Bar News - December 14, 2012
Business Law & Business Litigation: Crowdfunding and the JOBS Act: What Attorneys Need to Know
By: Albert Vanderlaan
Presidential election and fiscal cliff aside, one thing remains constant: The need to put Americans back to work to help continue the economy’s rebound from the Great Recession. But not just back to work – back to work in well-paying, stable jobs.
Above is a screen shot of the home page for www.wefunder.com, which is just one of the multiple crowdfunding websites geared toward investors in startups that has cropped up since the JOBS Act was passed in April 2012. The sites can’t accept investments from un-accredited investors until the SEC implements the law, which is expected to happen in January at the earliest.
To help the economy gain traction, President Obama signed the Jump Start Our Business Startups (JOBS) Act in early 2012. Recognizing that small businesses are a (the) major generator of jobs in the US, the JOBS Act was designed to lessen the regulatory burden on early-stage and small companies seeking to raise capital. The JOBS Act amends sections of the Securities Act of 1933 as amended (the Act) to allow for "crowdfunding" and eases long-time restrictions on general solicitation and advertising under Regulation D of the Act.The JOBS Act adds a new exemption under the Act for crowdfunding – the offer and sale of securities in small amounts to a large number of unrelated investors. Crowdfunding differs from contemporary "angel" or "seed" equity financings, which are funded by a relatively small number of high-net-worth individuals. The crowdfunding exemption is a product of the social-networking phenomenon that spawned crowdfunding websites such as Kickstarter and Indiegogo. The exemption, which will be available once the final rules are published by the SEC, will enable issuers (startups and other small companies) to contact large numbers of potential purchasers that are otherwise unapproachable under the current securities law regime, due to the prohibition on general solicitation and the requirement that purchasers be "accredited investors," pursuant to Regulation D under the Act.
Among other things, the crowdfunding exemption will require that within any 12-month period (i) the aggregate amount of securities sold by an issuer in all financings not exceed $1 million and (ii) the aggregate amount sold to any investor by an issuer not exceed (a) for investors whose annual income or net worth is less than $100,000, the greater of $2,000 and 5 percent of annual income or net worth or (b) for investors whose annual income or net worth is $100,000 or greater, 10 percent of the investor’s annual income or net worth, up to a maximum investment of $100,000. Further, the transaction must be conducted through an intermediary, either a broker or funding portal, meeting a lengthy list of requirements regarding disclosure and mitigation of risk to investors. The issuer must meet a similar list of disclosure and risk mitigation requirements.
The provisions include issuer liability for material misstatements and omissions pursuant to Section 12(a)(2) under the Act (i.e., prospectus liability). The definition of "issuer" for liability purposes is very broad and encompasses directors, partners, the principal executive officer or officers, the principal financial officer, the controller or principal accounting officer, and any other person who offers or sells securities in the transaction. Securities acquired in a crowdfunding transaction may not be resold for one year, except to the issuer or an accredited investor or in a registered offering.
The SEC has long maintained a ban on "general solicitation and general advertising" of private placement equity transactions under Regulation D. Typically, that means companies (small or large) must go to existing investors to raise money or work with a registered broker-dealer that has preexisting ties to the traditional sources of early stage investment capital. The JOBS Act, however, lifts the ban on general solicitation and advertising for sales effected under Rule 506 (though not Rules 504 and 505) of Regulation D. In theory, this means that a company wishing to find investors for its next round of financing could advertise a Rule 506 offering on the radio, on a banner behind a plane, or on the big screen at a ballgame.
The wrinkle in the rule as proposed earlier this year by the SEC is that not everyone who sees an ad or listing for an investment will be able to invest: like Rule 506 as it currently stands, all investors must be "accredited" – have a minimum net worth or annual income – before the issuer may accept an investment from a prospective purchaser.
In combination, the new crowdfunding exemption and the relaxation of the prohibition against general solicitation and advertising present a number of areas of risk for issuers, their attorneys and investors. Lawyers must be prepared to respond to novel client questions as the final JOBS Act rules are released in the next few months and media attention piques the public’s interest. Here are a few issues that may arise in this context.
First, using the crowdfunding exemption does not simply mean that an issuer can offer securities to hundreds of people willy-nilly by posting a "give me money" link on their Facebook page. As outlined in the proposed regulations, companies seeking crowdfunding must register with financial portals (specialized websites developed for seeking financing through crowdfunding).
Similarly, prospective investors must also register through such portals, ensuring that such investors meet the qualifications required under the JOBS Act and related regulations. Inevitably, attorneys will have small-company clients who believe the crowdfunding exemption permits a free-for-all mentality for fundraising, a risky proposition in this social-media-crazed society: #Section12Liability. Business attorneys with startup and small-business clients should be well-versed in the exemption before advising clients on the use and availability of crowdfunding as an option for raising capital.
Second, issuers and attorneys must be aware that securities issued pursuant to the crowdfunding exemption are still subject to a right of rescission in favor of the investor if the offering materials for the investment contain any material misstatement or omission. Personal liability can also extend to directors and officers under certain circumstances. Moreover, a larger number of purchasers means a greater likelihood that one of them will be unsatisfied, leading to litigation if the unsatisfied customer made a large enough investment to justify the initial costs of bringing suit (and can be easily joined by others seeking recourse).
Third, there is the potential that an entrepreneur’s failure when conducting a crowdfunding offering could be broadcast not to a limited group of family and friends or angel investors, but to the hundreds who invested during the company’s early existence through crowdfunding platforms.
Fourth, when engaging in a Rule 506 offering using general solicitation, issuers and attorneys must be aware that general solicitation does not mean that anyone on the street who sees an ad for an investment will necessarily be able to invest in such an offering. Prospective investors who become purchasers of an issuer’s securities must still be accredited investors and issuers. Attorneys should make sure any prospective investor who seeks information about an investment opportunity after seeing a general solicitation or advertisement completes and attests to an investor questionnaire. Of course, any general solicitation or advertisement must not be false or misleading as to any material fact or circumstance with regard to the offering.
Lastly, as always, attorneys must remind clients that investments in startup, early-stage and other small companies are speculative, and there is a risk that the investment may be lost in its entirety.
Albert Vanderlaan is an associate at Gunderson Dettmer Stough Villeneuve Franklin & Hachigian, LLP in Waltham, Mass., specializing in the representation of emerging growth companies throughout their lifecycles and can be contacted at firstname.lastname@example.org or (781) 890-8800. Albert currently sits on the New Hampshire Bar Journal Editorial Board.