So today was the day that the SEC finally released proposed rules on crowdfunding after more than 18 months of anticipation. I have two general observations.
My first observation is that the SEC rules are very true to The JOBS Act legislation. In many cases that is great – it means that the SEC did not add onerous provisions that would gut the intent of the law. In other cases it is a disappointment. For example, the audit requirement for companies that are raising more than $500,000 still remains (despite the statute’s provision which permits the SEC to adjust that threshold).
My second observation is that this is an enormously complicated undertaking. The proposed rules are 585 pages and ask for comment on nearly 300 individual questions. There is a 90 day comment period, after which the SEC is going to take a look at the comments and finalize the rules. After that, there is final publication and then the rules become effective. The punch line is that we are still a solid six months away (if everything goes well) from crowdfunding becoming legal. Companies cannot raise equity using crowdfunding until then. It is very important to understand that while crowdfunding is coming, that day is not here yet.
Because of the complexity in the length of the proposed rules, I can only highlight a few things. A number of commentators will be preparing much more extensive commentaries (including one from Crowdcheck.com which is sure to be excellent based on their track record). Also, remember that FINRA (the organization that regulates the broker-dealers and new funding portal websites) just published its proposed rules today also (right after the SEC release). So a lot more is coming over the next week or so. We have a long way to go, and a lot of information to digest. But, with that said, here are a few interesting points from my initial review of the extensive proposed rules.
Advertising. Companies that are using crowdfunding can only advertise the offering by directing potential investors to the funding portal. They are not allowed to advertise the terms of the offering, including the amount offered, the length of the offering, or even the price. All of that information can be in one place and one place only – the funding portal. This allows the company to leverage the power of social media to attract potential investors, while at the same time ensuring that all communication is centralized in one place – the funding portal. The point? Everything needs to be on the funding portal. Companies can direct people to the portal, but it isn’t open season on social media.
Cancellation period. The SEC believes that most of the power with crowdfunding comes from the fact that back-and-forth discussion on the campaign webpage will inform potential investors about whether or not it is a good opportunity. To that end, the rules permit an investor to cancel their commitment up to 48 hours prior to the deadline identified in the offering. In short, you could have a deal that looks like it is going to close, and then everybody backs out the last second. This has potential to be very disruptive to a company, but on the other hand, it does provide an important protection for the investors. A company can move up its closing date by providing five days advance notice, according to the proposed rules. This allows completely subscribed offerings to get closed up and funded, so long as they meet the other provisions in the law.
Investment limitations. The JOBS Act tries to protect investors by only permitting them to invest a maximum amount based on their income and/or net worth. The invest limits are between $2,000 and $100,000 per year, for ALL crowdfunded investments during the year. There was a lot of concern that the SEC would put forward a rule that was very difficult to be practical. Because people would be making investments on various funding portals, the information about how much investor has put into crowdfunded deals for the year may be hard to determine.
The SEC recognized that, and suggested that the investor would be able to “self-report” their income and net worth, as well as their previous crowdfunding investments for the year. The responsibility of a portal to investigate this information is limited. However, that doesn’t mean that funding portal who has already received more crowdfunding investments than is being reported by a particular investor is allowed to rely on information it knows is untrue. To the contrary, the portals still have a responsibility to pay attention. This is good news here; without allowing self-reporting of previous investments, it would be darn near impossible to figure out if someone was over the limit because of investments made on other funding portals.
Banks handle the money. Because a brand-new creature was created as part of the law called a “funding portal” (which doesn’t handle investor money), there was some question about how investor money would be transferred to the company. The SEC has proposed that only banks should handle the money. This is fine, provided that banks are willing to provide the service. There most certainly are broker-dealers, escrow agents, lawyers, are others who would be willing to fulfill this role if the banks don’t step up to the plate. The SEC needs to make sure that banks are “in” or else the whole system falls apart.
On-going reporting. This is an area where the SEC kind of whiffed. The JOBS Act requires annual reports. But, the SEC is requiring the same standard in financial reporting on an annual basis as for the offering itself. That means once a company raises $500,000+, it will always be required to produce audited financial statements. This is awfully expensive.
Additionally, the SEC wants companies to publish financial statements on their own websites. As you can imagine, the investors should have access to information, but it is kind of amazing that once a company is crowdfunded, it will be required on its very own website, to provide financial reporting. The SEC should consider giving some leeway and allowing companies to publish the information on a password protected site to investors or through the funding portal. Obviously, all this information is also available on EDGAR (the online public information tool), but it shouldn’t have to be on a company website.
Portals can’t give “investment advice”. Funding portals are different than broker-dealers, because they can’t promote specific opportunities. The idea is that a funding portal is a neutral marketplace which allows investors to make their own decisions. This created some real concern that funding portals would be unable to pick and choose deals which they wanted to list at all. Otherwise, they were worried about being accused of giving “investment advice” by curating only the best deals.
Fortunately, the SEC’s proposed rule permits a portal to set objective criteria that must be met in order to be displayed on the site. Moreover, the SEC rules permit search functionality which will allow an investor to look at opportunities that may work for them. Not surprisingly, the SEC prohibited enhanced fees to receive “featured listing” status (to have more prominence on the site). This is the sort of activity that could lead a funding portal to be perceived to be making recommendations. There does still remains some ambiguity regarding what criteria a funding more prominence on the site). This is the sort of activity that could lead a funding portal to be perceived to be making recommendations. There does still remains some ambiguity regarding what criteria a funding portal can used to choose its deals without running afoul of the prohibition on investment advice. But at least there will be a limited opportunity for portals to help screen real bad deals from the public.
Crowdfunded companies can also raise money through other avenues.Crowdfunded offerings are limited to $1 million over any 12 month period. There was a lot of concern that would prevent companies from raising any more than that $1 million through private placement or private equity funds (like venture funds). Lawyers call these “integrated offerings”, which means that you can’t combine two different rules to skirt around certain limitations.The SEC fortunately came down on the side of common sense. Because companies could raise money through variety of other methods, having a limitation on raising any other money for a full year could potentially have prevented these companies participating in crowdfunding at all. It also would have prevented private equity funds from making larger investments and successfully crowdfunded companies for an entire year. Capping all investment at $1 million is obviously contrary to the underlying purpose of the law: to make it easier for smaller and startup companies to raise money. SEC took a reasoned approach and proposed a rule that the $1 million limitation is for the crowdfunded portion of the deal only.
There are a ton of other rules, some of which are more important than others. Ultimately, this is the opportunity for voices to be heard. While you’re welcome to comment here, I strongly urge you to also hit the SEC.gov website if you’ve got something to add.
Jonathan Frutkin is CEO of Cricca Funding, LLC. He’s written a new book called “Equity Crowdfunding: Transforming Customers into Loyal Owners” which was published in May, 2013.