As author Thomas L. Friedman discusses in his book The World Is Flat, the instantaneity and pervasiveness of the Internet has created a “flatter” world. This impact has now rippled through the world’s startups and small businesses in the form of crowdsourcing and crowdfunding.
- Crowdsourcing is the practice of obtaining needed services from a large group of people and especially from the online community rather than from traditional employees or suppliers.
- Crowdfunding is the practice of funding a project or venture by raising monetary contributions from a large number of people, typically via the Internet.
Crowdfunding came about as form of crowdsourcing, which grew rapidly in the mid- to late-2000’s and utilized the reach of the Internet and social media to leverage the power of the masses to complete complex projects, build new products, or fund social impact investments that could not be accomplished by a small, geographically constrained group of people. Specifically, crowdfunding initially allowed inventors or innovators to develop a product idea and obtain small portions of funding from a much larger group in order to capitalize the product development. In return for their investment, the investors would receive the item produced or some other non-monetary reward as their return on investment. As the potential for crowdfunding became apparent, many began to call for a framework in which startups and small businesses could access capital through securities offerings utilizing crowdfunding. Startups and small businesses were given this chance on April 5, 2012, when the Jumpstart Our Business Act of 2012 (the JOBS Act) was signed into law by President Obama.
Authorizing Legislation and Rulemaking
Title III of the JOBS Act (Capital Raising Online While Deterring Fraud and Unethical Non-Disclosure Act of 2012” or Crowdfund Act) amended Section 4 of the Securities Act of 1933 by creating a new registration exemption in situations where an issuer meets specific requirements with regard to the size of the offering and the financial status of investors, and the sale is conducted through a broker or funding portal. Below is a summary of what is required to obtain the exemption provided by the Crowdfund Act:
- The aggregate amount of securities sold to all investors by the issuer, including any amounts sold in reliance on the exemption provided under this paragraph during the 12-month period preceding the date of such transaction is not more than $1 million;
- The aggregate amount of securities sold to any investor by an issuer does not exceed –
- The greater of $2,000 or 5 percent of the annual income or net worth of such investor, as applicable, if either the annual income or the net worth of the investor is less than $100,000; and
- 10 percent of the annual income or net worth of such investor up to a maximum of $100,000, if either the annual income or net worth of the investor is equal to or more than $100,000;
- The transaction is conducted through a broker or funding portal that complies with the Crowdfund Act and subsequent rulemaking.
The Securities and Exchange Commission (SEC) did not meet their initial rulemaking deadline of December 31, 2012, and the Crowdfund Act proposed rules (Regulation Crowdfunding) were not issued until October 23, 2013. Regulation Crowdfunding implements the exemption established under Section 4(a)(6) of the Securities Act, establishes the required forms to be filed and timelines to be met, and imposes some additional conditions.
Texas Crowdfunding Update
During the delay in rulemaking by the SEC, many states moved forward with the adoption of their own rules permitting crowdfunding on an interstate basis, which is not regulated by the SEC.
The Texas Securities Board under the leadership of Commissioner John Morgan has recently published a proposed crowdfunding rule that would permit Texas businesses to raise up to $1 million during any 12 month period from investors who seek to purchase securities through authorized portals registered with the Texas Securities Commissioner. Individuals may invest no more than $5,000 through the portals in a single business, unless they are “accredited investors” who meet statutory and regulatory guidelines, including minimum net worth of $1 million, annual income of at least $200,000, and other sophistication or experience guidelines.
Offerings under the proposed rule must comply with the federal intrastate offering exemptions under Section 3(a)(11) of the Securities Act and Rule 147 promulgated thereunder. Following Rule 147, the proposed rule requires that:
- the issuer is organized in and has its principal place of business in Texas;
- at least 80% of the issuer’s gross revenues during its most recent fiscal year prior to the offering are derived from the operation of a business in Texas;
- at least 80% of the issuer’s assets at the end of its most recent semiannual period prior to the offering are located in Texas;
- the issuer will use at least 80% of the net proceeds of the offering in connection with the operation of its business within Texas; and
- the issuer is not an investment company, an SEC reporting company, or a company with no business plan or a plan to merge with an undetermined entity.
In addition to these requirements imposed on issuers and investors, the proposed rule requires that offerings exempt under this rule must be made exclusively through an Internet website operated by a registered general dealer, or a registered Texas crowdfunding portal. These crowdfunding portals will be required to register with the Texas Securities Board and will be subject to the following regulations:
- the portals must contain a disclaimer that offerings are limited to Texas residents;
- evidence of residency within Texas is required as a condition prior to viewing offering materials or completing a sale of securities;
- the Securities Commissioner has access to the portal prior to the offerings; and
- prior to permitting investments in securities listed on the portal, certain disclosures regarding lack of marketability of securities and other financial risks are made.
The portals are prohibited from the following activities:
- offering investment advice or recommendations;
- compensating employees or agents for soliciting sales of securities offered through a portal;
- holding, managing, possessing, or otherwise handling investors funds;
- being affiliated with or under common control with an issuer whose securities appear on the portal;
- holding a financial interest in any issuer offering securities through a portal;
- or receiving a financial interest in an issuer as compensation for services provided to an issuer.
Under the proposed rule, portals are also required to conduct background and regulatory investigations of the issuers and “control persons” (officers, directors and individuals holding more than 20% of the outstanding equity of the issuer) prior to offering an issuer’s securities for sale.
The Texas Securities Board has continued to move forward with its proposal that would authorize such activity in Texas. Commissioner Morgan has thoughtfully engaged the banking industry, community and business leaders, and others in developing a workable, business-friendly model that should provide a new source of capital for small businesses throughout the state of Texas. The proposed rules will particularly benefit small and rural communities that typically do not attract the attention of the investment community, but whose businesses and communities nevertheless have growth development needs and opportunities that crowdfunding may be able to address. The Board is presently scheduled to consider the proposed rules in its meeting on August 28th. If adopted, the rules will become effective in late September after publication in the Texas Register. The Board will maintain a website that will provide detailed information on the rules and other topics affecting issuers, portals, and investors. A list of registered portals will be included on the website.
Several firms are preparing to file regulatory applications for the creation of crowdfunding portals which would review business proposals from entities seeking to raise capital utilizing this new exemption. The portals will manage websites through which the securities would be issued. The proposed rules outline straightforward and relatively simple disclosure requirements for the portals, referred to as an issuer in the proposed rules, as well as the businesses seeking to raise capital from the public.
Presumably, most candidates for crowdfunding would be local businesses, which would be well known to people in a community and, in fact, could provide goods and services that an “investor” might know, understand, and utilize, themselves. Examples of such local investments could include a local restaurant, health clinic, contractor, or even a bank; however, an investment could come from anywhere in the state of Texas under the proposed rule.
The Texas rule provides that funds invested through the portals in a particular company must be escrowed in a Texas-based state or national bank until the offering is completed under the announced terms and conditions. The issuer will contract with a bank for escrow services and direct the bank to transfer the funds to the business seeking the funds once the offering is complete. If the offering were to fail under its terms, the funds would be returned to the investors according to the terms of the offering. A bank serving in this role is performing a ministerial function and is not responsible for qualifying the proposed investment or the underlying business.
While the current proposal provides for a maximum offering of $1 million, we are hopeful that the rule will be expanded to increase the size of exempt offerings as well as the maximum amount of a single investor’s investment, as the crowdfunding model and its investors mature and gain experience. It is estimated that over $30 billion has been raised nationwide by crowdfunding among accredited investors. As such, this appears to be a tremendous new and modern way to raise capital using the internet.
Texas bankers need to be aware of this fast-approaching phenomenon. In addition to serving as escrow agent, banks could potentially offer crowdfunding solutions as a new source of capital for their customers.
Next Steps for Crowdfunding Candidates
Texas businesses, new or existing, who desire to access capital funding via a crowdfunding portal will need to prepare written materials as required by the rules which will be posted on a portal at least 21 days before an offering can commence. The disclosure statement required by the rule contains very specific categories of information including, among other things, a summary of the offering terms, a description of the entity, its business plan, history, use of proceeds, directors, officers, principal shareholders, financials, and any other material information and risk factors. The rule is intended to permit an abbreviated, and potentially less costly, form of disclosure document than would be typical for a private placement under Regulation D, for example. Nevertheless, the same obligations under the Texas Securities Act apply to an offering under the crowdfunding rules. Issuers must provide accurate and complete information that is not misleading and does not omit information which could be considered material in light of certain circumstances under which they were made. Liability for misstatements is nevertheless significant, and as such, counsel experienced in securities law and preparation of public and private offering documents should be engaged by the issuer.