Crowdfunding as a Platform for Small Business Capital Raising
Over the past 20 years, the Internet has introduced innovative business models and platforms at an astonishing pace. More recently, the rapid spread of social media and the proliferation of “smart” phones, tablets and other mobile devices have revolutionized further the way people interact with one another, both personally and professionally. Businesses are increasingly using social media platforms such as Facebook® and Twitter® to do business and interact with their customers. Now this social media boom is also affecting the way small businesses raise funds for growth and capital investment.
One of the first focused uses of the Internet to raise capital is the so-called peer-to-peer lending sites, such as Kiva. These sites take the broader concept of “crowdsourcing” and apply it to capital raising, i.e., using the “crowd” to obtain money from investors. The peer-to-peer sites provide a platform for individuals to loan funds to emerging ventures, both domestically and overseas. Some sites, such as Kiva, operate on a non-profit model and do not pay interest or provide other returns to lenders, who only have the right to repayment of principal. Other models of crowdfunding include the “reward” and “pre-purchase” models, such as Kickstarter and IndieGoGo, where contributors receive a reward or a product from the entrepreneur, but do not receive a financial return such as interest, dividends, or part of the earnings of the business. These models of crowdfunding are primarily motivated by non-economic considerations and generally do not involve the offer or sale of securities. On the other hand, sites that offer interest-bearing loans or other securities that provide potential returns to investors have been deemed to be engaged in the sale of securities to the public and have been required to register their offerings under the Securities Act of 1933 (the “Securities Act”) and, where applicable, under state securities or “Blue Sky” laws.
Crowdfunding and the U.S. Securities Laws
Crowdfunding as a method of raising capital for business ventures through the sale of securities has received significant attention and has been advocated by a number of lawmakers, commentators and bloggers. Use of this model of crowdfunding, however, has been held back by concerns that offering securities through crowdfunding without registration would violate the federal (and state) securities laws. An example of both the promise and the regulatory risks posed by crowdfunding is a 2010 campaign by two advertising executives to raise $300 million to acquire the Pabst Brewing Company through a crowdfunding website, BuyaBeerCompany.com. The principals of the effort entered into a cease and desist order with the Securities and Exchange Commission (“SEC”) in June 2011, but not before purportedly receiving over $200 million in pledges from over five million people in a six-month period. See In the Matter of Michael Miglozzi II and Brian William Flatow, Securities Act Release No. 9216 (June 8, 2011). The SEC shut the effort down, finding that the solicitation of investors through the crowdfunding site constituted an illegal public offering in violation of Section 5(c) of the Securities Act.
Although there are crowdfunding models like Kiva, Kickstarter and IndieGoGo that do not involve the sale of securities, in order for crowdfunding to be truly effective to raise capital for small businesses in the U.S. the offering must offer investors a potential economic return on their investment. Typically, start-up and emerging businesses raise capital by selling equity interests, such as common stock or securities convertible into equity interests. Common stock interests are “securities” under both the federal and state securities laws. Under Section 5 of the Securities Act, all securities offerings must either be registered or be exempt from registration. Under current law, the exemption universe potentially available for crowdfunded offerings is limited to the private and limited offering exemptions under Sections 4(5), 4(2) and 3(b) of the Securities Act.
Regulation D under the Securities Act provides three separate exemptions that are potentially available for offerings of securities on crowdfunding sites. Under Rule 506 of Regulation D, companies can raise an unlimited amount of funds from up to 35 nonaccredited investors, who must meet a sophistication test, and an unlimited number of accredited investors. Generally speaking, accredited investors are persons whose net worth (excluding equity in a primary residence) is over $1.0 million or who meet certain income tests. Rule 505 under the Securities Act provides a similar exemption for private offerings that is limited to $5.0 million in any 12 month period. If securities are sold to nonaccredited investors in offerings relying on Rules 505 or 506, then the issuer must provide specified disclosures and financial information that are scaled and increase in scope as the size of the offering increases. Rule 504 provides an exemption for offerings of up to $1.0 million in any 12 month period that does not require that investors be accredited or sophisticated and does not require that specified disclosures be made to nonaccredited investors.
However, because the three Regulation D exemptions, as well as the statutory exemptions in Sections 4(2) and 4(5) of the Securities Act, each prohibit general solicitation or advertising, they are inherently incompatible with the crowdfunding model. By its very nature, the crowdfunding model uses the power of the Internet and social media to reach numerous small investors with broad-based advertising and solicitation efforts. Although the SEC has concluded that Internet sites that adhere to procedural protections and that are restricted to certain prequalified accredited investors are not involved in general solicitation, See Lamp Technology, Inc., SEC No-Action Letter (avail. May 29, 1997), these restrictions do not work for crowdfunding. For crowdfunding to become a viable capital raising option for start-up and emerging companies the sites must be permitted to engage in general solicitation and advertising.
Regulation A, adopted pursuant to Section 3(b) of the Securities Act, provides an exemption for public offerings of up to $5.0 million, but requires the filing of disclosure documents and involves SEC and state review that make it a “mini registration” rather than a true offering exemption. The expense of Regulation A compliance and restrictions on communications during the filing and review process effectively disqualify it as useful for crowdfunding offerings. Accordingly, absent a new exemption, crowdfunded offerings of securities must be registered under the Securities Act. In most cases, the costs, complexity and time required to register a crowdfunded offering would make the offering impractical. Consequently, Congress needs to enact new laws, the SEC needs to adopt new rules, or both.
Crowdfunding websites themselves also raise significant issues under other federal securities laws. For instance, crowdfunding involves matching buyers and sellers of securities and thus implicates the need for the sites to register as broker-dealers under the Securities Exchange Act of 1934 (the “Exchange Act”). Section 3(a)(4) of the Exchange Act defines a “broker” as “any person engaged in the business of effecting transactions in securities for the account of others.” In the broadest sense, the question is whether the crowdfunding site has “a certain regularity of participation in securities transactions at key points in the chain of distribution.” See Mass. Financial Services, Inc. v. Securities Investor Protection Corp., 411 F. Supp. 411, 415 (D. Mass. 1976), affirmed 545 F.2d 754 (1st Cir. 1977). The SEC’s view is that intermediaries that receive transaction-based compensation in connection with a securities offering must register as a broker-dealer. Under the SEC’s position, a crowdfunding site that receives even a small percentage of the amounts raised on the site would need to register as a broker-dealer. See e.g., SEC v. Kramer, 778 F. Supp. 2d 1320 (M.D. Fla. 2011). However, the courts have not always agreed with this position and, unfortunately, the question of whether crowdfunding sites must register as brokers by virtue of hosting securities offerings remains uncertain. Accordingly, any resolution of the legal questions to allow crowdfunding to occur on a broad basis will need to include an exemption from SEC broker-dealer registration or provide an alternative regime for regulating the sites.
Another securities law compliance question raised by crowdsourcing is whether the sites themselves would need to register as investment advisers under the Investment Advisers Act of 1940 (the “Adviser’s Act”). As is the case with broker-dealer regulation, it is unclear whether crowdfunding sites should be considered investment advisers under the Adviser’s Act. The definition of an “investment adviser” in Section 202(a)(11) has two parts, either of which suffices to make one an investment adviser. Under the Adviser’s Act, a person is an investment adviser if the person “for compensation, engages in the business of advising others, either directly or through publications or writings, as to the value of securities or as to the advisability of investing in, purchasing, or selling securities.” Alternatively, a person is an investment adviser if the person “for compensation and as part of a regular business, issues or promulgates analysis or reports concerning securities.” The question of whether a crowdfunding site is an investment adviser is beyond the scope of this article. In many cases, crowdfunding sites should not be considered to be investment advisers because their operation does not involve giving individualized advice concerning securities, which is one of the touchstones of investment adviser activity. Lowe v. SEC, 472 U.S. 181, 208 (1985). The point is that, like the question of broker-dealer registration, new legislation or rule-making is needed to address the question of whether investment adviser registration is required.
Recent Crowdfunding Proposals
The SEC traditionally has been reluctant to expand exemptions for securities offerings by small businesses, even though Congress gave the SEC broad power to exempt such offerings by adding Section 28 to the Securities Act in 1996. Recently, however, pressure on the SEC to provide relief to smaller companies has increased. For example, in March 2011, the SEC Chairman received a letter from Representative Darrell Issa (R-CA) posing a number of questions and criticizing the SEC’s regulation of private capital formation. In an April 2011 letter responding to Congressman Issa, SEC Chairman Mary Shapiro expressly mentions crowdfunding as a new capital raising strategy and indicates that the SEC has been engaged with industry participants and is focused on how to address regulatory concerns relating to crowdfunding. In addition, in testimony before the House Committee on Oversight and Government Reform, Chairman Shapiro echoed many of the same themes from her letter and referenced the SEC’s formation of an Advisory Committee on Small and Emerging Companies to provide a formal mechanism for the SEC to receive advice and recommendations about programs that affect privately-held small businesses and small publicly-traded companies.
On the legislative front, in November 2011 the House of Representatives, spurred on by sluggish economic growth following the Great Recession, overwhelmingly passed H.R. 2930, the Entrepreneur Access to Capital Act, which includes features intended to provide small businesses with access to capital without significant regulatory and cost burdens. On March 8, 2012, the House of Representatives passed the Jumpstart Our Business Startups (JOBS) Act, which includes the crowdfunding provisions of H.R. 2930 (the “House Bill”). The House Bill limits the size of the overall offering to $1.0 million (or $2.0 million if the issuer provides potential investors with audited financial statements), as well as the amount which any individual can invest. Under the House Bill, individual investments may not exceed the lesser of $10,000 or 10% of the investor’s annual income. The House Bill also would require certain notice filings and impose investor protection measures on intermediaries, including investor warnings, SEC access to the intermediary’s website and custody and books and records requirements. Significantly, the House Bill also would preempt states from requiring registration of crowdfunded offerings.
There are two bills pending in the Senate. One, introduced by Senator Scott Brown (R-MA), the Democratizing Access to Capital Act of 2011 (the “Brown Bill”), would allow a private company to raise up to $1.0 million in a 12 month period. As in the House Bill, the Brown Bill requires disclosures and would impose restrictions on re-sales. In response to the Brown Bill, the North American Securities Administrators Association (“NASAA”) raised concerns that fund-raising efforts over the Internet will leave investors open to fraud and disproportionately place the risk of speculative business ventures on unsophisticated investors unable to financial handle the potential loss of the investment. See Letter from NASAA President Jack Herstein to the House of Representatives, dated November 3, 2011.
In response to concerns raised by NASAA and others, a second Senate bill sponsored by Senator Jeff Merkley (D-OR), the Capital Raising On-Line While Deterring Fraud and Unethical Non-Disclosure Act of 2011 (the “Merkley Bill”), was introduced in December 2011. The Merkley Bill is significantly more restrictive than either the House Bill or the Brown Bill. The Merkley Bill places significantly lower caps on individual investments and caps the overall offering at $500,000. The Merkley Bill also purports to limit the intermediaries permitted to run a crowdfunding site to registered broker-dealers or so-called “funding portals” that are defined as individuals or entities engaged in the business of affecting securities transactions on a limited basis where the site does not recommend securities, pay commission-based fees or hold or possess investor funds. The Merkley Bill would impose burdens on the issuer, including requiring the issuer to file a notice with the SEC prior to the offering and provide quarterly reports containing its results of operations and financial statements with the SEC and investors. Finally, the Merkley Bill provides for a private right of action against the issuers, officers and directors from misstatements and fraudulent acts.
There is significant evidence that start-up and emerging business enterprises lack sufficient access to capital under the current regulatory regime. Traditional sources of lending, such as commercial bank loans, are generally not available to emerging enterprises, which by definition do not possess significant assets. The advent of social media has been a game changer that has made traditional notions of private offerings very difficult to enforce. As of yet, the SEC has not embraced a significant revamp of the capital raising process for small businesses and emerging enterprises. However, some sort of loosening of the regulatory restraints on public solicitation of investors by small businesses seems inevitable in the current political and economic climate. In fact, the use of social media to raise funding for businesses is already occurring. Although both LinkedIn® and Facebook® do not encourage the use of their sites to raise capital, fundraising solicitations on these sites are common. Moreover, traditional media are increasingly featuring emerging enterprises that are seeking capital. See “Local gaming startup seeks more bucks to fuel its Bang,” BALT. BUS. J. (Nov. 3, 2011).
On the other hand, lawmakers and securities regulators face a thorny dilemma when opening up capital markets to permit public solicitations by start-up and emerging companies given the real opportunities for fraud. Even in the absence of fraud or other wrongdoing, investing in start-up and emerging businesses is extremely risky, especially for unsophisticated investors. Therefore, any exemption regime should contain limits on the size of the investment permitted, especially those by unsophisticated investors who are not accredited. Similarly, any crowdfunding exemption should contain limits on the overall amount that may be raised during any specific period. For example, one commentator suggested a crowdfunding exemption with an annual offering limit of $250,000 and an annual limit on individual contributions of $500 per investor. Steven C. Bradford, Crowdfunding and the Federal Securities Laws, COLUM. L. REV. No. 1 2012 (available here).
A workable crowdfunding exemption also must contain restrictions on the operation of the crowdfunding sites themselves. As is required by the House Bill, the sites should be open to the public and to regulators and should include a link to investor communication materials that is accessible by the SEC and state securities regulators. Other potential protections include withdrawal rights for investors if minimum targets for the funding are not met. Any crowdfunding proposal that requires registration of crowdfunded offerings with the SEC or state securities regulators would destroy the usefulness of crowdfunding and should be avoided. Similarly, a crowdfunding exemption that allows states to impose their own crowdfunding rules would increase costs and complexity and likely discourage the use of crowdfunding by many companies. Recognizing this, the House Bill would preempt most state regulation of crowdfunding. States would be permitted to require notice filings as is now the case for Rule 506 offerings. States also would have access to crowdfunding sites and the ability to monitor and respond to abuses with enforcement actions. NASAA’s concerns regarding fraud are valid and Congress should hold additional hearings to address NASAA’s concerns. Hopefully, this will result in legislation that maximizes investor protections while still allowing companies to raise meaningful funds at a low cost from the public.
This article is scheduled to appear in the July/August of the Maryland Bar Journal, and is reprinted with permission of the Maryland State Bar Association.