Category: JOBS Act

Is My Portal Legal?

On By crowdfundattnyIn Crowdfunding Portals, Entrepreneurs, General Solicitation, JOBS Act, Kickstarter, Rule 506, SECLeave a comment

As Crowdfunding gains traction, Crowdfunding portals are springing up and marketing themselves aggressively to entrepreneurs and prospective investors.

No, I take that back. Websites are springing up and marketing themselves aggressively to entrepreneurs and prospective investors, but technically there aren’t any “Crowdfunding portals” yet. Crowdfunding portals are a creature of the JOBS Act, and the JOBS Act hasn’t yet come into effect because the Securities and Exchange Commission (SEC) hasn’t yet issued regulations.

If the websites springing up today are not really Crowdfunding portals, then what are they? Are they legal? That matters a lot for entrepreneurs.

Background

The JOBS Act created two kinds of Crowdfunding:

  1. Using one kind of Crowdfunding, companies can raise up to $1 million from in unlimited number of investors through Internet “portals” that would be registered with the SEC and licensed by FINRA.
  2. Using the other kind, companies can use “general solicitation” to raise an unlimited amount of money from “accredited investors” by following Rule 506 issued by the SEC under Regulation D.

But neither kind of Crowdfunding is available yet.

Today, we see websites that combine the concept of a “portal” with a traditional private offering of securities. At these sites, accredited investors sign up to review companies, and companies sign up to raise money from investors. If everything goes right you end up with a happy entrepreneur and a legal Rule 506 offering.

What Could Go Wrong?

By definition, these Internet sites are not Crowdfunding portals and what they do is not JOBS Act Crowdfunding. For the sites to be legal they must satisfy the securities law rules as they existed before the JOBS Act. And it turns out that it’s not easy to mesh the very fast, very public world of the Internet with the rules in place long before the Internet was a twinkle in Al Gore’s eye.

These are a few of the tough issues these sites face:

  • Until the SEC issues Crowdfunding regulations, companies are not allowed to use “general solicitation” to attract investors. But if you visit some of these sites – public to anyone with Internet access – you see the companies listed.
  • If a portal isn’t careful, it might end up with one or more unaccredited investors, disqualifying the whole offering.
  • The sites generally don’t work for free – they are paid by the companies that raise money. In general, only a licensed broker can receive compensation in connection with the sale of securities.
  • Some sites provide “due diligence” on companies, offering to help investors to separate the good from the bad. That kind of service generally requires a license as an investment advisor.
  • State securities regulators can be even more aggressive than the SEC. If an offering violates Federal law then it probably violates state law, too.

Some sites seem more aggressive legally than others. Entrepreneurs should pay attention.

Why Does It Matter to the Entrepreneur?

If a website raises money improperly, the website can find itself in hot water. The operators of the website may be fined, banned from the securities industry (thus missing out on Crowdfunding when the SEC finally issues regulations), even go to jail.

But it’s no picnic for the entrepreneur and his or her company, either. If the portal does something wrong it likely means the company engaged in an unregistered, and therefore illegal, public offering of securities. The entrepreneur can also be fined, banned from the securities industry, or even go to jail. Moreover, the entrepreneur could be forced to give all the money back to the investors.

Conclusion

Raising money has always been hard. The internet and the JOBS Act are making it easier, but in the Wild West version of Crowdfunding we live in today, entrepreneurs have to be picky about their portals.

Questions? Let me know.

Four Kinds Of Crowdfunding: Which Is Right For My Company?

On By crowdfundattnyIn Crowdfunding, Donation-Based Crowdfunding, JOBS Act, Kickstarter, Product-Based Crowdfunding, Rule 506Leave a comment

Two years ago not many people had heard of Crowdfunding. With enactment of the JOBS Act early in 2012 and the well-publicized success of many companies on Kickstarter and other portals, everyone is talking about Crowdfunding today.

Yet many entrepreneurs are still unsure how Crowdfunding works and whether it can help their businesses. That is largely because Crowdfunding is not just one thing. It is really at least four very different ways to raise money, each with its own rules, audiences, and strategies. For many entrepreneurs the question is not whether Crowdfunding is right, but which Crowdfunding is right.

Donation-Based Crowdfunding

On portals like Kickstarter, companies raise money in the form of donations. The company raising the money does not give up any of its stock or even promise to pay the money back. Sometimes the company offers tokens of recognition to its donors, such as a baseball cap or a free massage, but donors expect and receive little or nothing of value.

Don’t expect to raise a lot of money through donations, but if you need to raise $10,000 or $25,000 to get started it might be worth the try. Make a good video and tell a good (and truthful) story, and you might be surprised how many people want to help.

Product-Based Crowdfunding

Say you want to develop a new kind of mousetrap, or camera, or car. You might ask your potential customers to fund the development of the product.

Eric Migicovsky raised more than $10 million on Kickstarter to create the new Pebble watch, and gave a new watch to everyone who contributed $99 or more. Migicovsky says he initially wanted to raise just $100,000 and was as surprised as anyone when donations mushroomed.

With product-based Crowdfunding, your customer receives just the product. He or she does not receive stock or the right to share in your future profits.

Rule 506 Crowdfunding

For companies that need to raise a serious amount of money, the most promising form of Crowdfunding available today is an old form of raising money, but with a twist.

For many years, Rule 506 issued by the Securities and Exchange Commission has allowed companies to raise large amounts of money from “accredited” (meaning, fairly wealthy) investors. Today, web-based companies are springing up to bring old-fashioned Rule 506 securities offerings to a larger group of accredited investors – accredited investors lurking in the Crowd, so to speak. At best, these new companies offer entrepreneurs access via the Web to a very large pool of wealthy investors, a virtually unlimited amount of money, and a relatively simple and straightforward process.

The caveat is that some of the web-based funding companies seem to be pushing the envelope of what the law allows in ways that could theoretically expose the entrepreneurs to liability. Buyer beware!

JOBS Act Crowdfunding

Ironically, the kind of Crowdfunding created by the JOBS Act – where companies are allowed to raise up to $1 million by selling stock to a lot of small investors – has been overshadowed by the other kinds of Crowdfunding. That’s because, despite the publicity, real JOBS Act Crowdfunding is stuck in the starting gate waiting for the Securities and Exchange Commission to issue final regulations. The regulations were supposed to be in place by January 1, 2013 but haven’t even been proposed yet.

When the regulations are finally issued, probably by the middle of 2013, thousands of companies will race to the Crowdfunding “portals” envisioned by the JOBS Act, which even now are waiting to start business. Any company that wants to raise money should be prepared when the SEC finally flips the switch.

Questions? Let me know.

Crowdfunding and Washington Politics

On By crowdfundattnyIn JOBS Act, SECLeave a comment

As it works on Crowdfunding regulations, the Securities and Exchange Commission is in a tough position, as we described here.

If the SEC’s job were not tough enough already – interpreting a brand-new, complicated concept with very little Congressional direction – it has just become tougher as Red State/Blue State politics has entered the equation.

Previously a group of Senators, all Democrats, sent a letter criticizing the regulations the SEC proposed to implement “Rule 506 Crowdfunding,” where the JOBS Act, for the first time, allows mass solicitation of investors in certain securities offerings.

Now a group of eleven different Senators, all Republicans, have sent their own letter praising those same regulations [Bill, see page 10 for confirmation]. In the view of the Republicans, the regulations proposed by the SEC properly implement the intent of the JOBS Act, contrary to the judgment of their Democratic colleagues.

There are two ironies: one, the two groups of Senators disagreeing about what the JOBS Act means, after both voting for the identical language; and second, the group of Republican Senators praising the work of President Obama’s SEC in the face of Democratic criticism.

For the SEC, however, the back-and-forth means one more headache, trying to produce workable JOBS Act regulations in the partisan atmosphere of Washington, D.C.

Questions? Let me know.

Why Is Kickstarter Successful?

On By crowdfundattnyIn Crowdfunding, JOBS Act, KickstarterLeave a comment

The success of Kickstarter – or more exactly, the success of the companies that raise money on Kickstarter – is surprising to many of us in the industry.

I have represented companies trying to raise money for many years. I have given many lectures about raising money. One of my central messages:  it is hard to raise money.

The founder of MCI, the former long-distance company, said that MCI was really in three different businesses at three different stages of its life. First it was in the business of fighting for access to AT&T’s phone lines. All the focus and energy of the company was devoted to that litigation because without access to the lines, the long-distance service would never have been born. Next came the business of raising money, an extremely difficult task that consumed all of the attention of management for a long time. Only after those two businesses had been successful could MCI be in the business of providing long-distance phone service.

Having represented many companies raising money, his story rings true for me. A typical entrepreneur creates a business plan, jumps through all the hoops of the securities laws, attends a hundred seminars and networking events, offers investors a good chunk of the company, and only then, if he or she is lucky, is able to raise money.

In contrast, the companies raising money on Kickstarter offer donors no stock or other financial return on their investment, because they are not allowed to legally. And yet many Kickstarter companies are successful, which leaves many of us veterans scratching our heads.

Why do people give money to Kickstarter companies? And will they continue to?

Like Facebook and many other social websites, Kickstarter gives users the feeling of participating in a community. And many of the companies on Kickstarter – though not all – are for good causes. Does participating in a community and doing good stuff attract people?

Does Kickstarter attract donors because it is new and cool? Will that wear off? Is the Kickstarter business model sustainable?

I wonder what, if anything, the Kickstarter model tells us about “real” Crowdfunding under the JOBS Act, where investors buy stock hoping to turn a profit. I expect that Crowdfunding will get off to a quick start also. I suspect that the most successful Crowdfunding companies, and the most successful portals, will be those that match the community and excitement of Kickstarter. Conversely, companies and portals that ignore the “newness” of the medium and use the old, boring model of the existing investment world might have less success, at least in the short term.

It’s an interesting puzzle. If you have any ideas I would be very happy to hear from you.

Questions? Let me know.

Crowdfunding On Hold

On By crowdfundattnyIn Crowdfunding, JOBS Act, SECLeave a comment

When the JOBS Act was signed into law by President Obama on April 25, 2012, the idea was to have both kinds of Crowdfunding up and running by January 1, 2013:

  • The “real,” broad-based Crowdfunding, which allows companies to raise up to $1 million from large numbers of investors of any income level; and
  • The “Rule 506” Crowdfunding, which allows companies to raise money from accredited investors using general solicitation.

Yet neither kind of Crowdfunding is available now, and neither is likely to be available on January 1st.

The bottleneck is at the Securities Exchange Commission. The JOBS Act established the basic Crowdfunding rules but left it to the SEC to work out the details. So far, the SEC has proposed rules for Rule 506 Crowdfunding but has not yet finalized those rules, and has not yet even proposed rules for the real, broad-based Crowdfunding.

Apart from a lack of manpower, the reason for the delays can be seen from the reaction to the rules the SEC proposed for Rule 506 Crowdfunding. As reported in this blog, the proposed rules did not draw clear lines, instead leaving it to companies and ultimately the courts to establish what was reasonable. The lack of specificity left many people unhappy, including a group of Senators that excoriated the SEC publicly for the lack of guidance and accused the rule-makers of failing to protect the investing public.

Congress passed to the buck to the SEC, but now the SEC isn’t sure what Congress wanted. It’s a very tough bind for the regulators.

And if Rule 506 Crowdfunding presents tough issues for the SEC, they are child’s play compared to the issues that arise from broad-based Crowdfunding, where the investing public, by definition, needs much greater protection than accredited investors.

There is no definite word as to when the SEC will finalize the rules for Rule 506 Crowdfunding or even propose rules for broad-based Crowdfunding. Meanwhile, companies wanting to raise money, portals wanting to help them raise money, and investors wanting to invest are like travelers at the airport seeing “Delayed” on the overhead screen. Nobody can do anything until the SEC acts.

Questions? Let me know.

SEC Proposes Rules for Crowdfunded Rule 506 Offerings

On By crowdfundattnyIn Crowdfunding, JOBS Act, SECLeave a comment

The JOBS Act required the SEC to issue regulations allowing the use of “general solicitation” in Rule 506 offerings, as long as all the purchasers are accredited investors. The SEC has now proposed such regulations, which is welcome, but anyone expecting step-by-step guidance will be disappointed.

The proposed regulations establish three criteria:

  1. The issuer must take reasonable steps to verify that the purchasers are accredited investors.
  2. All purchasers must be accredited investors, either because they meet the objective definitions of “accredited” or because the issuer reasonably believes that they do at the time of the purchase.
  3. All of the other terms and conditions of an offering under Regulation D must be satisfied.

Note the key phrases: the issuer must take reasonable steps to verify that the purchasers are accredited and must reasonably believe that they are accredited.

The definition of “reasonable” is critical here, as it is in many other areas of law – but no real definition exists. Reasonable is whatever a reasonable person thinks is reasonable, yet reasonable people sometimes disagree. For the issuer trying to complying with the law, the important points are (1) you cannot merely pretend to believe your purchasers are accredited, but are required to really look into the question and be able to prove that you did so; and (2) as long as you tried to ensure that your purchasers were accredited, not in a perfunctory way but in a meaningful, reasonable way, you will not be penalized just because you turn out to have been wrong.

Some hoped that the SEC would offer more objective criteria, e.g., if you take steps one through six then you will satisfy the legal requirement. However, the SEC decided that the question could come up in so many different ways, no single approach would be sufficient.

The SEC did note that the steps an issuer might take to determine whether a purchaser is accredited, and the information it might require, would vary depending on such factors as the nature of the purchaser (e.g., individual or established business), the amount and type of information the issuer has about the purchaser, and the nature of the offering. For example, an individual purchaser claiming to be accredited based on his or her income might need only to produce W-2 statements, while the situation would be more complicated for an individual purchaser claiming to be accredited based on net worth.

If adopted in their current form, the SEC regulations would, in effect, require issuers, their lawyers, the SEC, and the courts to work all of these questions out over time. For now, proceed with caution.

“General Solicitation” With Accredited Investors: Another Kind of Crowdfunding

On By crowdfundattnyIn Crowdfunding, Financings, JOBS Act, SEC, Securities Laws, UncategorizedLeave a comment

In President Obama’s JOBS Act, Crowdfunding means a very specific thing:  raising money from lots of investors through a registered broker-dealer or a “portal.” That kind of Crowdfunding won’t come into effect until January 1, 2013 or such later time as the SEC issues regulations. 

But the JOBS Act made another important change to the way companies can raise money from investors, and in the scheme of things this change might turn out to be even more important.

Background:  When a company raises money from investors it becomes subject to the securities laws, administered by the SEC. Big companies like Facebook are required to go through a long and expensive process of registering their stock with the government, but long ago the SEC adopted a much simpler set of rules for smaller companies, often referred to as Regulation D, or Reg D for short. Reg D provides for three main varieties of raising money legally:  a Rule 504 offering, a Rule 505 offering, and a Rule 506 offering.

Of these the Rule 506 offering is the simplest and most streamlined, in part because it allows the company to avoid state “blue sky” laws. Until now, however, Rule 506 has comes with one key limitation:  the company seeking to raise money could not engage in “general solicitation.” That means the company could look for investors through word of mouth, or from friends and family, or by using brokers, but it could not run a television advertisement or ask for money on the internet.

The JOBS Act changes that rule. As long as a company is willing to limit its investor pool to accredited investors – generally meaning institutional investors or investors with high incomes or high net worth – it may conduct a Rule 506 offering using general solicitation, and thereby reach a much larger audience than it could before.

By definition, accredited investors have more money than non-accredited investors. By definition, startup companies (and other companies) are looking for investors with money. It stands to reason that the market for “crowdfunded Rule 506 offerings” could become much larger than the market for Crowdfunding itself. In a true Crowdfunding offering, for example, the company can raise no more than $1 million and will likely end up dealing with many, many investors. In a crowdfunded Rule 506 offering, on the other hand, a company could raise $10 million from one investor that it found through the internet.

The SEC was required to issue regulations about “general solicitation” within 90 days after enactment of the JOBS Act. The regulations have been delayed, but probably not for too much longer. Within the next month or so we expect the ban on general solicitation to be lifted, allowing at least one form of “crowdfunding” to spring to life.

Crowdfunding? Form a “C” Corporation

On By crowdfundattnyIn C corporations, Choice of Entity, Crowdfunding, JOBS Act, LLCs, TaxLeave a comment

One of the earliest decisions for every entrepreneur is the form of his or her company – whether a C corporation, an S corporation, a partnership, or a limited liability company. Designed as the perfect business entity, combining the flow-through tax treatment of a partnership with the liability protection of a corporation, the LLC is the first choice of many.

Things look different in the Crowdfunding universe, however. A company raising money on the Internet – whether in a true Crowdfunding offering or in a Rule 506 offering to accredited investors – will by definition end up with lots of investors, at least dozens, perhaps hundreds. Practically speaking, a company with dozens or hundreds of investors must be a C corporation.

Start with the tax filing requirements for partnerships, LLCs, and S corporations. At the end of each tax year the company must send a K-1 schedule to each owner. More exactly, two K-1 schedules, one for Federal taxes and one for state taxes. If a company has a dozen investors preparing all the K-1s is hard enough. For a small company with 100 investors the burden would be untenable.

On top of that, some states impose a per-head fee based on the number of owners. In New Jersey, for example, the fee is $150 per owner. Multiply that by 100 or more and we are talking about a serious cost for a startup company.

The lesson is unavoidable:  absent very unusual circumstances, a crowdfunded company must be a C corporation.

But that does not mean that all of the LLCs looking to the JOBS Act for funding will have to convert to C corporations. Instead, we anticipate that an existing LLC will form a separate C corporation as a member, and that the “crowd” investors will own stock in that company. The LLC will issue only one K-1 schedule and the separate C corporation will count as only one owner, despite having hundreds of stockholders.

For example, suppose Newco, LLC wants to raise $500,000 in exchange for 30% of its stock. Newco, LLC will issue 30% of its stock to a newly-formed C corporation, Investor Corp, Inc. Investors will purchase stock in Investor Corp, Inc., not Newco, LLC.

Using a C corporation will potentially impose a second level of tax if Newco, LLC is sold, and investors who purchase stock in Investor Corp, Inc. will not be entitled to write off “pass thru” losses for tax purposes. But in the Crowdfunding universe, that’s the lay of the land.

Questions? Let me know.

Crowdfunding – What It Is And How You Can Benefit

On By crowdfundattnyIn Crowdfunding, JOBS Act, UncategorizedLeave a comment

The Internet has changed many things, and now it is about to change the way companies raise money.

Since the 1930s, a company that wanted to raise money from investors had two choices: go through a very long and expensive public offering of the kind Facebook completed recently; or conduct a private offering, a prominent feature of which was the inability to reach a large number of prospective investors.

The JOBS Act signed by President Obama offers a third choice, called “Crowdfunding.” In its simplest form, a company seeking capital will register with a special kind of Internet site created for this purpose, referred to in the law as a “portal.” Prospective investors will also register with the portal. If a registered investor likes a registered company then a marriage is made—all through the portal and all online.

Probably the most important change to the securities laws in 80 years, Crowdfunding offers rich new opportunities:

    • Because the Internet portal is accessible all the time, the company looking for money can be exposed to many more investors than through a traditional private offering.
    • By registering with more than one portal, an investor on the lookout for growing, entrepreneurial companies can see many more companies than available at present.
    • The portal business is a new creature entirely, offering entrepreneurs the opportunity to get in on the ground floor of legitimate Internet-based fundraising.

The Securities Exchange Commission (SEC) is writing the final rules for Crowdfunding right now. Here are some of the most important rules and limitations you should know:

    • Crowdfunding will not begin officially until January 2013, when the SEC finishes writing the final rules. But that isn’t stopping companies and entrepreneurs from figuring out how to do business.
    • If a company raises money using Crowdfunding, it may raise only $1,000,000 from all sources during any 12 month period.
    • The law limits how much any investor can invest: for those whose income or net worth is less than $100,000, the limit is the greater of $2,000 or 5%; for those earning more, the limit is 10% of annual income or net worth, with an upper limit of $100,000. These limits refer to the total invested in all Crowdfunding investments during any 12 month period.
    • The company seeking investors will be allowed to advertise, but only to direct potential investors to the portal.
    • The company seeking investors will be required to provide fairly extensive information to potential investors. The kind of financial information—whether merely certified by the principal officer, reviewed by a CPA firm, or audited by a CPA firm, depends on the size of the company.
    • The portal will be required to register with the SEC, become a member of a national securities organization (probably FINRA), and will be responsible for many aspects of the compliance process.
    • The portal may not offer investment advice, recommendations or compensate its employees based on the volume of sales on its site.
    • Offerings conducted through Crowdfunding are exempt from the registration and disclosure requirements of state laws (so-called “blue sky” laws).
    • An investor who acquires stock through a Crowdfunding offering is subject to some restrictions on disposing of the stock.

Crowdfunding, and more generally, the ability to raise money through the Internet, is in its infancy. If Crowdfunding is the success that many expect, it seems very likely that these rules will be changed, allowing more money to be raised from additional investors in more ways. Surely, there will someday be an “app” for that.

There will be many traps along the way. To avoid the traps and discuss the opportunities, please contact me.