Legal V Michigan

Sharks, angels, crowds and the SEC: Who killed the crowdfunding buzz?

Michelle Harrell

Will the SEC kill the crowdfunding buzz? An attorney with Maddin, Hauser, Roth & Heller considers the question.

Guest post by By Michelle Harrell Maddin, Hauser, Roth & Heller, PC

Crowdfunding is white hot with popularity and has emerged as a capital formation tool and a way for nearly anyone to financially support an idea, invention, cause or business. Heads were spinning with crowdfunding’s potential to disrupt established principles of capital formation. The start-up nation believed that the days were gone when only titans of industry or the wealthy few decided which ideas came to fruition.

The idea was that, if a crowdfunding campaign gained online buzz, the product, idea or cause could jumpstart from capital built upon a wave of $10 bills from everyday investors. But instead of reaching new heights, the crowdfunding speeding train has rolled over into the proverbial legal ravine. After enjoying an evolutionary period free of oppressive regulations, certain types of crowdfunding have now become subject to SEC oversight and control.

What is Crowdfunding?

Crowdfunding is an evolving method of obtaining capital through the internet, typically through small individual contributions from a large number of people, for a variety of projects ranging from innovative products to artistic ventures. Crowdfunding is an important type of bridge financing between the time when startups have exhausted their personal funds and when they may qualify for venture capital funds or traditional financing.

How Much Money is Raised by Crowdfunding?

The figures relating to the crowdfunding industry are staggering. Crowdfunding Web sites have raised more than $89 million from the public in 2010, $1.47 billion in 2011 and $2.66 billion in 2012, with $1.6 billion of the 2012 figures raised in North America. In 2012, more than 1 million individual crowdfunding campaigns were established. The crowdfunding industry is expected to grow to more than $6.2 billion in 2014. According to the “State of the Crowdfunding Nation,” more than $60,000 an hour is raised through crowdfunding as of March 2014.

The Different Types of Crowdfunding

As crowdfunding has evolved, two primary types have emerged: reward-based crowdfunding and equity-based crowdfunding. Reward-based crowdfunding involves entrepreneurs, individuals or organizations that seek funding to pre-sell a product or service, launch a business concept or perhaps support a social purpose or cause, without sacrificing equity or incurring debt. The crowdfunding backer receives some reward or benefit from the recipient, such as a sample of the proposed product. Equity-based crowdfunding provides the financial backer with unlisted shares in the company in return for the funds.

SEC Regulation of Equity-Based Crowdfunding

Because of the solicitation and transfer of equity, investment-based crowdfunding can implicate securities laws. Soliciting investments from the general public is often illegal unless the securities laws and regulations of the U. S. Securities and Exchange Commission (SEC) have been followed. In the United States, there is some debate about what constitutes a security for purposes of the securities laws in relation to crowdfunding but a general test looks at whether there is an exchange of money with an expectation of profits arising from a common enterprise that depends solely on the efforts of a promoter or third party. Any crowdfunding arrangement in which investors are asked to contribute money in exchange for potential profits based on the work of others would likely be considered a security for purposes of the securities laws. As a result, the promoter would need to comply with the securities laws, and those requirements can be quite onerous and expensive.

The crowdfunding movement faced definite obstacles to growth and functionality due to the impact and application of the securities laws. Many bills were proposed and, for an extended period, continued churning with modifications with none being codified. That is, until April 5, 2012, when Pres. Obama signed the Jumpstart Our Business Startups Act, or JOBS Act, in the White House Rose Garden.

The impact of the JOBS Act

The reviews of the JOBS Act are mixed as to its impact upon crowdfunding. Effective as of Sept. 23, 2013, Title II of the JOBS Act allows equity-based crowdfunding from accredited investors only. To qualify as an accredited investor, a person must have income of at least $200,000 a year ($300,000 for married couples) or a net worth, excluding a principal residence, of at least $1 million.

The SEC requires that crowdfunding companies take reasonable steps to insure that all investors meet the accreditation requirements. Although previously prohibited for more than 80 years by the SEC, Title II allows general solicitation and advertising (such as through the Internet and Web sites) to raise investment funds. The crowdfunding offerings are exempt from state registration. There are no per-investor limits and no limit upon the maximum amount that can be raised. Certain “bad actors” are ineligible to participate in a Title II crowdfunded offering. A company seeking to raise funds through Title II crowdfunding may register on an internet portal but is not required to do so.

In contrast to Title II, the goal of Title III was ostensibly to allow crowdfunded investments by non-accredited investors. Because non-accredited investors are often seen as vulnerable, the Title III rules and limitations are extensive. Title III of the JOBS Act enables equity-based crowdfunding but only when done in compliance with a spider-web of onerous SEC regulations.

The SEC’s proposed Title III rules were published on Oct. 23, 2013, but the SEC has not adopted its Title III rules yet. As a result, companies cannot solicit investments pursuant to Title III’s provisions. Pursuant to the proposed Title III rules, companies may raise up to $1 million maximum each year from an unlimited number of investors. However, the amount that each investor may invest is based upon that investor’s net worth and income. The investment limits apply to the total invested by the investor during any 12-month period for all Title III crowdfunding investments.

For those earning less than $100,000 a year, the limit is $2,000 or 5 percent of their annual income, whichever is greater. This effectively results in a cap of $5,000 annual investment a year for those investors earning under $100,000. For those investors earning $100,000 or more, the cap is 10 percent of income or $100,000, whichever is greater.

The company seeking investors has extensive obligations to provide information to potential investors. Also, all Title III crowdfunding must be conducted through either a FINRA-registered broker-dealer or a registered funding portal. These broker-dealers and portals face extensive reporting, registration and operational requirements. Unlike Title II crowdfunding, advertising (except to direct investors to the correct portal) remains prohibited.

After much ado about the JOBS Act and its highly anticipated “green lighting” of equity crowdfunding, the result is buzz kill. Given the burden and expense imposed by the proposed SEC rules, it remains to be seen if any companies will avail themselves of Title III.   The equity crowdfunding rules are a morass of oppressive, technical rules that prevent equity crowdfunding by those companies that need it most. The bright minds who started crowdfunding in the first place may eventually find a way to equity crowdfund with typical citizens who have a few dollars and a lot of hope to spare. We will have to wait and see.

Michelle Harrell is a litigator, shareholder and chair of the complex and general litigation practice group of Southfield, Mich.-based Maddin, Hauser, Rother & Heller, P.C.