On April 5, 2012, President Obama signed into law the landmark Jumpstart Our Business Startups Act (JOBS Act), for the purpose of encouraging the funding of startups and small businesses throughout the United States. Title III of the JOBS Act, otherwise known as Regulation Crowdfunding or Reg CF, received the most attention because it legalized investment crowdfunding. The purpose of Reg CF was to make it easier for startups and small businesses to access capital, to give more people the ability to participate in investment opportunities, and ultimately, to create jobs and stimulate economic growth.
Crowdfunding is the practice of funding a business by raising small amounts of money from a large number of investors, typically via the Internet. Prior to Reg CF, generally only accredited investors – those who earn an annual income of at least $200,000 (or $300,000 if married), or those with a net worth of at least $1 million (excluding one’s primary residence) – could invest in startups and small businesses, usually through Rule 506 of Regulation D. Reg CF created a new exemption to the Securities Act of 1933 that allows ordinary people the opportunity to invest in startups and small businesses alongside angel investors and venture capitalists.
So how does Reg CF work? In general, Reg CF allows startups and small businesses to raise up to $1 million in a rolling 12-month period from any investor, including non-accreditor investors. Issuers are required to use online intermediaries known as “funding portals.”
Reg CF officially went into effect in May 2016, but has been off to a slow start. This is due to several factors that make it difficult for potential issuers to utilize the new law. The primary difficulty is that Reg CF imposes high regulatory burdens and costs on startups and businesses attempting to raise funds. For example, Reg CF requires that businesses raising more than $500,000 have GAAP standard financial statements ready to share with potential investors. While transparency in investing is important, few startups and small businesses have funds available to pay the accountant fees necessary to prepare GAAP financials.
Moreover, Reg CF requires issuers to file a Form C with the SEC prior to raising funds. Form C is a complicated document that in most cases requires legal review. The fact is that very few startups and small businesses have the money to cover the legal fees associated with such review. Reg CF itself is long and complex, requiring further expensive legal assistance to make sure its requirements are followed. To make matters worse, Reg CF prohibits issuers from making any offering, or any announcement about an offering (including any general announcement or tombstone statement), without first making the required disclosures with the SEC, including Form C. This rule prohibits potential issuers from “testing the waters” – i.e., from soliciting non-binding indications of interest from potential investors prior to an issuance, thereby minimizing the risk of paying accounting and legal fees, among other expenses, for an offering that may turn out to be unsuccessful.
There are additional problems with Reg CF. The $1 million cap on yearly fundraising is a nonstarter for small businesses in industries that require larger sums of startup capital.
There have been efforts to make Regulation Crowdfunding more useful to issuers. In June 2016, the House of Representatives approved the “Fix Crowdfunding Act” bill (HR 4855). While the original bill sought to remedy the shortcomings discussed above, the legislation was significantly amended prior to being passed by the House. HR 4855, however, died in the Senate.
Any new bill should try to address the following issues.
First, the issuer cap should be raised from $1 million to $5 million and the investor caps should be modified by basing the percentage caps on the “greater of” net worth/income, not the “lesser of.” These higher caps would vastly improve the capital raising capabilities of startups and small businesses.
Second, potential issuers should be able to “test the waters,” permitting them to solicit interest before actually spending money on accountants and lawyers. Allowing potential issuers to test the waters would reduce the upfront cost of conducting a Reg CF offering and the risk of paying accounting and legal fees for an unsuccessful offering.
Finally, the burden on funding portals to vet the Reg CF offerings they post should be reduced to encourage the development of these new facilities. Currently, Reg CF requires portals to act as gatekeepers of the offerings they post by imposing significant liability on portals for misstatements or omissions of the issuer, even if the portals are not aware that the information is false. While the due diligence obligations of the portals should be retained, the new rule should clarify that portals would not be liable under Reg CF unless they knowingly allowed material issuer misstatements or omissions or otherwise engaged in or aided fraud.
It has been nearly 5 years since the passage of the JOBS Act, and the most anticipated portion of the landmark legislation, crowdfunding, has been a bust. It is finally time to fix the problem, make it easier for startups and small businesses to access capital and democratize access to startup investment opportunities for the every-day investor.