Changes to SEC Rules on Equity Crowdfunding Loosen Restrictions on Raising Capital
New Securities and Exchange Commission rules that raise funding caps for all levels of equity crowdfunding and clarify requirements for entrepreneurs went into effect on March 15, 2021.
- The JOBS Act of 2012 legalized equity crowdfunding, a way for early-stage private companies to raise capital without an IPO
- Entrepreneurs using equity crowdfunding raise capital by selling securities or stakes in their company to investors through an online portal
- A 2015 SEC ruling implemented limits on the amount and frequency of investor contributions
- These regulations were recently amended, loosening limits on investors and clarifying requirements and processes for entrepreneurs
Private companies seeking to raise capital without the expense and intensity of an IPO have gravitated toward equity crowdfunding, an option legalized in the 2012 Jumpstart Our Business Startups (JOBS) Act. Since then, the SEC has issued several revisions to both the scope of equity crowdfunding and the amount of fundraising allowed.
Equity crowdfunding, also referred to as Regulation Crowdfunding by the SEC, is the process of using an online platform to raise funds from the public to finance a project or private business. It differs from the type of crowdfunding popularized by Kickstarter campaigns in that equity crowdfunding entrepreneurs raise capital through the sale of securities (shares, convertible note, debt, revenue share, and more) in a private company.
Instead of a transaction-based “pre-sale” agreement that concludes with the delivery of the product or service (as in traditional crowdfunding), each investor in an equity crowdfunding deal is entitled to a stake in the company proportional to their investment. The process gives investors skin in the game. Until recently, that “skin” was capped at what some considered to be an unreasonable amount.
The following presents a brief regulatory history of equity crowdfunding—including the latest changes and their implications for entrepreneurs and investors.
The JOBS Act and the introduction of Regulation CF
The 2012 JOBS Act legalized equity crowdfunding as part of a campaign to energize the economy by making numerous capital sources available to small and “micro-cap” companies while easing regulatory burdens.
Prior to this ruling, any person or venture selling securities without an exemption from SEC registration (something not typically available to potential crowdfunders) could be held liable in federal, state, and maybe even foreign jurisdictions. The introduction of the JOBS Act established the crowdfunding exemption along with a regulatory structure. It also set limits on funding amounts and contained protections against fraud.
The crowdfunding exemption from SEC registration is at the heart of Title III of the JOBS Act. More than two years after the act’s passage, the SEC adopted Regulation Crowdfunding to implement Title III’s requirements.
This effort included provisions governing funding portals; compliance, recordkeeping, and filing requirements; and conditional safe harbors for permissible activities. Some of the finer points of Regulation Crowdfunding, 2015 are:
- All transactions must take place online through an SEC-registered intermediary, either a broker-dealer or a funding portal;
- The amount raised through equity crowdfunding cannot exceed $1.07M in a 12-month period; and
- Individual investors are limited in how much they can invest across all crowdfunding offerings in a 12-month period (based on annual income or net worth).
Additionally, the ruling listed companies that were not eligible for the crowdfunding exemption, including non-U.S. companies, Exchange Act reporting companies, certain investment companies, and companies that had been previously disqualified under Regulation Crowdfunding’s “bad actor” rules.
The long-awaited changes of 2020
On November 2, 2020, the SEC voted on amendments to harmonize, simplify, and improve the exempt offering framework for investors, emerging companies, and more seasoned issuers. These amendments were developed from reviews the Commission had conducted since the initial JOBS Act crowdfunding regulations went into effect in 2015.
The existing “patchwork system” was determined to be complex and inefficient—a costly deterrent for small, early-stage private businesses searching for alternate funding mechanisms. The 2020 ruling sought to clarify standards and raise limits while retaining investor protections.
The Regulation Crowdfunding (Reg CF) changes that will take effect on March 15, 2021, include:
- An increase in the offering limit, from $1.07 million to $5 million;
- Removal of investment limits for accredited investors (a person with an annual income exceeding $200,000 for the last two years, or $300,000 for joint income; or a net worth exceeding $1 million, either individually or jointly);
- For non-accredited investors, the investment limit changed to be the greater of (as opposed to “lesser of” under the current rule) existing limits based on an investor’s annual income or net worth;
- A new “test the waters” provision that allows Reg CF companies to build crowdfunding pages to share information with potential investors prior to issuing securities; and
- The amount of time required between Reg CF fundraisers decreased from 180 days to 30 days.
Before the most recent amendments, there was no clear framework for companies looking to benefit from several exemptions simultaneously or within a tight timeframe. Reg CF companies now have access to safe harbors for multiple offerings, enabling them to lead several successive fundraising campaigns.
This set of amendments also increased the offering limits for Regulation A+ (the “mini-IPO” for more established companies) and Rule 504 /Regulation D (for accredited investors only) offerings.
The implications for entrepreneurs and investors
The revised regulations governing equity crowdfunding are intended to level the playing field for early-stage startups by making more capital available from more types of investors, without the complexities and costs of formally “going public.”
The relaxed limits could make the U.S. more competitive globally. France, the U.K., and Germany all raised their equity crowdfunding limits to generous amounts at least three years before this latest SEC amendment.
For entrepreneurs, the new $5M limit could be a stand-alone means of financing their company through a few key growth milestones. By broadening the scope of who can invest, startups are essentially recruiting highly motivated brand ambassadors with a stake in their business success. Through equity crowdfunding, founders can use the power of their online network not only to raise capital but also raise awareness of their business.
Entrepreneurs who opt to raise capital by equity crowdfunding are in total control of the offering process. They set the terms—no venture capital firms or institutional investors to dictate conditions. It is up to the company to target a maximum goal based on the valuation they set.
Allowing the public to buy a stake in private companies opens up access to more investors and compensates for the declining number of IPOs over the past decade. Although it may seem that there is no shortage of companies going public with great fanfare, especially in the technology sector, the number of public equities in the U.S. halved between the mid-1990s and 2020, from around 8,000 to 4,000. This decrease has left the “common investor” with limited access to high-growth opportunities.
Since the Sarbanes-Oxley Act’s enactment in 2002, the financial and regulatory burden of being a fully reporting public company has increasingly proven too much for startups or even medium-sized businesses. Because of the recent SEC rulings, equity crowdfunding could provide a viable alternative for early-stage companies and, in turn, give the economy a needed jumpstart—as the initial 2012 legislation intended.
The attorneys at Johnston Clem Gifford routinely advise companies on issues related to securing capital and regulatory compliance. Our Financial Services team works with the world’s largest institutions as well as smaller and middle-market firms. Contact us online or by calling (214) 974-8000.