Crowdfunding: The New Frontier in Raising Capital

As access to capital for startups and small business owners decreased significantly in the past few years, crowdfunding advocates began pushing heavily for changes to the law that would allow businesses to raise capital from the public in exchange for equity without undergoing the onerous and extremely costly securities registration filing process with the Securities and Exchange Commission (SEC).

In April 2012, crowdfunding securities offerings became a reality when the Jumpstart Our Business Startups (JOBS) Act became federal law. Title III of the JOBS Act amended the Securities Act of 1933 (the Securities Act) to provide an exemption from securities registration requirements for crowdfunding securities offerings of up to $1 million in any 12-month period, so long as such offerings comply with the requirements of the JOBS Act and rules created by the SEC to govern such offerings (which should be adopted by the end of 2012 or early 2013). While the changes to the law will allow small business owners and entrepreneurs’ to reach the public to raise capital in exchange for equity, there are some restrictions and requirements under the JOBS Act that may make access to the public less appealing than many had hoped would be the case.

Restrictions on Offering and Individual Investment Amounts; Informational Requirements

Under the JOBS Act, an issuer is restricted in the aggregate amount of investments it may accept from any individual investor. Individual investors with net worth or annual income below $100,000 are limited to investing no more than the greater of $2,000 or 5 percent of their net worth or annual income with an issuer in any 12-month period. Investors with net worth or annual income equal to or greater than $100,000 are limited to investing no more than 10 percent of their net worth or annual income in any 12-month period, not to exceed $100,000 in any 12-month period.

In order to comply with the new law, issuers under the crowdfunding exemption will also need to provide a considerable amount of information to investors. This information includes, but is not limited to, a business plan, ownership and capital structure, risk factors related to the investment and a description of how the securities offered are being valued (including examples of methods that may be used in future valuations of the offered securities). In addition, issuers must provide the following financial information:

-For an offering of up to $100,000, income tax returns from the most recent year and financial statements,
-For an offering greater than $100,000 but no more than $500,000, financial statements reviewed by an independent public accountant,
-For an offering greater than $500,000, financial statements audited by an independent public accountant. In addition to the foregoing, unless the SEC provides an exception under the crowdfunding rules it adopts later this year, an issuer will have an ongoing obligation to provide to the SEC and its investors, at least annually, reports on the results of its operations and financial statements.

Crowdfunding May be Cost Prohibitive for Some

The access to a larger pool of investors under a crowdfunding offering may be outweighed to some extent by the significant costs an issuer may incur with such an offering. Depending on the size of the offering, the issuer may incur substantial costs for the review or audit of its financial statements. In addition, the JOBS Act requires that all offerings under the crowdfunding exemption be conducted through funding portals (i.e., Kickstarter or Indie Go Go) or brokers rather than directly between issuers and investors (as is often the case in private offerings under Regulation D of the Securities Act), so the issuer will need to take into consideration the costs of conducting transactions through such intermediaries.

Also, the preparation of annual reports that must be filed with the SEC and investors will be an ongoing expense that must be factored into the use of the exemption. An issuer will need to carefully balance the benefits of the increased access to capital under the crowdfunding exemption against the costs and time incurred in complying with its rules and restrictions. At least initially, crowdfunding may be most beneficial to businesses that are several years beyond their start-up phases. The above offering costs and the aggregate offering restriction on the issuer of $1 million in any 12-month period means that many start-ups will likely need to continue to consider more traditional channels of raising additional capital to adequately fund the growth of their businesses.

For more information on the crowdfunding securities offering exemption under the JOBS Act, please contact Malene T. Prince at (317) 236-2316 or malene.prince@icemiller.com or any member of Ice Miller's Private Equity or Venture Services Group.

This publication is intended for general information purposes only and does not and is not intended to constitute legal advice. The reader should consult with legal counsel to determine how laws or decisions discussed herein apply to the reader's specific circumstances.