Updates to Crowdfunding
Fundraising is essential for many startups, but the types of fundraising methods are limited. The traditional methods are bootstrapping, convertible notes, simple agreements for future-equity (SAFEs), and priced equity rounds. We have guided many founders through fundraising.
Equity crowdfunding is a newer option. Crowdfunding is meant to allow founders to accept small investments from a broad base of investors. True crowdfunding was not previously feasible: securities laws – intended to protect investors (discussed below) – made it difficult for companies to accept investments from investors not meeting certain financial requirements, a.k.a. “non-accredited investors” (discussed below).
In 2013, the Securities and Exchange Commission (SEC) proposed its first set of rules governing equity crowdfunding. However, equity crowdfunding has not been as popular as proponents had hoped. The cost of complying with the SEC’s restrictions often outweighed the capital a founder could raise through crowdfunding. (See our original posts about the proposed rules in 2014 and their efficacy.)
This blog post aims to help you understand equity crowdfunding in general and how the new amendments to Regulation Crowdfunding may make equity crowdfunding more attractive to founders.
First, some basics…
Why does the SEC regulate securities offerings?
The SEC’s mission is to protect investors. It does so by imposing significant disclosure requirements on companies that wish to offer securities through public markets (i.e., stock exchanges), and by restricting access to private offerings to investors able to bear the risks of those investments.
The SEC can enforce its rules through fines and penalties, which can pierce through the corporate shield and reach a founder’s personal assets. (We recommend that you ask an attorney for assistance with fundraising efforts to ensure that your fundraising efforts comply with securities laws.)
What is crowdfunding?
There are two types of crowdfunding for businesses: rewards-based crowdfunding and equity crowdfunding.
With rewards-based crowdfunding, a business creates a campaign (e.g., Kickstarter, Indiegogo) seeking contributions in exchange for rewards (often including preferential access to the final product). If the business’ announced funding goal is met, the business receives the funds and is then responsible for delivering on its campaign promises.
Equity crowdfunding focuses on investors instead of contributors. Regular people invest small amounts of money in exchange for a small stake in a company. These investors usually interact with the company through a representative.
Can non-accredited investors participate in equity crowdfunding?
The SEC classifies investors as accredited or non-accredited. Accredited investors are presumed sophisticated enough to understand and bear the risks of investing in private markets. The SEC recently broadened the criteria for who can qualify as an accredited investor. Non-accredited investors, by contrast, do not benefit from this presumption, and are essentially excluded from participating in the traditional forms of private-company fundraising.
Now, to the recent changes…
What recent amendments did the SEC make to Regulation CF?
The SEC has scaled back the compliance burdens associated with equity crowdfunding. Investors now have greater freedom to invest, and private companies (startups in particular) have greater latitude with fundraising. The amendments took effect on March 15, 2021. Here are the key points:
- Increase in offering limit
The offering limit for non-accredited investors has been increased from $1.07 million over any 12-month period to $5 million, which may shift the cost-benefit analysis when companies are considering equity crowdfunding.
Regulation CF no longer limits how much an accredited investor can invest. (This makes equity crowdfunding more closely resemble traditional private investments under Regulation D.)
- Broadening the class of permitted investors
Non-accredited investors may now use the greater of their annual income or net worth when calculating their limits on investment amount – this should result in non-accredited investors investing more.
- Extending the exemption from financial statement review requirements
A business offering securities under Regulation CF is required to file annual financial disclosures with the SEC. The disclosures must be made on Form C-AR and the first is due within 6 months of the completion of the offering.
The SEC has created an exemption to the filing requirement for companies that raise less than $250,000 within a 12-month period under Regulation CF. The exemption has been in place since the Regulation was first published and is periodically extended. The recent amendments have extended the exemption by an additional 18 months. This provides some additional temporary relief but is unclear if this exemption will be made permanent.
- Classifying Regulation CF securities as Covered Securities
Securities issued under an equity crowdfunding campaign that complies with Regulation CF will also be exempt from state registration. As we discuss here this is already the case with securities issuances that comply with other federal safe harbors.
What does all this mean for startup founders?
Time will tell if these changes make equity crowdfunding more attractive to founders. If you are interested in raising capital (via equity crowdfunding or otherwise) goodcounsel is here to help.