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Posted on 04-30-2014
Crowdfunding must meet certain SEC requirements

Crowdfunding has financed movies and music recordings. It has made Kickstarter a national brand. However, it has not been used to sell securities because current regulations make this impractical due to the costs involved in a registered securities offering,. There are also regulations that make private placements impractical, such as prohibitions on advertising and limitations on the number of shareholders a private company can have.

Don’t know what crowdfunding is? Simply put, companies and organizations that seek financing turn to a “crowd” of potential backers for money, and more often than not, they do this over the Internet.

The Jumpstart Our Business Startups (JOBS) Act may change regulations, opening up crowdfunding as a viable means of funding small businesses and startups. Congress passed the JOBS Act on April 5, 2012, with the intent to aid the funding of small businesses by easing securities regulations. Title III of the JOBS Act added a new Securities Act Section 4(a)(6), which provides an exemption from the registration requirements of Securities Act Section 5 for certain crowdfunding transactions.

In response to the Congressional mandate of the JOBS Act, the SEC published proposed Rule #S7-09-13 on Oct. 23, 2013, to establish the framework for implementing the exemption. The proposed rule included a 90-day public comment period that ended Feb. 3, 2014.

To qualify for this exemption under the provisions of Title III and the SEC’s proposed rule, a crowdfunding offering must meet certain requirements. These include:

  • The amount raised must not exceed $1 million in a 12-month period.
  • Individual investments in a 12-month period are limited to the greater of $2,000 or 5 percent of annual income or net worth, if annual income or net worth of the investor is less than $100,000 or 10 percent of annual income or net worth (not to exceed an amount sold of $100,000), if annual income or net worth of the investor is $100,000 or more.
  • Transactions must be conducted through a registered broker dealer or a new type of entity that also must be registered called a funding portal.

However, reduced regulations do not mean that there are no regulations. Companies seeking a crowdfunding offering would be required to disclose, in an offering document, certain information, including:

  • Information about officers and directors, as well as owners of 20 percent or more of the company
  • A description of the company’s business and the use of proceeds from the offering
  • The price to the public of the securities being offered and the target-offering amount
  • Certain related-party transactions
  • A description of the financial condition of the company
  • Financial statements of the company that, depending on the amount offered and sold during a 12-month period, would have to be accompanied by a copy of the company’s tax returns or reviewed or audited by an independent public accountant

The offering document and other information would be required to be filed with the SEC. There is also an annual reporting requirement. All of this would be filed on a newly created Form C.

Not all companies would be eligible to use this exemption. For example, companies that are already SEC-reporting companies, non-U.S. companies and most investment companies would be ineligible. Also, startups must have a business plan.

The broker dealer or funding portal through which crowdfunding transactions are processed would have an important role in safeguarding investors. These transactions could only be done online. They would be responsible for providing educational information to, and communication channels for, investors to discuss the offering and to take certain measures to reduce fraud risk. While they would facilitate crowdfunding transactions, they would be prohibited from soliciting purchases, sales or offers to buy on their website.

The SEC would like to remind potential issuers of securities that relying on exemption 4(a)(6) in a securities offering before a final rule is issued is a violation of federal securities laws. Companies contemplating a crowdfunding offering or investors wanting to participate in one should monitor the SEC’s website for the news regarding the final rule. In the meantime, a copy of the proposed rule can be found at the SEC website.

Marty Lindle, CPA, is a director of Audit for PKF Texas. He works with energy, hospitality and real estate clients. Contact him at mlindle@pkftexas.com or (713) 860-1400.