Thursday, August 25, 2016

Regulation Crowdfunding: Are You the Right Candidate for It?

As you all probably already know, in 2015 the Securities and Exchange Commission (or the SEC) adopted Regulation Crowdfunding to implement Title III of the Jumpstart Our Business Startups (JOBS) Act.  The Regulation Crowdfunding (or Regulation CF) became effective on May 16, 2016.  So, let's summarize the regulation and see how the Regulation Crowdfunding has been doing in its first three months of existence.

Offering Amount

Here is one of the most important (and limiting) limitations of offerings pursuant to Regulation CF: a company can raise only a maximum of $1 million in a 12-month period.  The good news is that this does not affect the amounts that the company can raise in other exempt (non-crowdfunding) offerings during that same 12-month period.  So, conducting a Rule 506(b) private placement to accredited investors and a Regulation CF offering at the same time is possible.

The Investors

The good news is that investors do not have to be accredited.  However, there are limits as to how much individual investors can invest.  They are:

  • if annual income or net worth is less than $100,000 - then $2,000 or 5% of the lesser of the investor's annual income or net worth; and  
  • if both annual income and net worth equals to or more than $100,000 - then 10% of the lesser of annual income or net worth.
In any 12-month period, an individual investor cannot invest more than $100,000 regardless of such person's annual income or net worth.  Spouses can calculate their net worth and annual income jointly.

The Portals

Each Regulation CF offering must be conducted exclusively through one of the funding portals registered with the SEC and FINRA.

The Issuers


First, let's talk about the issuers (i.e., the startup companies that can use this rule to raise money from the general public).  What type of companies can participate?  The Regulation tells us that certain companies cannot:
  • non-U.S. companies;
  • companies that are already public reporting companies;
  • certain investment companies;
  • companies that have been disqualified under the disqualification rules (see my earlier posts here and here)
  • companies that have already conducted an offering pursuant to Regulation CF and then failed to comply with the annual reporting requirements; and
  • companies that have no specific business plan or have indicated their business plan is to engage in a merger or acquisition with an unidentified company.

The issuers have to prepare and file an offering statement on Form C through the SEC's EDGAR system.  What information should be included in this offering statement?  Here is a list:
  • information about officers, directors, and owners of 20% or more;
  • a description of the company's business;
  • the use of proceeds of the offering;
  • the price to the public (or how the price is determined);
  • the target offering amount and the deadline to reach it;
  • whether the company will accept investments in excess of the target offering amount;
  • certain related-party transactions; and 
  • a discussion of the company's financial condition and financial statements.
The financial statements requirements depend on the amount offered and sold in reliance on Regulation CF in the preceding 12 months:
  • if no more than $100,000: financial statements of the issuer and certain information from the issuer's federal tax returns, both certified by the principal executive officer (unless CPA-audited or reviewed statements are available);
  • if more than $100,000 but no more than $500,000: financial statements reviewed by an independent public accountant (unless audited statements are available);
  • if more than $500,000: financial statements reviewed by an independent public accountant.
While the offering is ongoing, the issuer will need to amend Form C to disclose any material changes or updates (and then re-confirm all commitments).

The issuer may also need to file Form C-U to update on the progress towards meeting the target offering amount, unless the portal provides frequent updates.

Then comes an obligation to provide annual reports on Form C-AR on a yearly basis and post those on the website until one of the following takes place:
  • the issuer becomes a public company;
  • the issuer has filed at least one annual report and has fewer than 300 holders of record;
  • the issuer has filed at least three reports and has less than $10 million in total assets;
  • the issuer or another party purchases or repurchases all of the securities issued pursuant to the Regulation CF, or
  • the issuer liquidates or dissolves in accordance with state law.
These are onerous requirements that can become quite costly in terms of legal fees.  Fortunately, some portals assist companies with preparation of Forms C. There is also iDisclose, an exciting young company founded by lawyers, that can expertly generate for you a Form C (or a PPM, if needed). iDisclose actually works with SeedInvest, Republic, and several other portals on preparing Forms C for their crowdfunding clients.

Advertising, Communication, and Promoters

The company engaged in Regulation CF crowdfunding may not advertise, but it is allowed to provide factual information.  It can only post a notice directing prospective investors to the portal's platform.  The notice can include the following:
  • a statement that the issuer is conducting a Regulation CF offering;
  • the name of the portal it is using and a link to it;
  • the terms of the offering (amount, terms of the securities, price, closing date); and
  • information about the legal entity and business location of the issuer and a brief description of the business.
The issuer can communicate with investors and prospective investors through communication channels provided by the portal.  Of course, it doesn't mean that the company cannot talk to anyone at all outside of the portal.  The company representatives can still attend conferences and talk to prospective investors.  But they need to limit the information they give to the four points listed above, and avoid statements such as "my ... doughnuts ... are the best doughnuts in the world."

The issuer may compensate others to promote its offering through the portal, but needs to make sure that the promoter clearly discloses the compensation with each communication.

Need a Transfer Agent

When conducting a Regulation CF offering, companies should engage a transfer agent.  Here is why.  There is Section 12(g) of the Exchange Act that says that every issuer with total assets of more than $10 million and over 2,000 record holders of its securities (or 500 not accredited) must register that class of securities with the SEC.  There is an exemption.  Securities issued pursuant to Regulation CF are exempt from the holder count so long as the following criteria are met:
  • the issuer files its annual reports on Form C-AR on time;
  • it has less $25 million or less in total assets; and 
  • ***it has engaged the services of a transfer agent registered with the SEC.
Current Practice

According to Stratifund, in just one week after the Title III crowdfunding became available on May 16, 2016:
  • $21 million: Amount startups are seeking to raise
  • $1 million: Amount invested in startups in week 1
  • 32: Startups launched their campaigns.
As of August 24, 2016, 88 Form Cs (offering statements) have been filed with the SEC which means that 88 Regulation CF campaigns have been launched. Some of the Regulation CF funding portals are NextSeed, Wefunder, SeedInvest, FlashFunders, StartEngine, TruCrowd, and Republic.

The securities offered are all over the spectrum: debt, revenue sharing, SAFE, preferred stock, LLC units, convertible debt, and common stock.  Some portals have been developing new forms of securities that are specifically geared towards Regulation CF offerings (in an attempt to address the main problem: managing a large number of small shareholders).

Let's take a look at NextSeed, a crowdfunding portal in Texas.  It actually has two portals: one for Regulation CF projects, and another one registered with the Texas State Securities Boards that conducts intra state offerings.  Revenue sharing seems to be the preferred method of crowdfunding financing at NextSeed.  According to their disclaimer, NextSeed assists small businesses issue debt securities in the form of term notes, revenue sharing notes, and other debt products.

Here is one of the funded campaigns that closed on August 23, 2016: the Brewer's Table.  The minimum investment is $100, and there is no limit for accredited investors.  There are 190 investors and the company raised $300,000. The company is a Texas LLC, and is offering revenue sharing notes.  Investors will not receive equity in the company.  Following a startup up period of 5 months, investors will start receiving 5.25% of each month's gross revenue, distributed pro rata among them, up until each investor receives 1.5x their original investment.  If the investors have not been paid in full in 40 months, the company is required to promptly pay the entire outstanding balance.  The note is secured with the company's assets.

Let's now turn to WeFunder.  This portal suggests that Wefunder companies consider offering one of four types of securities specifically developed by them for Regulation CF offerings: WeFunder SAFEs, promissory notes (with or without discount or valuation cap), revenue loan agreement, and investor perks agreements (that can be combined with one of the other three types of offerings). All documents are available on their website free of charge.  For Regulation CF offerings, Wefunder charges investors up to 2% of their investment and the company up to 3% of their total funding volume.

Here is Hawaii Cider Company that is currently doing a raise on WeFunder.  The company is offering a SAFE with a $7 million valuation cap and a 10% discount with some additional interesting features. The company is also offering various investor perks based on investment amount.

On SeedInvest's website,  you can find ongoing offerings in three categories: Regulation CF offerings made through their SI Portal, Regulation A offerings, and offerings open to accredited investors only (need to log in first).  SI Portal receives cash compensation equal to 5% of the value of the securities sold and equity compensation equal to 5% of the number of securities sold.  At this time, there are only two companies raising money through SI Portal, both offering preferred stock.  


There can be no conclusion to this blog post.  The field of Regulation CF is rapidly developing, changing, adapting, and growing.  It is exciting to see some small businesses getting funded, and small investors finally being able to participate in the start-up community.  Let's keep on watching, learning, and investing!

This article is not a legal advice, and was written for general informational purposes only.  If you have questions or comments about the article or are interested in learning more about this topic, feel free to contact its author, Arina Shulga.  Ms. Shulga is the founder of Shulga Law Firm, P.C., a New York-based boutique law firm specializing in advising individual and corporate clients on aspects of corporate, securities, and intellectual property law.