New Laws, Rules Offer Options for Raising Capital

Attempts to bring crowdfunding to industry fall short, but new mechanisms are available.
By Todd Taylor | May 21, 2015

Companies are pressing harder and harder to raise capital to grow or just to survive. As a general rule, raising money is challenging because federal and state securities laws prohibit the sale of securities without registration with the U.S. Securities and Exchange Commission or an exemption from such requirements. Like an initial public offering, registration is expensive and complex. Three recently passed laws and rules, however, may help companies raise the capital they need: crowdfunding, Rule 506(c) and Regulation A+.

You have likely heard about crowdfunding sites like Kickstarter and Indigogo. Unfortunately, the promise of bringing the “crowd” to regular businesses has so far fallen short. To facilitate broader use of crowdfunding, the JOBS Act added a crowdfunding exemption that will allow companies to sell equity or other securities to the crowd. In practice, however, the requirements to use the crowdfunding exemption may be too onerous for most. While an overview of the general requirements for crowdfunding is possible, specifics will not be available for companies until the SEC adopts final rules.
The aggregate amount of securities sold under the crowdfunding exemption during any 12-month period may not exceed $1 million. In addition, if either the annual income or the net worth of the investor is less than $100,000, the aggregate amount that can be sold to such investor may not exceed the greater of $2,000 or 5 percent of the annual income or net worth of the investor. If either the annual income or net worth of the investor is equal to or more than $100,000, the aggregate amount sold to the investor may not exceed 10 percent of the annual income or net worth of the investor; and, in any case, the aggregate amount sold to any investor may not exceed $100,000. 
Additionally, the transaction must be conducted either through a registered broker-dealer or a funding portal registered with the SEC. If a registered funding portal is used for crowdfunding, the portal will not be allowed to offer investment advice or recommendations, solicit purchases, sales or offers to purchase the securities displayed on its website, pay employees, agents or other people based on the sale of securities displayed on its website, or handle investor funds or securities. In other words, companies will not be able to use their own website as a “funding portal.”

The company must also disclose information to investors, including:

• General information about its business such as location, directors and officers, description of business.

• A business plan.

• A description of financial condition, including tax returns and financial statements for offerings of $100,000 or less, independent accountant reviewed financial statements for offerings between $100,000 but not more than $500,000 or audited financial statements for target offerings more    than $500,000.

• The purpose of the offering and proposed use of proceeds.

• The target offering amount and deadline to reach such amount.

• The price of the securities.

• A description of company ownership and capital structure, along with specific information regarding the company’s securities. In addition, the company must provide investors financial statements and reports on the results of operations on an annual basis following the sale. 

The relatively low transaction and investor limits permissible under the federal crowdfunding exemption, coupled with the funding portal limitations and the upfront and ongoing disclosure obligations, could prove to be too much of a burden for many companies. There are several state legislatures that have adopted or are considering their own crowdfunding exemptions that may provide a more efficient means to raise capital from several investors.  
Got all that? Now for something a bit easier…

Rule 506(c)
Prior to the JOBS Act, Rule 506 was and remains the most used exemption. However, Rule 506 did not permit general solicitation or advertisement, so companies raising capital under Rule 506 could not legally use social media, printed flyers or other channels to solicit investors they did not know. Now, Rule 506(c) allows companies to advertise to find investors.  

Rule 506(c) does not have a dollar limitation, does not limit the number of investors or their investment amount and does not require specific information be disclosed to investors (but most companies make disclosures to avoid misrepresentation or fraud claims).

Rule 506(c) does have certain restrictions, however. A primary restriction is that all investors must be accredited, which generally equates to the investor being relatively wealthy (e.g., annual income in excess of $200,000 for an individual and $300,000 for married couples, or net worth of at least $1 million, excluding the investor’s principal residence).

In addition, the company must take reasonable steps to verify the accredited status of such investors. Whether steps taken are “reasonable” depends on particular facts and circumstances of each purchaser and transaction. The SEC has provided some guidance as to what constitutes reasonable steps, but this is still relatively unclear and untested. Overall, companies seeking to solicit sales from a large group of wealthy investors may find Rule 506(c) as a viable exemption, but will need to be careful to conduct proper diligence on the investors.

Regulation A+
Regulation A+ is a complex exemption, and in many ways, reflects a scaled back version of registration requirements and the ongoing requirements of reporting companies. The following summary only scratches the surface of the various requirements and limitations of Regulation A+ and many companies may find this exemption too burdensome and expensive, but for some, it may be the perfect fit.

The SEC adopted the Regulation A+ amendments March 25, but they will not likely become effective until sometime in June.

Regulation A+ will permit two tiers of offerings. Tier 1 offerings have aggregate sales of up to $20 million during the preceding 12 months. Tier 2 offerings have aggregate sales of up to $50 million during the preceding 12 months. In addition to a larger offering size, the primary advantage of Tier 2 is companies will not be required to also navigate state law registration and exemption requirements.
Companies will be able to sell securities under Regulation A+ to accredited and nonaccredited investors. Sales to nonaccredited investors under Tier 2 offerings will be subject to a maximum amount equal to 10 percent of the nonaccredited investor’s annual income or net worth, whichever is greater.

To conduct a Regulation A+ offering, companies will need to file Form 1-A with the SEC, which will then complete a process to qualify the offering prior to the company selling the securities. Form 1-A will provide investors with basic information about the company, offering, securities and other general information. Form 1-A will also provide an offering circular that contains extensive narrative discussion similar to that of registration statements, such as a description of the business, risk factors, use of proceeds, capitalization, description of securities, director and officer information, related party transaction disclosures and other disclosures. Form 1-A will also include financial statements for the two most recent fiscal years (that must be audited for Tier 2 offerings).

Subject to certain requirements, companies are allowed to test the waters to gauge investor interest prior to filing Form 1-A and during the qualification process, but securities cannot be sold prior to qualification. After the sale, companies that engaged in Tier 2 offerings will be subject to ongoing reporting requirements, such as filing annual reports, semiannual reports and current event reports.
Whatever your company needs to do to raise money, be aware that the rules and regulations are complex and vary from state to state, so please check with a competent securities lawyer before you start. This article isn’t intended to give anyone legal advice, so don’t try to do an offering based on it.

Author: Todd Taylor
Attorney, Fredrikson & Byron P.A.

Contributing author: Joseph Schauer
Attorney, Fredrikson & Byron P.A.