Finally! The Day has arrived! We’ve only been talking about it for the past 3 years and quite frankly, we were starting to wonder whether the SEC would ever get around to it.
But … the SEC finally voted on October 30, 2015 t,o implement the new Crowdfunding Rules that will allow syndicators to use Internet marketing to attract non-accredited, less sophisticated investors to invest in their projects. As with all securities regulations, these rules are quite complex and clocked in at 685 pages! If you have insomnia, I invite you to check out the complete rule here. For the rest of you, here are my thoughts as to the good, the bad, and the ugly of these rules.
THE GOOD
1. You Can Now Advertise and Solicit Your Syndication to Target Non-Accredited Investors. Until these new rules were passed, syndicators were prohibited from generally soliciting or advertising their offerings to non-accredited investors without first registering their syndication with the SEC and/or the States (an expensive and time-consuming process that is generally to be avoided at all cost). These new rules (officially called ‘Regulated Crowdfunding’) create a brand new exemption to registration and, subject to some restrictions discussed below, syndicators are free to advertise their deals to anyone they wish.
2. You Can Conduct Parallel Raises. This is a big one, and is often overlooked. Although the new Regulated Crowdfunding Rules limit your raise in reliance on these rules to one million dollar ($1,000,000), there is nothing that prevents you from raising additional capital in compliance with another exemption so long as you independently comply with both. In the case of Regulated Crowdfunding, this essentially means that as long as you don’t mention the other raise in your Crowdfunding materials, then you are free to raise an unlimited amount of capital somewhere else, in compliance with another exemption.
For example, lets say you need to raise $2,000,000 for your project. You could rely on the new Regulated Crowdfunding exemption to raise $1,000,000 and then at the same time, raise an additional $1,000,000 under the Rule 506(b) exemption, which allows an unlimited raise so long as you have a pre-existing relationship with your investors and limit yourself to 35 non-accredited investors.
3. You Have Access to Unlimited Capital. Probably the most exciting part of this new law is that it provides individuals who don’t have a big network of investors (other than their family and friends) and people who would rather die than be forced to pitch an idea to a total stranger (or worse yet, a friend) an opportunity to reach a worldwide audience. Many people have great business ideas or would like to start or expand their real estate portfolio, but simply feel that they don’t know enough people who can fund their deals or are not comfortable talking to people or selling themselves or their ideas. This new avenue should alleviate many of those issues for up and coming companies as it allows the syndicator to communicate their vision without having to know the interested investor or having a personal or telephonic conversation with them.
THE BAD
1. Raise Limitations. The Regulated Crowdfunding exemption imposes significant limitations as to how much money you can raise over the course of a year and how much money you can accept from each investor. (a) Overall Raise: Syndicators can raise no more than one million dollars ($1,000,000) over any 12-month period. This is a gross number from which you will need to deduct your costs associated with the CrowdFunding platform. (b) Investor Limitations. Investors are broken down into 2 categories and limitations are imposed depending on what category the investor falls into.
Lower Category. Investors with annual incomes or net worth of less than $100,000. For this category, investors are limited to investing the greater of $2,000 or 5% of the lessor of their annual income or net worth.
Higher Category. Investors with annual incomes and net worth of $100,000 or more. For this category, investors are limited to 10% of the lessor of annual income or net worth, not to exceed $100,000.
Both Categories. During any 12-month period, the aggregate amount an investor can invest through this Regulated Crowdfunding cannot exceed $100,000.
So many variables here: lets attack these one at a time. The first unusual observation is that it is very possible to be an accredited investor, yet fall into the Lower Category, as the test is income OR net worth. So, a young doctor earning $250,000 a year with a net worth of $50,000 due to student loan debt, is an accredited investor (based on this income) but falls into the Lower Category since he needs to satisfy BOTH the income and net worth tests. Similarly, it is possible to be an accredited investor by having over $1,000,000 in net worth, yet if the investor earn less than $100,000 a year, the accredited investor will fall into the Lower Category.
Second observation is to note that in both cases, one must look at the lesser of these 2 numbers. So in the case of the accredited doctor, we look to his $50,000 net worth and thus he is limited to a $2,500 investment (5% of $50,000). This is a significant (if not gigantic) change from the original proposed rules (which proposed using the higher of these two numbers) and we believe severely limits capital formation. Finally, there is a $100,000 cap on the investor for any syndications during a 12-month period. Therefore, if the investor has already invested in a few other Regulated Crowdfunding projects with other investors, the investor could be severely limited. For example, lets say a Higher Category investor has already invested $75,000 in other crowdfunding projects, then the maximum this investor could contribute to your project is $25,000.
2. Funding Portals. You must use a qualified intermediary, which will be an Internet platform that needs to be either an SEC Broker-Dealer, or a newly created Funding Portal, which will be registered and regulated by the SEC. You, personally, are not allowed to discuss the details of your syndication in any marketing materials, websites, social media outlets, other than the following:
3. Rescission. The Crowdfunding Rules allow any investor to change his or her mind within 48 hours of the Close of the raise. You should strongly consider setting a higher raise target than needed, to account for investors who may back out of the raise.
4. Lots of Investors. If most investors are investing $2,000 or $5,000, it is not inconceivable that you will have 200 investors or more in your syndication. Most of them, unsophisticated. That is a lot of people that you need to communicate with, and as experienced syndicators will tell you, about 20% of those investors will take up about 80% of your time, specially if things aren’t going as planned.
THE UGLY
1. Financial Disclosures. As the syndicator, you will be required to provide different levels of financial information, depending on the amount of your raise.
Raises Less Than $100,000. Provide to the investors, the Funding Portal, and the SEC, the most recently completed year (if any) and financial statements that are certified by the principal executive officer to be true and complete in all material respects, in addition to disclosing the Company’s total income, taxable income and total tax as reflected in the federal tax return (actual tax return not provided).
Raises Between $100,000 and $500,000. Provide to the investors, the Funding Portal, and the SEC financial statements reviewed by a public accountant that is independent of the issuer.
Raises over $500,000. Provide to the investors, the Funding Portal, and the SEC financial statements audited by a public accountant that is independent of the issuer.
As many of you are aware, audited financials can be extremely expensive depending on the type of business you have. Although the SEC did provide some relief in exempting first time users, for those who expect to use the Regulated Crowdfunding exemption as a regular source of capital formation, this will definitely raise your compliance costs.
2. Progress Updates. In addition to filing certain update reports throughout your raise, you are required to file an annual report with the SEC and post the annual report on your website. The annual report would include a disclosure similar to that in the original offering statements, including the financial conditions and financial statements referenced above (although for purposes of annual reports, it is sufficient to simply provide financial statements that are certified by the principal executive officer). Failure to do so may result in your ineligibility for future reliance on this exemption.
3. Portal Cost. According to the SEC, by the SEC estimated that for raises under $100,000, the cost to comply with the Regulated Crowdfunding[1] would be between 6.7% and 11.7% of the raise. If raising between $100,000 and $500,000, the SEC estimated a cost of between 4.1% and 11.3% and for raises over $1,000,000, the SEC estimated a cost of between 4.8% and 12%. Although these numbers clearly indicate that a syndicator is better off raising as close to the maximum as possible, these are only best guesses by the SEC and we won’t know the true numbers until the Funding Portals come online.
Regulated Crowdfunding won’t become effective until May 16, 2016, but syndicators should take a serious look at this exemption as a legitimate avenue to raise some if not all of their capital needs.
This blog post is intended to provide general information and should not be construed as, and does not constitute legal advice on any specific matter, nor does this message create an attorney-client relationship with Premier Law Group.
[1] Assuming raises of $100,000, $500,000 and $1m