With all of the recent changes in the securities laws ushered in by the 2012 JOBS Act, it may be helpful now to take a step back and look at how these changes fit into the broader landscape of capital-raising for small and medium sized businesses.
We’ll start with a definition of “crowdfunding.” This is a versatile term that means raising small amounts from many people, rather than large amounts from a few. In practice it includes both, because in any crowdfunding campaign you also want a few people putting in large amounts alongside the many putting in small amounts.
But there are several types of crowdfunding. Here are the major ones:
Donations: On donation-based portals like DonorsChoose.org, contributors get nothing in return for their donation, other than (maybe) a tax deduction. It works well for nonprofits, but not so well for others.
Rewards and pre-sale: Portals like Indiegogo and Kickstarter have surged in popularity. They can offer a variety of incentives, like a signed copy of your favorite band’s latest record or discounts off merchandise. But contributors still can’t get their money back or any financial return on investment.
Peer-to-peer lending: Also surging in popularity, portals like Prosper and Lending Club do offer a true investment in the sense that investors can get their money back and a return on their investment. From a borrower’s point of view, however, it looks (and typically is) more like a bank loan in the sense that the portal dictates the terms.
Investment crowdfunding: This is a true securities offering by an “issuer” (the for profit or nonprofit company raising the money) that is open for investment by the “crowd” (meaning both accredited and non-accredited investors). Since securities laws at both the state and federal level regulate these investments, it is important that a company gets sound legal advice to help it map out the best securities compliance strategy for its needs.
The category of “investment crowdfunding” can itself be broken down into several distinct legal strategies:
Title III exempt crowdfunding: This is the one that has generated the most buzz since the SEC issued enabling regulations on October 31, 2015. It’s a federal exemption that pre-empts state law and allows a company to raise up to $1 million from investors in all states. It has some pretty tight limitations that many think will limit its usefulness. One potential disadvantage is that it requires the use of a third-party intermediary portal, regulated by FINRA, which will significantly add to the costs. The new regulations will go into effect in May of 2016.
State-specific exempt crowdfunding: While waiting for the SEC’s Title III regulations, more than half of the states enacted their own crowdfunding laws. Most of them were modeled after Title III, though some of them are less restrictive. For example, a few do not require use of a third-party portal. Now that Title III is about to go into effect, most of them will probably not get much use, except for those that will remain advantageous because they are less restrictive.
Nonprofit direct public offering: The SEC and most states allow a charitable organization to offer an investment without securities registration, though a notice filing may be required. For nonprofits in those states, this is the easiest way to do a direct public offering. A few states, notably California, do not have such an exemption and require registration even for nonprofits.
Intrastate direct public offering: This may be the most popular strategy for direct public offerings because it allows a company to raise an unlimited amount of money, as long as all investors are in the same state (along with a few other requirements). It requires state-level registration of the offering, which is not nearly as burdensome or expensive as a federal registration; and it can be cost-effective for raises as small as $250,000.
Rule 504 direct public offering: This strategy allows a company to take investment from multiple states, as long as you register (or otherwise find an appropriate exemption) in each of those states. The disadvantage of this strategy is that there is a $1 million aggregate cap, which will increase to $5 million as of January 20, 2017. It can be an attractive strategy because it allows for a public offering in one state, while still being able to take private investment from other states.
Regulation A+ direct public offering: This strategy was also spawned by the 2012 JOBS Act and allows a company to raise up to $50 million from investors in multiple states. The main disadvantage is that it is a much more burdensome process that in some ways is akin to a full-blown SEC registration. It actually includes two different variants: Tier 1 allows a company to raise up to $20 million without audited financials, but it does require registration in each state where investors reside. Tier 1, which allows raises up to the full $50 million, requires audited financials but pre-empts state law.
So is a direct public offering (DPO) the same as crowdfunding? Not exactly. As indicated above, investment crowdfunding includes both direct public offerings and exempt crowdfunding. There are two reasons why Title III exempt crowdfunding, in particular, is not a direct public offering: First, it is not direct because the rules require use of a third-party crowdfunding portal. Second, while it has some of the characteristics of a public offering (i.e., it’s open to non-accredited investors), there are limitations on your ability to market the offering (specifically, all communications must go through the portal), so it may not be a true public offering.
Another distinction between a DPO and exempt crowdfunding is that most DPOs are vetted by either state regulators (in the case of intrastate or Rule 504 DPOs) or by the SEC (in the case of Regulation A+). In both Title III and state-specific exempt crowdfunding there is no regulatory review. This regulatory exemption can cut both ways: While it can help you launch your offering faster and at a lower cost, you may find that investors have less confidence than they might have in a registered offer that the state regulators reviewed.
At Cutting Edge Capital we like crowdfunding of any variety, because it democratizes the capital-raising process. The old conventional wisdom is that once you’ve tapped out your friends and family, your options are to get a loan from a bank or an investment from an angel, a venture capital firm or other institutional investor. Regardless of the option, your fate is in the hands of wealthy individuals or organizations who will make their decision largely on the basis of how much money you can make for them… and how fast they can get their money and their large returns back out.
But with investment crowdfunding you can raise capital from your own community, however you may define it – your neighbors, customers, affinity groups, or even your professional network. And their investment decisions may be based on much more than just profit or a quick exit. This opens the door for true impact investment for everyone.
We note that a lot of investment portals out there that purport to be crowdfunding portals are really only open to accredited investors, in reliance on the SEC Rule 506(c) exemption that allows for general solicitation and advertising. Yet even though an offering that is only open to the wealthiest 3% of Americans doesn’t qualify as true crowdfunding, these portals can still provide a great service for entrepreneurs, and we’ve worked with a number of them.
At Cutting Edge Capital, while we’re best known for our work with direct public offerings, we help our clients with many capital-raising strategies, including private placements, Rule 506 offerings (with or without general solicitation), and exempt crowdfunding. If you’d like to discuss which strategy is best for your enterprise, please contact us.