The expanded use of crowdfunding as a capital raising tool by start-ups and small businesses is closer to reality with proposed rules the Securities and Exchange Commission approved and put out for public comment this morning.
The proposed framework establishes guidelines for investors and rules for issuers that want to raise up to $1 million a year through crowdfunding and not have to register those publicly offered securities. Whereas private companies are limited to seeking out accredited investors (with a net worth of $1 million or an individual annual income of more than $200,000),crowdfunded ones, as envisioned by the JOBS Act in its Title III mandate to the SEC, could reach out to unaccredited investors. They would not need to register those securities offerings with the SEC, but will need to meet a variety of requirements included in the SEC's proposal.
The framework approved unanimously by Commissioners, dubbed Regulation Crowdfunding, requires that all offerings be facilitated through an intermediary, defined as either a registered broker-dealer or an online, registered funding portal. The Commission included proposed rules on how those intermediaries will operate.
Among the proposed requirements for funding portals are providing investors with educational materials about the risks of their investment, and compliance with anti-money laundering controls and privacy requirements. They must also register with the SEC and Financial Industry Regulatory Authority.
Crowdfunding will come with a variety of disclosure requirements. Issuers must provide detailed information on the nature of their business and operations; terms of the offering; and use of proceeds. Financial statements, at least initially, must be compliant with U.S. GAAP accounting standards. Final rules will clarify how those statements will be certified.
Under proposed framework, those with an annual income of less than $100,000 will be limited to investing $2,000, or 5 percent of their annual income (whichever is larger), every 12 months. Those above that income threshold, would be prohibited from investing more than 10 percent of their annual income through funding portals.
Not everyone will be able to take advantage of crowdfunding as a tool to raise capital. Foreign issuers, SEC-reporting companies, and issuers delinquent with SEC filings are among those prohibited. Also ineligible are companies lacking a clearly defined and detailed business plan.
The SEC also proposed “bad actor” rules to protect investors, a primary concern for many and among the reasons it took considerable time for the proposed rule to emerge. Investor protection is a running theme throughout the nearly 300 questions posed for public feedback in the proposal.
Crowdfunding, pioneered by line sites like Kickstarter, allows start-ups and entrepreneurs to make their pitch for small investments online. Most of these ventures have rewarded investors with tokens of appreciation, such as a CD for donating to a recording artist, or a DVD for financing a film. This funding method to date, however, has not involved the offer of a share in any financial returns or profits. As noted by SEC Chairman Mary Jo White prior to Wednesday's vote, doing so would trigger the application of the federal securities laws, under which the offer and sale of securities are required to be registered with the SEC unless an exemption is available.
At the meeting, Commissioner Luis Aguilar said supporters of crowdfunding point to the success of existing efforts around the world, which raised an estimated $2.7 billion in 2012, up 80 percent from the prior year.
“However, even the strongest supporters of crowdfunding acknowledge that it carries substantial risks,” he said, adding that small business investing is inherently risky and the majority of new business establishments fail. Small business investments also tend to be highly illiquid, as most securities offerings may be too small for an active secondary trading market to develop.State securities regulators have noted that small business investments may pose relatively high risks of fraud, and afford the potential for self-dealing or overreaching by controlling shareholders, Aguilar added.
“The hope is that such risks will be minimized by the disclosures that will be required under Regulation Crowdfunding, and by the individual and aggregate investment limits to be imposed in such offerings,” he said.
“The worthy goals of crowdfunding do not alter the fact that this new mechanism for raising capital presents a number of challenges,” said SEC Commissioner Michael Piwowar. “The JOBS Act not only requires the Commission to develop a completely new regulatory framework that promotes capital formation for start-up companies, but also to implement this innovative framework in a way that protects investors from fraud.”
Piwowar was optimistic the changes would be a boon for small businesses and investors. “I have no doubt that the Commission is up to the challenge of developing a successful ‘outside of the box' crowdfunding regulatory framework that is consistent with our core mission,” he said.