Social media is all the rage and seems to be rearing its head in just about every aspect of daily life. Turn on any television news program, whether CNN, ESPN, or any other, and you’ll be sure to be brought up to date with who has “tweeted” what to whom or what someone’s latest facebook status update means to the future of the world as we know it. However, there is more to social media than providing additional outlets to those persons and businesses already in the limelight. The fact of the matter is that these new social media tools allow just about anyone to widely disseminate information across the world at little to no cost. Naturally, organizations have realized the power of social media for promoting their cause and for fundraising purposes, particularly charitable organizations and political campaigns, many of which have raised significant amounts through a crowd-sourced approach.
Entrepreneurs have also recognized this potential and have sought to utilize social media for their own capital raising purposes. Unfortunately, many of the entrepreneurs may not realize that raising capital in this manner has securities laws implications which, if not sufficiently addressed at the outset, could be extremely detrimental to their business. Accordingly, these social media-based capital offerings are required to be registered with the SEC or offered pursuant to an exemption from registration. Until recently, there did not exist a specific exemption for crowdfunded offerings. However, the recently enacted Jumpstart Our Business Start-ups Act, or “JOBS Act”, created a crowdfunding exemption as the result of a successful campaign by small business advocates who saw crowdfunding as a useful tool to help small businesses in need of capital while at the same time minimizing investor protection concerns by imposing a small per capita investment limit. Many blogs and business-oriented publications have been creating a buzz about the new crowdfunding exemption and have been touting it as a boon for small businesses in need of capital. But as the title, of this post implies, we feel that this excitement is generally misplaced.
Despite the new legislation creating the new crowdfunding exemption and all of the notoriety it has been garnering in the U.S. business community, the exemption will likely be of little or no use to companies of any size because it is so restrictive and laden with rules and requirements that the compliance costs for issuers using the exemption greatly outweigh the benefits. For example, companies seeking to undertake a crowdfunded offering must provide certain financial information to investors based on the amount to be raised. For offerings up to $100,000, the company must provide its most recent tax return and have the principal executive and financial officer certify the accuracy of the company’s financial statements. For offerings between $100,000 and $500,000, the company must provide financial statements which have been reviewed by a certified public accounting firm. For offerings between $500,000 and $1,000,000, the company must provide audited financial statements. What’s interesting to note is that no other registration exemption, including the Rule 504 small business offering exemption pursuant to which companies can raise up to $1,000,000, require company officers to certify financial statements or audited financial statements (which most small businesses do not have the financial means to obtain in the first place). Companies will also be required to utilize registered intermediaries called “funding portals.” These funding portals will be subject to certain regulations and requirements which will ultimately increase costs of the companies using their services.
As one legal commentator has pointed out, there is a twist of irony in the crowdfunding situation that is also noteworthy in that Congress granted rule making authority to create and implement the crowdfunding exemption to the SEC – an agency whose perceived lack of responsiveness to adequately address the capital raising needs of small businesses kick started the Congressional securities law reform movement in the first place. Given the SEC’s negative view towards crowdfunding, we would expect the final rules to make the exemption even less issuer friendly. In fact, since the enactment of the JOBS Act, the SEC has already issued interpretive guidance that subsequent purchasers of securities issued pursuant to the crowdfunding exemption will each count as shareholders of record for 1934 Act reporting company determination purposes even though the initial purchasers are specifically exempted under the JOBS Act legislation. This may force companies who are successfully able to grow using a crowdfunded offering to go public before they would have liked which could make the crowdfunding exemption less attractive up front. For the small businesses the exemption was intended to help, these compliance costs will likely make the exemption cost prohibitive. For larger companies, the $1 million annual limit for crowdfunded offerings is too probably low to be of any real use. While final rules have yet to be adopted by the SEC, the legislative requirements of the exemption alone render the exemption practically useless. Although the crowdfunding exemption will give companies another arrow in their capital raising quiver, we expect, in light of the foregoing, that the Section 4(2) private offering exemption to continue to be the primary exemption for small business issuers going forward, especially because of partial repeal of the ban on general solicitation and advertising for certain offerings exempt by Rule 506.