up to $1M in 12 months via crowdfunding.
  • Varying levels of public financial disclosure are required depending on how much money is raised, including the price per share, audited financial statements, information about majority shareholders, along with public annual reports post-investment.

Crowdfunding transactions must take place through a broker-dealer or funding portal registered with the Financial Industry Regulatory Authority (FINRA). So far there are only a handful of companies that have applied for funding portal status: CrowdBoarders, FlashFunders, NextSeed, SeedInvest, StartEngine and ZacksInvest.

Note: none of the content in this article is intended as legal advice.

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