June 29, 2014

Crowdfunding Law Made Simple

photo by Twose
One of the topics I am often asked about these days, and one of the subjects that even smart, well-informed people seem to be most confused about, is "crowdfunding."  It seems appropriate, therefore, to offer a basic, high-level summary of the topic here on the N.C. Business & Banking Law Blog.   

Is crowdfunding just a bunch of hype?

Crowdfunding is a Really Big Deal.  Entrepreneurs and owners of businesses with growth potential have historically found it somewhat difficult to access the money that individuals and institutions have accumulated and want to invest without going through traditional gatekeepers (i.e., Wall Street).  This is largely because federal and state securities laws have limited their ability to raise investment capital from anyone other than well-to-do people in their immediate sphere of influence (in SEC-speak, "nonpublic offerings" to "accredited investors").  Most inventors and entrepreneurs do not have enough high net worth friends and business associates to raise large amounts of capital.  The securities rules were designed to protect investors that Congress or the SEC deemed vulnerable, but they had the unfortunate consequence of hampering the efficient flow of investment dollars.  However, recent changes to securities laws (including crowdfunding) are making it much less burdensome to borrow money or raise equity capital.   Crowdfunding will make it possible to raise investment money from virtually anyone.

What does the JOBS Act of 2012 have to do with crowdfunding?

The federal JOBS Act (Jumpstart Our Business Startups Act), enacted on April 5, 2012, required the SEC to write regulations to implement many of its various provisions.  More than two years later, the SEC has not yet finalized rules to implement Title III of the JOBS Act, known as the "crowdfunding" section of the law.  The JOBS Act also called for a new Rule 506(c) to allow a similar method of raising capital, but with important distinctions, which are covered below.

So what exactly is crowdfunding?

Many (perhaps most) of the media and many others who are unfamiliar with the JOBS Act have been referring to multiple methods of soliciting and raising investment as "crowdfunding."  This is often incorrect.  People are using the term to describe a number of different capital-raising methods, only two of which are actually crowdfunding.

Most people are familiar with websites like kickstarter.com and indiegogo.com that allow inventors and entrepreneurs to raise money for new products and services.   These sites existed before the JOBS Act and are unaffected by securities law because no equity or debt is being offered or sold.   People who contribute to campaigns on these websites usually have some personal affinity for the cause or an expectation of receiving the product or service if a sufficient amount of funds are pledged to enable the project to be completed.  Basically, this is not crowdfunding. The important thing to know about these websites, however, is that they demonstrate how popular actual crowdfunding sites are are likely to be, and they are probably the models on which crowdfunding sites will be designed.

Crowdfunding is offering and selling securities to the crowd, by which I mean both accredited and non-accredited investors.  (Accredited investors are essentially those who have $1,000,000 in assets, excluding equity in their primary residences, or $200,000 in annual individual income. Congress and the SEC think that accredited investors are less vulnerable to fraud.)   The crowdfunding rules the SEC proposed in July 2013 (in response to the JOBS Act mandate, but which are not yet final nor effective) will allow people to sell up to $10,000 of debt or equity to each individual as long as they do not raise more than one million dollars in a 12-month period. The SEC's leadership and staff are widely believed to be philosophically opposed to the idea of crowdfunding, and they seem to be attempting (i) to delay finalizing rules and (ii) to make the process difficult.  (The SEC believes that crowdfunding will result in widespread fraud and that the victims will be among society's most vulnerable.)

What is a Rule 506(c) public/private placement?

Another new legal avenue for fundraising that is not actually "crowdfunding" involves the process allowed by new SEC Rule 506(c), which--as mentioned above--the SEC was required to create by the JOBS Act.  Rule 506(c) allows businesses to offer securities to the general public and raise unlimited investment with relatively low compliance costs, provided they sell only to "accredited investors" who have been reasonably verified as such.  Rule 506(c) is very attractive because of the ability to publicly advertise the offering using social media, investing websites, newspapers, magazines, television, radio, and--someday soon--crowdfunding websites.  In the months since Rule 506(c) became effective in October of 2013, billions have already been raised using its provisions. 

What about single-state crowdfunding?

Largely due to frustration at the SEC's foot-dragging, some states have enacted crowdfunding laws to permit limited offerings to investors in certain states without complying with the SEC's more burdensome rules.

A bill (the NC JOBS Act, or House Bill 680) was introduced in the North Carolina House of Representatives in April 2013 to permit intra-state crowdfunding.  After a couple of rounds of amendments, it was passed by the House in June 2013 by a 103-to-1 margin.  The bill now sits in the Senate Commerce Committee, which along with the Senate Finance Committee, must approve it before the full Senate can vote.

The NC JOBS Act would create an exemption from North Carolina's securities registration requirements for offers and sales of securities (also known as the Blue Sky Law) that meet certain criteria.   The requirements of the current version of the proposed crowdfunding provisions include the following:

  • The offering must meet the requirements of the federal exemption for intrastate offerings under Section 3(a)(11) of the Securities Act of 1933.
  • The issuing entity must be organized under the laws of North Carolina (no out-of-state entities).
  • All purchasers must be residents of North Carolina.
  • No more than one million dollars can be raised in 12 months, unless prospective investors have been given audited financial statements, in which case the limit is two million dollars.
  • No more than two thousand dollars can be received from a non-accredited investor.
  • A notice filing with the Securities Division of the Secretary of State's office.
  • An offering circular must be provided to prospective investors and to the Securities Division.
  • Risk disclosures and certifications.
  • Website registration requirements.
  • A bank must act as escrow agent for investment funds collected during the offering period.
  • Officers and directors of the issuing entity cannot receive commissions on sales of securities unless they register themselves as a "dealer" or "salesman."
  • Quarterly reporting to investors.
As you can see, the North Carolina crowdfunding proposal is more restrictive than the SEC's proposal. 

(To better understand the interplay between federal securities laws and state securities laws, see my article here, which was first published in 2008 by WRALTechWire.com, but note that it is now out-of-date.)

More information is available.

This has been a brief summary of some key points relating to crowdfunding, but there is much more that I have not covered in this article.  I have done a little bit of speaking, writing, and tweeting about crowdfunding, but my law partner Jim Verdonik knows more about it than anyone I know.  He has written about it on his blog, Entrepreneur Intersection, and in the Triangle Business Journal.  If you're interested in hearing more about crowdfunding, or have a group that might be interested in having me or Jim speak, please let me know.


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