April 5, 2012, President Obama signed the Jumpstart Our Business Startups Act (aka the JOBS Act), which included the cleverly titled Capital Raising Online While Deterring Fraud and Unethical Non-Disclosure Act, or “CROWDFUND Act.” The CROWDFUND Act established a securities law exemption (codified at Section 4(a)(6) of the Securities Act) allowing startups to raise funds under conditions that would have previously been considered a general solicitation. Many of the editorials written about the Act expect a paradigm shift in fundraising behavior and offer predictions ranging from the dawn of a golden age to the undoing of 80 years worth of investor protections.
Although the Act did usher in a number of outwardly dramatic regulatory changes, we are not expecting many sophisticated startup companies to take advantage of Section 4(a)(6). Instead, we expect that “accredited investor” offerings under Rule 506 of Regulation D will remain the dominant paradigm. Why? Because there are a number of things that the Act did not or cannot change.
Consider the following requirements of Section 4(a)(6):
• An issuer can raise up to $1 million each year from what the brokerage industry might call “retail” investors. An investor can invest the greater of $2,000 or 5% of his annual income or net worth, if either is below $100,000, or the lesser of $100,000 or 10% of his annual income or net worth, if either is above $100,000.
• These transactions must be conducted through a registered broker-dealer or a “funding portal.” The CROWDFUND Act gave the Securities and Exchange Commission until December 31, 2012 to come up with “funding portal” regulations, but there is not yet a clear sense of the registration or ongoing compliance requirements.
• Startups will have to provide certain information to participating investors. All startups relying on Section 4(a)(6) will have to provide basic information about the offering, the company, and its officers, directors and major stockholders. Startups will also have to provide financial information, depending on the target offering size. For rounds up to $100,000, the company will only need to provide tax returns, if any, and financial statements certified by the chief executive officer. For rounds between $100,000 and $500,000, the financials must be reviewed by a certified public accountant. Above $500,000, the financials must be audited.
Now consider the implications of those requirements:
• Many investors at the upper end of the income/asset ranges will be “accredited,” and therefore eligible to participate in less restrictive Rule 506 offerings. The real change is that unaccredited investors can write checks for a few thousand or even a few hundred dollars. Even if the process of closing with individual investors can be fully-automated, the ongoing cost of dealing with potentially hundreds of minor investors will be overwhelming. The burden of managing relationships with that many stockholders is typically reserved for significantly larger and more mature companies. In addition to being an expensive distraction, this may be a turnoff for more traditional venture capital investors.
• Broker-dealers are in the habit of charging significant placement fees, at least in part due to the cost of complying with laws and regulations. Most legal commentators anticipate that “funding portals” will face significant registration and compliance expenses, which will be reflected in the transaction fees charged to startups. By contrast, offerings limited to “accredited investors” under Rule 506 of Regulation D do not need to be transacted through an intermediary.
• The information requirements of Section 4(a)(6) may seem fairly relaxed, but bear in mind that there is no information delivery requirement at all for Rule 506 offerings limited to “accredited investors.”
The CROWDFUND Act does create a novel and interesting exemption strategy for startups that do not have access to more traditional sources of angel or venture capital financing, but given the difficulties of managing a diffuse stockholder base, the cost of fundraising through intermediaries, and the disclosure burden imposed by the Act, it is very likely that sophisticated startups will continue to limit their offerings to accredited investors under Rule 506 of Regulation D.
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