Intrastate Offerings Made Easy

Last week, the Securities and Exchange Commission (the "SEC") made an important step towards facilitating intrastate securities offerings.  Up until now, the intrastate securities offerings had to rely on Section 3(a)(11) and Rule 147 that was developed by the SEC in 1974 as a safe harbor for Section 3(a)(11) exemption.  This federal level exemption applied to the securities offerings  to persons resident in a single state, provided that the issuer of such securities was formed in, was a resident of, and was doing business within, such state.  The exemption was not widely used because many companies are registered in Delaware even though they are doing business in other states.

The SEC "modernized" Rule 147 while keeping it consistent with the requirements of Section 3(a)(11) exemption.  The final rules can be found here. The issuer is still required to be incorporated or organized in that state, have its principal place of business there, and be doing business within that state.  Offerings can only be made to residents of that state or to those who the issuer reasonably believes are residents of that state.  Obtaining a written representation regarding the residency is not sufficient to establish a reasonable belief.  The SEC is leaving it up to the issuers to determine which verification method to use in addition to the representation.

Amended Rule 147 will vary from the new Rule 147A only in two provisions: Rule 147 limits offers to in-state residents (i.e., no general solicitation allowed here) and issuers must be formed in the state where they conduct the intrastate offering.

The new Rule 147A is not a safe harbor for exemption under Section 3(a)(11).  It is a separate exemption from Section 5 registration requirements.  It allows the use of general solicitation and advertising (for example, it will be permissible to announce the intrastate offering on the company's website and therefore make offers to out of state residents) so long as the following requirements are met:

• The issuer must be resident of the state (have its principal place of business in that state).  Note that it is no longer required that the issuer be formed in that state, which will enable more companies to rely on intrastate offerings to raise capital.
• The issuer is doing business within the state (need to satisfy one of the four well-defined tests).
• As opposed to offers, the actual sales of securities can only made to residents of that state (same reasonable belief standard as in Rule 147)
• There is a six month restriction on resale of securities into other states.

The ability to use a whole array of advertising options, including online advertising, in Rule 147A offerings will facilitate state-based crowdfunding offerings that rely heavily on online platforms.

If companies rely on either Rule 147 or 147A, they still need to comply with the state blue sky laws.  However, they do not need to file Form D with the SEC. Rule 147 or 147A do not impose any restriction with respect to "accredited" or "sophisticated" status of investors (but states may do so).  Investors will continue to count for the purposes of Section 12(g) (it requires the issuer to register its securities with the SEC if its assets exceed $10 million and that class of securities is held by either 2,000 persons or 500 non-accredited investors). Some investors (Tier 2 offerings and Regulation Crowdfunding) do not count towards the totals.

Additionally (and importantly), the SEC revised Rule 504 of Regulation D (another private placement exemption that is rarely used) to increase the offering limit from $1 million to $5 million and applied bad actor disqualification provisions of Rule 506(d) to Rule 504 offerings.  It also repealed Rule 505 of Regulation D.

Amended Rule 147 and the new Rule 147A will be effective at the end of March 2017 (150 days from the publication in the Federal Register), and the amendments to Rule 504 will be effective in about two months (60 days after the publication in the Federal Register).

In conclusion, I'd like to note that these are exciting changes that will lead to an increase in intrastate crowdfunding offerings.  There are already a number of existing exemptions that startups and small businesses can use to raise capital.  These include Rule 147 under Section 3(a)(11) (and soon the new Rule 147A), Section 4(a)(2) for "transactions by the issuer not involving a public offering", Regulation A, Section 4(a)(6) for the Regulation Crowdfunding offerings, and finally Rules 504, 505 (for a little while longer), 506(b) and 506(c) of Regulation D.  Each exemption has its own limitations, and an experienced legal counsel can help you find the best suitable exemption for your company.

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.

Title III Crowdfunding Update

I recently listened to a webinar regarding equity crowdfunding by the Angel Capital Association.  It was very informative, and I decided to share with you some insights.  You can listen to the full webinar here.  Here are their presentation slides.

After giving a helpful overview of the regulation, the speakers turned to the overview of the current crowdfunding landscape, about 3.5 months after the SEC rules regarding Title III crowdfunding became effective.  I found this to be the most informative part of the webinar.  Below is a brief summary.

The speakers mentioned that as of the end of August, 16 Title III crowdfunding portals were approved by FINRA.  Even though several of the portals are registered broker-dealers, the majority is not, and in fact have little operational experience in the crowdfunding space.  One of the portals, WeFunder, has been the portal of choice for about 92% of all money raised through Title III crowdfunding since May 16th (the effective date of the SEC rules).  Most of the existing crowdfunding platforms for accredited investors are still staying away from Title III crowdfunding until the market stabilizes.

In general, there was an expectation that there would be more Title III deals (like, 5-10 times more).  As of the end of August, only 22 companies had raised at least their minimum threshold amounts.  Most are local companies, not experienced in fundraising.  Many are in the food & beverage-related industry.

The fewer number of participants is not all that surprising given the high costs involved in raising the money through Title III crowdfunding campaigns, once you add all the marketing costs, platform fees, accounting costs, and the cost of preparing disclosure documents and other information.  Companies should also add $3,000-$5,000 ongoing yearly compliance once the offering ends.

As the Title III crowdfunding market develops and stabilizes, albeit slowly, we may see more crowdfunding regulation coming from Washington, where several legislative initiatives that aim at revising the final SEC rules are currently in the works.  

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.

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

Eligibility

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.

Disclosures

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.  

Conclusion

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.