On Monday, May 16, 2016, the Title III crowdfunding regulations became effective. This will offer startups a new alternative to traditional channels for raising capital. Instead of restricting investment in startups to wealthy individuals who are personal contacts of the founders, startups will be able to raise up to $1 million over the internet from ordinary investors, subject to certain restrictions and conditions. Keep reading to understand what Title III crowdfunding is and how it works, as well some of the downsides to using it.
What is Title III Crowdfunding?
“Crowdfunding” is the practice of funding a venture by raising many small amounts of money from a large number of people, typically via the Internet. The “Title III” designation comes from the fact that the regulations were promulgated by the Securities and Exchange Commission pursuant to Title III of the Jumpstart Our Business Startups Act (a.k.a. The JOBS Act).
Traditionally, securities law limited startups to raising capital solely from accredited investors. Accredited investors are wealthy investors who meet certain minimum income or net-worth standards. Securities law also placed significant restrictions on “general solicitation” by private companies like startups, which means they were prohibited from publicly discussing or advertising their capital raising. In the past few years, the JOBS Act provided a new option for startups, allowing them to raise money from accredited investors through the internet and other public advertising (this option is often called “TItle II crowdfunding” or Rule 506(c)).
In addition, it also provided an option for established late-stage startups to conduct a public offering to all investor with less legal compliance than a full IPO (this option is frequently referred to as “Regulation A+”). Missing, until earlier this week, was a method for early-stage startups to raise money on the internet from any investors (including non-accredited investors).
To that end, Title III crowdfunding permits a startup to raise up $1 million in a 12-month period. The offering must be conducted on an online platform set up by a registered broker-dealer or funding portal. The startup is still subject to significant advertising restrictions. The offering can be advertised publicly on the portal itself and the startup can promote the offering by distributing links to the platform and certain basic information about the offering. Startups are not permitted to distribute any significant offering literature themselves. In addition, there are limits to the amount that each investor can put into crowdfunding offering each year based upon the income and net-worth of each investor.
Downsides to crowdfunding for startups
While Title III crowdfunding presents an exciting opportunity for startups looking to raise capital, there are some downsides to it:
- You’ll need to get your company’s financial statements in order. The financial statements need to be prepared in accordance with GAAP, and if you are raising more than $100,000, they must be reviewed by an outside accountant. So, the average startup that has a basic quickbooks account to keep track of their finances will need to do some work here.
- The regulations require some significant securities disclosure. Each company conducting a crowdfunding offering will need to prepare a comprehensive disclosure document on Form C, which is filed with the SEC. It can be costly and time-consuming to do this.
- There is some significant potential liability. Investors can sue your company and each of the founders personally for material inaccuracies or omissions in the securities disclosure. So if the company fails to perform as expected, there could be personal liability for those involved.
- There will be additional legal compliance for the company going forward. Your company will need to keep track of all of the new shareholders. It will also need to file annual reports, which will need to contain the same information and disclosure as the initial Form C, including financial statements. Failing to keep up with all of this would have some significant legal consequences (including potentially being forced to register as a public Exchange Act reporting company – a very expensive proposition). So use of this will likely increase company overhead and administration.
- The demand for investments in startups by the general public is untested. We don’t know exactly how many investors will be willing to put money into these offerings. The fact that Kickstarter and Indiegogo, which have been conducting crowdfunding campaigns for some time in which participants donate or receive a free product rather than receive ownership, have been such big successes is a good sign. That said, for now, the success of this model is uncertain.
Starting a Crowdfunding Offering
In order to start a crowdfunding offering, you will need to choose a funding portal on which to conduct the offering. The funding portal must be registered with the SEC and FINRA. A list of such portals can be found at www.finra.org/about/funding-portals-we-regulate. A decision whether to engage in a crowdfunding offering should be done in conjunction with legal counsel to determine if it is a suitable option in light of the company’s overall fundraising strategy and potential other avenues.
