ATTORNEY: The youngest son, the 20-year-old, how old is
he?
WITNESS: He's 20, much like your IQ. (Courtesy Lowell Hare)
“I have no idea what Gluten is, either, but I’m avoiding it
just to be safe.” (Anon)
“Crowdfunding” as a way of raising capital for small businesses
has been in the news since Congress passed the Jobs Act in 2012. Although the
role of bankers in the Crowdfunding process may evolve, there is a role—how big
may depend on the success of the concept.
As presented in the media and in Congress, Crowdfunding was
presented as a way to raise capital through the internet in a less rigid format
than the usual U.S. Securities Act exemptions.
Ideally, small business issuers would present their start-up companies
to a “crowd” of investors who would buy shares in the start-up for relatively
small amounts. In the absence of explicit amendments to the Securities Act of
1933, Crowdfunding would not be a legal way to raise capital. Small businesses would have to follow the
very rigid exempt transaction rules of the Act with sales only to “accredited
investors” or , limited Regulation A offerings or “go public”.
Congress added the Crowdfunding sections to the securities laws as
a way to promote capital raises for small or start-up companies.
The SEC’s release of the proposed Crowdfunding rules on
October 23, 2013 is more than 585 pages long and poses more than 250 questions
for comment. The full release can be retrieved from the SEC EDGAR site. The Crowdfunding rules are not likely to become final for some
time. The rules are open for a 90 day
comment period and then the Commission has to adopt the final rules, and then
there is statutory 60 day wait for the rules be effective. Most experts expect that no Crowdfunding issues will occur before Summer
2014. Some important highlights of the
SEC’s proposed rules follow:
1. The maximum annual limit for a Crowdfund
issue is $1 million, with rather stringent requirements concerning financial
and other information about the issuer.
Lower Crowdfund limits of $500,000 and $100,000 have much less rigid or
burdensome requirements for the issuer.
Given the expected legal and other costs of a Crowdfund issue it is not
likely that many $100,000 issues will be done.
2. Significantly, the SEC’s proposed rules do
not aggregate Crowdfund issues with other exempt issues (as is often the case
in the SEC rules). For example, the
issuer could do a Crowdfund issue and, when successful, follow it with a much
larger Regulation D exempt offering or vice-versa.
3. If the
annual income or net worth of an investor is less than $100,000 (net worth does
not include a principal residence), the investor may not contribute more than
$2,000 or 5% of annual income or net worth, whichever is larger. If the
investor’s income or net worth exceeds $100,000 the limit is 10% of net income
or net worth. Under the current proposal
no laborious due diligence is required of the internet portal or broker-dealer
(called collectively “intermediaries”) to confirm the investor’s financial
status. One expert said that the investor
would merely “check a box” and the intermediaries could rely on that, given
good faith belief. We will see if that
survives the comment period.
4. Although the Crowdfunding security issue can
be done through a broker-dealer, it is difficult to imagine Raymond James or
even small broker-dealers’ undertaking a $1 million Crowdfunding offering. Most issues will probably take place through
“funding portals” which, while not broker-dealers, will have to register with
the SEC and follow a fairly rigid set of rules.
One of which, of interest to bankers, is the explicit requirement that
all funds collected during the offering by the funding portal be deposited in
an escrow type account with a bank. The
funding portals also have to be a member of a national exchange. The SEC has designated FINRA to serve as the
funding portal exchange. FINRA is
drafting rules for the funding portals.
5. What about fraud? Many pundits have predicted widespread fraud
by the unscrupulous scam artists. Obviously,
there is no guarantee that fraud can be
prevented, rules or no rules. However,
the funding portals have a duty under the proposed rules to do background
checks and pursue other means to determine if the issuers are real. The issuers must give the “crowd” a fairly
detailed disclosure statement, which when the lawyers get involved will look
like a full blown prospectus. In the $1
million offerings, detailed financials and business plans are required. I think
the most likely ground for fraud may lie in funding portals. Despite the requirement that funds be
deposited in banks one knows that such requirements are easily dodged. The Act and rules contain provisions for
legal recoveries for fraudulent conduct similar to the Securities Act’s
anti-fraud provisions.
6. The investors in a Crowdfunding venture are
subject to restrictions on resale of their stock. They must hold the stock for one year,
except for sales to an accredited
investor, to the issuer or to family.
Crowdfunding, as presented by the SEC proposed rules, is not
simple or cheap. One expert has predicted
that the legal and business cost of
raising capital under the Crowdfunding concept may amount to 20-25% of the
amount raised. I think this is possible,
but not after funding portals become more common and expert in their work. The
accounting requirements for issuers for the $1 million issue will be expensive
and the issuer will also have to do what amounts to SEC style MD&A (management discussion and
analysis) for issuer.
Sorry to take up so much space but Crowdfunding may be a
significant way to raise capital for small business. Bankers may get involved in escrowing funding
portal’s issuer funds or evaluating the
chances of success for an existing customer.
Among other things, it will be a faster way to raise capital from the
public than existing stock raises. Until
it gets going it is difficult to determine if it will be a success.
Do Good,
Marshall Martin
(505)228 8506
(505)982 4611
