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Crowdfunding in JOBS Act Poses Risks for Entrepreneurs

Published onApr 24, 2012
Crowdfunding in JOBS Act Poses Risks for Entrepreneurs

On April 5, 2012, President Obama signed H.R. 3606Jumpstart Our Business Startups Act into law.  The Act is largely a liberalization of securities laws with regards to small businesses seeking capital from outside investors; because of this, it has been controversial and widely discussed (see hereherehere and here).  Harvard Law professor John Coates thinks that Enron-like fraud will spring directly from the JOBS Act.  He contends: “It’s not just a possibility; I guarantee that someone will in fact do worse than Enron as a result of this bill.  There will just be outright fraud.”

Predictions aside, there is no doubt that the law will change small-scale securities offerings as they currently exist.  The Act consists of six titles, each addressing a different segment of securities regulation.  Jumpstart Our Business Startups Act of 2012, H.R. 3606, 112th Cong. (2012).  Title I creates a new category of issuer called the “Emerging Growth Company.”  EGCs avoid executive compensation disclosure obligations under Section 14A of the Exchange Act and registration disclosure requirements under Section 7(a) of the Securities Act, among other exemptions.  Title II requires the SEC to revise the Rule 506 exception to eliminate the ban on general solicitations under the rule.  Title III is the long-anticipated “crowdfunding” provision that allows small companies to raise up to $1 million in any twelve month period without having to register the offering under the Securities Act registration requirements.  Title IV raises the registration exemption under Regulation A from $5 million to $50 million, a significant expansion.  Title V raises the Exchange Act reporting requirements in Section 12(g) to $10 million from $1 million, and to 2,000 persons from 500 persons, and exempts holders of securities issued in employee compensation plans from “held of record” designation.  Finally, Title VI raises the Exchange Act shareholder registration threshold for Banks and Bank Holding Companies.

Many of these changes offer technology start-ups alternatives to the typical IPO securities issuance route.  In particular, entrepreneurs and venture capitalists are excited about the crowdfunding provisions.   As already noted, the crowdfunding provisions of the JOBS Act allows small companies to raise up to $1 million in any twelve month period without having to register the offering under the Securities Act of 1933.  JOBS Act, Title III, § 301(a).

Mechanically, the crowdfunding measure works by adding a sixth exemption into Section 4 of the Securities Act.  Section 4 contains transactional exemptions from Section 5 liability for failure to register an offering under the Act.  For example, widely used securities practices including Rule 144 and Rule 506 offerings use Section 4(1) to avoid having to register the offerings under the Act.

The JOBS Act crowdfunding provision adds section 4(6) to the Securities Act.  JOBS Act, Title III, § 301(a). Though much maligned by academics for the lack of disclosure that it will allow, Section 4(6) still requires companies to provide information to the SEC and potential investors.  JOBS Act, Title III, § 301(b).  First, each company raising capital through crowdfunding must file some basic information with the SEC, including the names of directors, officers, and holders of more than 20% of the company’s shares, plus a description of the business and its financial condition.  JOBS Act, Title III, § 301(b).  Second, the provision imposes a tiered disclosure regime based on the amount of money the company is seeking to raise.  JOBS Act, Title III, § 301(b).  For companies seeking up to $100,000, tax returns and a financial statement certified by a company principal must be disclosed.  JOBS Act, Title III, § 301(b).  Issuers raising up to $500,000 must provide financial statements certified by an independent public accountant.  JOBS Act, Title III, § 301(b).  Finally, for companies raising more than $500,000, the issuer must provide audited financial statements.  JOBS Act, Title III, § 301(b).

Along with these disclosure requirements, Congress also added a $10,000 limit on the amount any individual investor may purchase under the crowdsourcing exemption. JOBS Act, Title III, § 301(a).  Finally, Congress also added a requirement that the transaction is conducted by a broker-dealer that complies with the new Section 4A that is also added by the JOBS Act.  JOBS Act, Title III, § 301(b).  Section 4A lays out twelve conditions on the transaction’s intermediary.  JOBS Act, Title III, § 301(b).  So long as the tiered limits, the investor limit, and the intermediary conditions are satisfied, a crowdfunding offering does not have to be registered under the Securities Act.  JOBS Act, Title III, § 301.

A few final notes about the crowdfunding provision: the Act explicitly grants a cause of action for rescission under Section 12(a)(2) of the Securities Act; the Act explicitly allows crowdfunding over the internet through so-called ‘funding portals’; and, finally, the Act exempts crowdfunding investors from the Exchange Act reporting thresholds.

Entrepreneurs and venture capitalists are very excited about this new source of funding.  But the reality is that crowdfunding is not likely to be a “game-changer” for small companies.  From the business point of view, there are several distinct risks that come with raising capital under a program that the SEC is already against.  Several of these risks should be weighed against the perceived benefits of crowdfunding.  Let’s take a look at the benefits and the risks.

Benefit: Avoiding Costly State-by-State Registration:

The crowdfunding provision pre-empts state blue sky laws with regards to state registration.  JOBS Act, Title III, § 303.  As a result, crowdfunding issuers can avoid thousands of dollars in registration fees and a significant amount of reporting requirements.  JOBS Act, Title III, § 303.  The issuer does not get off scot-free though since the Act requires the issuer to make the basic disclosures available to the States. JOBS Act, Title III, § 303.

Benefit: Issuers Can Raise Funds for Niche Projects:

Because the venture capital industry is competitive and selective of funding opportunities, many projects go unfunded.  Some of these projects may go unfunded because their intended market is not developed enough to support a large-scale investment.  Crowdfunding will help these ‘niche’ projects since chances are that someone else probably sees the utility in the niche project.  Now, those like-minded persons can band together to fund the project and still avoid costly registration.

Benefit: Funding Without Ceding Control:

In a typical venture capital relationship, the entrepreneur cedes significant control of the project to the venture capital or angel investor.  Crowdfunding allows the entrepreneur to avoid having to give up control since the funds come from a dispersed group of investors who are purchasing small stakes in the company rather than a single investor who will want some control for safety.

Risk: Crowdfunding Law is Unsettled:

The JOBS Act is a significant liberalization of securities law; as such, the outer boundaries of crowdfunding practice have yet to be established.  This uncertainty presents significant risk for issuers.

Risk: Greater Number of Investors Means Greater Exposure to Lawsuits:

Because the Act grants a cause of action to investors by which they can rescind their investment with interest, each investor presents an individual chance of antifraud liability.  JOBS Act, Title III, § 301(b). This should be a top concern to issuers.

The take-away here is that the crowdfunding is still a fairly risky strategy for issuers.  Small businesses and entrepreneurs should weigh the costs of extra registration under Reg A, Rule 144, or Rule 506 versus the uncertainty and liability under Section 4(6).

* Joseph Norman is a third-year law student at Wake Forest University School of Law. He holds a Bachelor of Science in Management from North Carolina State University and an MBA in Finance from the McColl School of Business at Queens University of Charlotte. Prior to enrolling in law school, Mr. Norman worked for Wells Fargo Wealth Management in Equity Research. Upon graduation in May 2012, Mr. Norman will practice corporate law.

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