With entrepreneurs facing difficulties raising enough funding for their startups, crowdfunding has become increasingly popular.
Crowdfunding involves using social networking and a strong product campaign to gather support from the general public -the “crowd” – for a multitude of small investments. Accumulating many small investments from the crowd then becomes equivalent to and has the same market power as single source of funding. Most crowdfunding services are all or nothing – an entrepreneur will set a goal amount to fund-raise and will only receive all the funds if the goal is met, otherwise the entrepreneur will receive nothing.
Many different sites provide an online platform for crowdfunding: Kickstarter, Indiegogo, RocketHub, and Onevest. Crowdfunding is a very general term, as it covers many different models of fundraising. There are five main models of crowdfunding and each model differs by what each investor will receive in return for their small investment in the business.
The Five Models Are
Donation model – crowd investors provide donations to a business without receiving anything in return. This model is best used for social causes and charities for amounts under $10,000.
Reward model – crowd investors provide funding in return for rewards. There may be different levels of rewards to encourage investors to provide more money. This model works well for businesses with tangible products and seeking to raise under $100,000.
Debt model – crowd investors provide funding in return for a loan agreement, with a definite payoff timeline and set interest rate. This is a good alternative for business owners who want to raise over $100,000 but do not want to use an equity model.
Royalties model – crowd investors provide funding for a project or venture in return for a percentage of revenue once it has generated capital, essentially a small royalty percentage from sales. This model works well for a project or venture that is not fully developed or launched yet, such as an application.
Equity model – crowd investors provide funding in exchange for actual equity shares of the business. This has been provided for under the JOBS Act signed by President Obama in April 2012. This is best used for businesses seeking $100,000 or more of funding, however, there are many caveats to using this model. The Equity model is the newest and most talked about model presently. In regards to the equity model, there are three main legislations that are important to know:
- Title III of the JOBS Act,
- Title II of the JOBS Act, and the
- Michigan Invests Locally Exemption (“MILE”).
JOBS Act Title II
Title II of the JOBS Act [xxi], also currently in effect, helps provide access to capital by effectively allowing private companies to publicly advertise that they are raising capital. Generally, the Securities Act of 1933 prohibits the use of general solicitation to offer securities to investors. However, Title II relaxes this prohibition by permitting general solicitation to accredited investors as long as the issuer of securities takes reasonable steps to verify that purchasers of the securities are accredited investors. [xxii] In addition to reasonable verification, there are also other requirements regarding the timeline, resales, and disqualification of bad actors.
General solicitation to accredited investors opens up more avenues to capital for a business because it may enable an exception from registering securities with the SEC if the requirements of Rule 506 of Regulation D are met. Under Reg D, an accredited investor can fund an unlimited amount of money to a business.[xxiii] General solicitation includes, but is not limited to: any advertisement, article, notice or other communication published in any newspaper, magazine, or similar media or broadcast over television or radio; and any seminar or meeting whose attendees have been invited by any general solicitation or general advertising. [xxiv]
JOBS Act Title III
Equity is the stock or security that represents an ownership interest in a business, which is protected by Section 5 of the Securities Act of 1933. Section 5 requires that any offer or sale of securities using the means or instrumentalities of interstate commerce be registered with the SEC, unless an exemption exists. Registration of securities is both costly and time-consuming, therefore it is not ideal for a small or new business with limited capital. However, Title III of the JOBS Act provides an exception from registering securities as required by Section 5 and allows businesses to pursue equity crowdfunding on a national level. [ix]
The forms enabling funding portals to register with the Commission became available effective January 29, 2016. [x] The SEC’s final rules and forms implementing Title III of the JOBS Act – the rules for debt and equity crowdfunding (aka Regulation Crowdfunding) [xi] – came into effect May 16, 2016. [xii]
In essence, under the Rules companies are able to “crowdfund” up to a maximum aggregate of $1.07 million over a 12-month period from both accredited and unaccredited investors by offering and selling securities through SEC-approved “crowd funding” portals. Each offering must include a business plan for which the underlying purpose must be a bona fide business and not an investment vehicle. [xiii] Inflation-adjustments, issued by the SEC in May 2017, now allow unaccredited investors whose annual income or net worth are less than $107,000 per year to offer the greater of $2,200 or 5% of the lesser of their annual income or net worth. If their annual income and net worth are equal to or more than $107,000, the investor may offer 10% of the lesser of their annual income or net worth. During the 12-month period, the aggregate amount of securities sold to an investor through all crowdfunding offerings may not exceed $107,000. [xiv] Businesses are now able to advertise to potential investors using Facebook, Twitter, email etc., so long as the company hits 100% of their funding target, does not exceed $1.07 million, and makes their offerings on a SEC-registered funding portal or through broker/dealer. [xv] At the end of 2017, there were a total of 36 FINRA approved crowdfunding portals. [xvi]
The SEC has made it clear that any company choosing to solicit securities-based crowdfunding dollars must still strictly adhere to an immense number of rules – as is evidenced by the 685 pages of rules produced by the SEC. As disclosure is one of the key features of the rules, businesses are required to disclose any information about their business which could materially impact an investor’s decision to back it. This can include everything from ownership and directorship information, risk factors, the company’s financial condition, the price to the public of the securities being offered, and much more. [xvii] The business is also required to publish annual reports. [xviii] Startups, small businesses, and entrepreneurs all across the United States are now able to take advantage of a previously unexplored source of investment, but should do so carefully to ensure compliance with the new rules. [xix] Michigan’s LARA has created a FAQ which can help answer some key questions regarding the rules and how to implement crowdfunding in Michigan. [xx]
The Michigan Invests Locally Exemption
The Michigan Invests Locally Exemption (“MILE”) was enacted in 2014 to help Michigan residents receive crowdfunding funds on an intrastate level. To qualify for this exemption, intrastate crowdfunding must meet the requirements under Section 3(a)(2) of the Securities Act of 1933 and under MILE itself. Section 3(a)(2)[xxv] provides an exemption from registration for “[a]ny security which is a part of an issue offered and sold only to persons resident within a single State or Territory, where the issuer of such security is a person resident and doing business within or, if a corporation, incorporated by and doing business within, such State or Territory.” Specifically, the issuer must be a resident and doing business within the state in which all offers and sales are made and no part of the issue may be offered or sold to non-residents within the time specified. [xxvi] An issuer is deemed doing business in a state if the issuer meets all of the following 80% tests:
- It derives at least 80% of its gross revenues and those of its subsidiaries on a consolidated basis within the state;
It has at the end of its most recent semi-annual fiscal period prior to the first offer of any part of the issue, at least 80% of its assets and those of its subsidiaries on a consolidated basis located within such state;
It intends to use and uses at least 80% of the net proceeds to the issuer from sales made pursuant to this rule in connection with the operation of a business or of real property, the purchase of real property located in, or the rendering of services within such state or territory; and
It has its principal office located within such state. [xxvii]
In addition to Section 3(a)(2), the intrastate crowdfunding must meet the requirements under MILE. MILE provides that an offer or sale of a security by an issuer during a 12 month period is exempt from State registration if the offer or sale meets all of the following:
- Issuer is an entity that is incorporated or organized under the laws of Michigan and authorized to do business in Michigan.
- The term of the offering does not exceed 12 months.
- The sum of all cash and other consideration cannot exceed 1 million dollars. However, if the issuer can provide audited financial statements to each prospective purchaser, then the maximum is 2 million dollars.
- A single purchaser cannot invest more than $10,000 unless he is an accredited investor. [xxviii]
Before using the MILE exemption, the issuer must file a notice, escrow agreement, and disclosure statement with LARA and pay a filing fee. Additional filings are required if using an internet website, such as Michiganfunders.com, to conduct the offering. A copy of the disclosure statement must be provided to each prospective purchaser at the time of the offer. Any funds raised will only be released by the escrow if the minimum target offering amount specified in the disclosure statement is met, otherwise the funds will be returned to the purchasers. Each participating purchaser must sign a certification and acknowledgement about investing in a high risk-speculative investment and the issuer must provide quarterly reports to the purchasers until none of the securities issued are outstanding.
In considering using Title II, Title III, or MILE, it is important to speak to an attorney to ensure all requirements are properly met. Failing to comply with the requirements may require that the security be registered with the SEC and could be a breach of federal securities laws. In addition, each of the crowdfunding models have different tax implications and regulations to follow; therefore it is important to speak to an attorney or advisor before proceeding.
If you have any questions regarding crowdfunding or avenues to funding for your new business, please contact Randolph M. Wright in the firm’s Birmingham office.