Equity Crowdfunding After Six Months: The Early Results

Authored by
Kate Georgen, David Feinberg, Adam Sonnenschein and David Romanow (research and statistics)

On November 16th, equity crowdfunding celebrated its six-month anniversary. The SEC’s new light-handed regulatory scheme (“Regulation Crowdfunding”), effective since mid-May, permits an issuer to sell equity securities to an unlimited number of investors, regardless of income or net worth.

From a standing start, Regulation Crowdfunding is becoming increasingly visible as a funding alternative for start-ups and smaller companies. As of the six-month mark, 152 issuers have filed with the SEC to commence an offering and 21 companies have registered with the SEC as “portals” to manage more than 14,000 investments.

The early issuers come from wide range of industries. As might be expected, technology companies are most active, with 45 offerings, followed by retail (16), breweries (13), entertainment (9), real estate development (7), education (7), and small but growing numbers in the life science, agriculture, food and beverage, hospitality, energy, manufacturing and recreational industries. Also unsurprising, California-based companies are most active (44 issuers), but in a quirk that is hard to explain, there are significant regional differences in acceptance of this approach to financing. For example, there have been more than 27 crowdfunding offerings started by Silicon Valley tech companies, but only 3 by  Boston area issuers. Florida, New York, Texas and Illinois trail California with 17, 13, 10 and 7 issuers, respectively. So far, only 5 Massachusetts companies have claimed the Regulation Crowdfunding exemption. One of the three Boston-area issuers, Beta Bionics, a biotech company developing a wearable device that autonomously manages blood sugar levels for patients with type 1 insulin-dependent diabetes,  was the most successful of the early filers  in terms of how quickly the offering reached its maximum limit.

Crowdfunding offerings are occurring on over 20 different online portals. The most widely used currently include Wefunder, NextSeed, DreamFunded, FlashFunders, StartEngine Capital, SeedInvest, Opendeal, Indie Crowdfunder and TruCrowd. The rewards-based crowdfunding giant, Indiegogo also just joined the equity crowdfunding scene this week through a partnership with MicroVentures. Portal compensation rates range from 2% - 10% of the total crowdfunding raise, with the top player, Wefunder, claiming 3% and Indiegogo claiming 7%. Some portals also require an additional equity interest.

The investment documents look like private placement documents, with the vast majority of offerings to date using common stock subscription agreements, SAFE instruments (i.e. agreements for future equity), debt (i.e. promissory notes and revenue loan agreements) and convertible notes as the security.

In addition to potentially providing essential start-up funds, Regulation Crowdfunding is a way for companies to build a community around their business and their mission. Beta Bionics successfully raised $5 million from Eli Lilly, but chose to pursue additional equity crowdfunding for the community it offered. In its SEC filing documents, the Massachusetts public benefit corporation stated, “the overriding purpose of this public offering is to give the [Type 1 Diabetes] community an opportunity to take a direct ownership stake in Beta Bionics and a sense of commitment to it – to literally own a piece of what we have been building all of these years.” The “community” benefit is unique to Regulation Crowdfunding and is particularly relevant to today’s new companies, including benefit corporations with a social mission, local businesses, and companies that want to grow a more active and committed base of supporters.

For the most up to date statistics, see www.wefunder.com/stats and the SEC database.

As with most fundraising options there are pros and cons to using Regulation Crowdfunding. We put together an overview of the legal requirements, below, and discuss some factors that companies should be thinking about before pursuing a Regulation Crowdfunding offering.

In a nutshell, the basic elements of Regulation Crowdfunding are as follows:

  • Issuers can sell up to $1 million in securities to an unlimited number of non-accredited investors in a 12-month period;
  • Investors with annual income and net worth each equal to or greater than $100,000 can invest up to $100,000 in crowdfunding start-ups in a 12-month period (as long as their investments do not exceed the lesser of 10% of their annual income or 10% of their net worth);
  • Investors with less than $100,000 in annual income or net worth can invest up to the greater of $2,000 or 5% of the lesser of either their annual income or net worth in a 12-month period;
  • Crowdfunding offerings will need to be conducted through an online portal that serves as an intermediary between the issuer and the investors;
  • Disclosure documents will need to be publicly filed with the SEC prior to the offering and made available to investors at least 21 days prior to a closing; and
  • At least one post-offering annual report will need to be made; Issuers, with input from their counsel and advisors, will need to make sure that the initial disclosure and any annual reports comply with Regulation Crowdfunding.

A more detailed Q&A on Regulation Crowdfunding can also be found at the end of this Insight Note.

In the legal community there are several concerns about the regulations, namely: (1) the potential costs of disclosure requirements, (2) the costs of having a large number of non-accredited investors, and (3) the impact of crowdfunding on future equity rounds or a stock-for-stock sale of the company.

We think, and the Regulation Crowdfunding filings to date seem to show, that the burdens of disclosure requirements are overstated, particularly for early-stage start-ups. We also think that the concerns about managing non-accredited investors and their impact on future equity rounds can be addressed through thoughtful documentation. While the costs of disclosure will vary by company, they should be de minimis for early-stage start up companies with little financial information or history to disclose. And while having a large number of nonaccredited investors on the cap table may require some planning from a securities law and an administrative perspective, these are mechanics that experienced counsel should be able to navigate.

We highlight some strategic suggestions below:

  • Keep it Simple.  To date, most Regulation Crowdfunding issuers are offering common stock, agreements for future equity and convertible notes. A form of preferred stock with a liquidation preference can also be attractive. Whichever security is offered, issuers should optimize for simplicity by, for example: (1) Offering a separate class of common stock with de minimis voting rights; (2) Designating a representative to act on behalf of crowdfunding shareholders for administrative processes such as amending investment documents or executing other important transaction documents where shareholder consent is required; and (3) Where applicable state law permits, adopting provisions in the charter, by-laws, or subscription documents enabling electronic delivery of stockholder notices.
  • Protect Future Financings.  Non-accredited crowdfunding investors should not have rights to participate in future rounds of financing because disclosure for non-accredited investors increase the regulatory burdens for subsequent financing rounds. For the same reason, if a crowdfunding round involves convertible notes, non-accredited noteholders should not have any optional conversion rights in subsequent scenarios like a sale transaction or at maturity (rather, conversion should be mandatory). Crowdfunding investors should also be party to the lock-up obligations and drag-along rights that subsequent institutional investors may require, ideally through provisions in the corporate charter rather than separate agreements.
  • Protect Future SalesIf a crowdfunded company is sold in a stock-for-stock transaction, the presence of a large number of non-accredited investors (generally more than 35) may restrict the purchaser’s ability to pay with securities because the traditional securities exemptions will not be available. To avoid this, consider including a provision in the Certificate of Incorporation providing that, in a sale transaction, any non-accredited stockholders may be treated differently than other stockholders, such that they may receive cash in lieu of stock.
  • Consider Concurrent OfferingsRegulation Crowdfunding permits equity crowdfunding offerings to occur concurrently with other private placements, as long as the issuer complies with the exemption requirements of each type of offering. With guidance from legal counsel, a crowdfunding offering may be part of a larger fundraising effort without integration of the crowdfunding offering into the larger offering.

In our view, Regulation Crowdfunding is a promising alternative finance vehicle and can play an important role in start-up fundraising. The eco-system is still rapidly evolving and much remains to be seen, but the presence of an increasingly robust market of online portals and early-stage companies willing to utilize Regulation Crowdfunding suggest that it has the potential to substantively fill a market gap in early-stage financings.

Crowdfunding Q&A
1. Who can (or cannot) take advantage of Regulation Crowdfunding?

Any issuer that can offer equity or convertible debt can participate in crowdfunding, except foreign companies, public companies, certain investment companies, companies with no specific business plan or specify that their business plan is to engage in a merger or acquisition with an unidentified company. Companies that have completed a financing under Regulation Crowdfunding and subsequently fail to comply with the annual reporting requirements, and companies that have committed or are affiliated with someone who has committed securities fraud under §227:530 of Regulation Crowdfunding are also precluded from participating in crowdfunding offerings.

2. How much can an issuer raise?

An issuer can raise up to $1 million through crowdfunding from an unlimited number of investors in a 12-month period. In addition to crowdfunding, issuers can also engage in concurrent funding rounds with accredited investors using other SEC regulations. Because solicitation requirements vary by exemption, careful attention should be paid ahead of time to how solicitations are made in concurrent offerings.

3. How much can an investor invest?

An investor can calculate how much he, she or it can invest (in aggregate) in a 12-month period based on annual income and net worth:

  • If either annual income or net worth is less than $100,000, an individual can invest whichever is greater: $2,000, or 5% of whichever is less: annual income or net worth.
  • If both annual income and net worth are each equal to or more than $100,000, an individual can invest whichever is less: 10% of annual income, or 10% of net worth.
  • Individuals can invest no more than $100,000 through crowdfunding investments in a 12-month period.

Note: Investors may calculate their annual income and net worth jointly with a spouse, in which case the aggregate crowdfunding investments of both spouses in a 12-month period may not exceed the limit that would apply to an individual investor at that income and net worth level.

4. Who is responsible for making sure the investor complies with these limits?

Crowdfunding offerings must use a web based or online platform run by a registered broker or registered crowdfunding portal that serves as an intermediary between the issuer and the investors. In addition to providing access to disclosure documents, managing paperwork and safeguarding investor funds, the intermediary is responsible for determining whether an investor satisfies the investment limits (the issuer could be on the hook, however, if the issuer knows the investor has exceeded or will exceed the investment limits by participating in the issuer’s crowdfunding). The intermediary is entitled to rely on each investor’s representations concerning annual income, net worth and the amount of other investments (unless there is reason to question the reliability of the representation).

5. Can investors resell their securities?

Within the first year from the date the securities are issued, an investor can resell to (i) the issuer of the securities, (ii) accredited investors, (iii) members of the investor’s family or the equivalent, a trust controlled by the investor, a trust created for the benefit of a member of the investor’s family or the equivalent, or in connection with the death or divorce of the investor or other similar circumstances, or (iv) as part of an offering registered with the SEC.

6. Can an issuer conduct a crowdfunding offering on its own?

No. All crowdfunding transactions must be conducted using a registered broker portal or registered funding portal, and using exclusively that intermediary’s online platform.

7. Can an issuer advertise a crowdfunding offering?

Yes, but only if certain restrictions are observed. Any notice that advertises an offering must direct the investor to the intermediary’s platform on which additional information about the issuer and the offering may be found. A notice can include no more than the following:

  • A statement that the issuer is conducting the offering, the name of the intermediary through which the offering is being conducted and a link directing the investor to the intermediary’s platform;
  • The amount, nature, and price of the securities, and the closing date of the offering;
  • Name, address, phone number, e-mail and website of the issuer, and a brief description of the business of the issuer.

Issuers and affiliates of the issuer will also be able to communicate openly about the offering on the intermediary’s platform, provided the person identifies his or her relationship to the issuer and whether he or she receives any compensation for promoting the offering.

8. Can the intermediary platform draw attention to an issuer’s crowdfunding offering?

Yes, an intermediary may choose to highlight crowdfunding offerings on its platform or in its advertisements as long as the intermediary does not receive any compensation for highlighting any of the offerings, and as long as it uses objective criteria, such as the type of security being offered, geographic location of the issuer, industry of the issuer, etc., in deciding to highlight the selected offerings.

9.  When and what does an issuer have to disclose in a crowdfunding offering?

Companies using crowdfunding must file certain information required by Form C with the SEC prior to the start of an offering, and on the intermediary’s website at least 21 days prior to any sale of securities. Form C requires companies to disclose, among other things, the price (or the method for determining a price), target offering amount, deadline to reach the target amount, and whether or not the company will accept investments in excess of the target amount. The company must also list a description of the business and intended use of the crowdfunding proceeds, information about officers, directors and major shareholders (20% or more), as well as information about certain third-party transactions.

Perhaps most notably, companies must provide financial statements that may or may not need to be reviewed or audited. If the aggregate of an issuer’s crowdfunding offerings (including offerings of any predecessors or entities controlled by the issuer) during the last 12 months, plus the target offering, is:

  • $100k or less, disclosure must include certified information from the issuer’s tax returns;
  • $101k - $500k, disclosure must include financial statements reviewed by an independent public accountant (“reviewed financial statements”);
  • $501k - $1,000,000, disclosure must include reviewed financial statements if the offering is the company's first under Regulation Crowdfunding; if an issuer or its predecessor has conducted a prior crowdfunding offering, disclosure must include audited financial statements.
10.  Are there any ongoing reporting requirements?

Yes. An issuer must file with the SEC and post on its website an annual report containing certain information required in Form C, along with certified, reviewed or audited financial statements (whichever is available) and a description of the financial condition of the issuer. This obligation continues until the issuer:

  • Files at least one annual report and has fewer than 300 shareholders of record;
  • Files annual reports for at least three years and has less than $10,000,000 in total assets;
  • Repurchases all of the outstanding securities issued under the crowdfunding exemption, including repayment in full of any debt securities or complete redemption of any redeemable securities issued under the crowdfunding exemption;
  • Is required to file reports under certain sections of the Securities Exchange Act; or
  • Liquidates or dissolves its business.
11.  Can crowdfunding trigger requirements to report under certain sections of the Securities Exchange Act?

For most early-stage companies, no, but there are some caveats. Normally, under section 12(g)(1) of the Exchange Act, a company that has total assets exceeding $10 million and a class of securities held by either 2,000 persons or 500 non-accredited investors is required to register that class of securities with the SEC. But under Regulation Crowdfunding, the total number of persons holding a certain class of securities will not include holders of Regulation Crowdfunding securities as long as the issuer:

  • Is current in its ongoing reporting requirements under Regulation Crowdfunding;
  • Has total assets not exceeding $25 million; and
  • Has engaged a registered transfer agent to help manage Regulation Crowdfunding securities.
12.  What about state law?  Are state “blue sky” filings required?

No. Crowdfunding is intended to preempt state law. There are currently no state registration requirements for a crowdfunding offering. While Massachusetts recently proposed a state filing requirement, it has not yet become effective.

13.  Are there any “bad actor” disqualifications?

Yes, crowdfunding issuers are subject to the same “bad actor” disqualifications as they would be under a Rule 506 offering. Intermediaries are required to conduct a background and securities enforcement regulatory history check on the issuer and each officer, director and shareholder with voting equity of 20% or more.

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