Imagine a scenario: After spending many months or years working to get your start-up off the ground, your solution is beginning to catch on with the greater public. Given current demand and your forecasts, you envision that hockey stick type growth curve common in popular startups in the near future. Having exhausted your bootstraps and immediate friends and family for financing, you look outside of your inner circle to raise additional capital that will support your company’s uptick in growth. With that you take your company to Kickstarter or another similar site and offer equity in your company to almost anyone who has access to the internet to purchase shares of your company.
This scenario is not completely without merit. You would not use Kickstarter per se, but, as a result of relatively new legislation, you can generate capital through a crowd funded offering via Regulation Crowdfunding.
Historically, the general public could only invest in public companies listed on a national stock exchange through brokers who would charge high fees in exchange for enacting trades. This process has become more democratic over time as brokerages reduced and eliminated fees for trading, enabling even more individuals to enter the retail market. However, even as the public markets have opened, private markets, that is the ability to purchase shares in companies not listed on an exchange, remained closed to all but the upper echelons of individuals, known as accredited investors. An accredited investor is an individual whose annual income exceeds $200,000 (or $300,000 jointly) for the two years prior to participating in a private offering or an individual who has a net worth over $1,000,000. In early 2020 the SEC expanded the definition of accredited investors to those who hold a Series 7, 65, or 82 certification issued by FINRA.
Regulation Crowdfunding or Reg CF for short creates an entirely new market of investors for the entrepreneur. Created under President Obama’s Jumpstart Our Business Startups Act in 2012, the regulation was adopted by the SEC in 2015 paving the way for companies to start raising capital under Reg CF in May of 2016 . The regulation requires (a) raises to occur online (like Kickstarter) through an SEC registered intermediary; (b) limits on the amount non-accredited investors can invest; (c) caps raises at a maximum limit; and (d) requires certain disclosures to be filed with the Securities and Exchange Commission and to investors.
Registered Intermediary
To offer securities under Reg CF, an issuer (the company issuing shares) must conduct the offering through a broker-dealer or funding portal that is registered with the SEC and FINRA. A quick google search of registered intermediaries will provide a number of options for the entrepreneur looking to issue securities via the regulation.
Once a registered intermediary is selected by the issuer, the intermediary will work with the issuer and the issuer’s attorney to prepare the offering. This will include determining the amount of capital to raise, the fees and commission, what type of securities will be offered (e.g. SAFE, convertible note, etc.), and valuation among other questions.
Non-Accredited Investor Limits
While non-accredited investors now have a seat at the table, the regulation limits the amounts each individual non-accredited investor can invest. Effectively the regulation will prevent individuals from over-leveraging themselves based on their income and net worth. Each investor must meet certain thresholds before they can invest in private companies through Reg CF similar to the requirements to be an accredited investor.
For non-accredited investors, the regulation uses a simple calculation to determine the maximum amount that can be invested in a 12-month period. If a non-accredited investor’s annual income or net worth is less than $107,000 then the investor can invest the greater of $2,200 or 5% of the investor’s annual income or net worth. If both the annual income and net worth for the non-accredited investor is $107,000 or greater then the investor’s limit is 10% of either his or her annual income or net worth whichever is greater up to a maximum of $107,000. Accredited investors do not face investment limits during a 12-month time frame.
The SEC provides a nice example outlining the potential investment limits for various income and net worth levels:
|
Investor |
Investor |
Calculation |
Investment Limit |
|
$30,000 |
$105,000 |
Greater of $2,200 or 5% of $30,000 ($1,500) |
$2,200 |
|
$150,000 |
$80,000 |
Greater of $2,200 or 5% of $80,000 ($4,000) |
$4,000 |
|
$150,000 |
$107,000 |
10% of $107,000 ($10,700) |
$10,700 |
|
$200,000 |
$900,000 |
10% of $200,000 ($20,000) |
$20,000 |
|
$1,200,000 |
$2,000,000 |
10% of $1,200,000 ($120,000), subject to $107,000 cap |
$107,000 |
Maximum Capital Raise
At the outset of Regulation CF, the maximum offering amount in a 12-month period than any investor could raise was $1,070,000. This would include all amounts issued under Regulation CF and any future amounts the issuer intends to raise under Regulation CF, but it excludes amounts sold in other, non-Regulation CF, offerings. Recent amendments to the rules have raised this minimum to $5,000,000 in a 12-month period.
Disclosure Requirements
To take advantage of Regulation CF, the SEC requires that the issuer file a Form C electronically through the EDGAR system and with the chosen intermediary. This form contains important information on the company including information on the officers, directors, and owners of a certain percentage of the company; a description of the business; financial statements and description on the financial condition of the company; the number of employees; the target offering amount; and whether the issuer will accept oversubscription. This is not a comprehensive list of the Form C requirements but provide a sampling of the information required of the issuer.
In addition to the Form C disclosure requirements, an issuer needs to keep the SEC apprised of the progress the issuer makes with its offering. Form C-U needs to be submitted within 5 business days of reaching 50% and 100% of the target offering amount. There are also additional annual disclosures via Form C-AR that are required to be submitted until the issuer terminates the reporting obligations in accordance with one of five specific circumstances described in the regulations.
Additional Requirements
The regulation provides additional rules around advertising and promotions, resales, and certain “bad actors” (e.g. securities fraud violators and other sanctions) may be disqualified from issuing under Regulation CF, and there is a specific exemption if an issuer has assets of greater than $10,000,000 and classes of securities held by either 2,000 people or 500 people who are non-accredited all of which can be discussed with your attorney should you decide to pursue a crowd funding issuance.
Drawbacks
While Regulation CF opens a world of potential capital to an entrepreneur, like any financing transaction, the benefits must be weighed against any potential negative impacts. The registration requirements are disclosed to the SEC’s EDGAR portal and are thus accessible to anyone using that platform. Additionally, an inaccurate valuation risks setting the initial bar too high or too low. Failing to meet the target minimum threshold set by the issuer means, just like Kickstarter, the money is returned to the investors and the project goes unfunded. On the flip side of the coin, setting the bar too low could send a message to potential investors that the company is not worth their money and may choose other projects to fund. Having a large pool of investors can also pose an administrative headache as it relates to the capitalization table. Some platforms offer assistance with managing the cap table, but the fact of the matter remains that anyone proceeding with Regulation CF will have a bevy of new owners to manage.
Conclusion
There are alternatives to Regulation CF including Regulation A+ and the more traditional methods of debt and equity financing. If you are interested in evaluating all of these options for your company it is best to speak with your attorney who can help you evaluate the options for your specific situation.
Raising capital is often a necessary step for a growing business. Not all companies are able to bootstrap themselves or are willing to take on debt financing. Regulation CF is another arrow in an entrepreneur’s quiver.
If you would like to hear one founder’s experience with Reg. CF, listen to our Founder’s Friday podcast with Anthony from At Ease Rentals.
Matt is a founding partner at Peak Corporate Counsel. He focuses his practice on outsourcing and tech licensing, corporate governance, and commercial agreements. When not in the office Matt enjoys spending time outdoors, paddling on the ocean and hiking in the White Mountains, or on walks with his wife and small pug.
This article is for informational purposes only, and may not be considered legal advice.