Deep Dive into Regulation D; Part 6 Crowdfunding
In 2011, I had been an Angel Capital member in several local groups for a number of years. One of the prominent discussion topics was the anticipated implementation of the JOBS Act of 2012. Of the many notable changes that were expected to come to the private equity marketplace was the implementation of crowdfunding.
Crowdfunding, as defined by the SEC, generally refers to a financing method in which money is raised through soliciting relatively small individual investments or contributions from a large number of people.
The JOBS Act of 2012 proposed crowdfunding, but it took until [May 16th] 2016 for it to be fully implemented because the Securities and Exchange Commission (SEC) needed time to develop specific regulations, known as "Regulation Crowdfunding," to govern how crowdfunding could be structured safely and fairly for investors. This involved a lengthy rulemaking process, with much of the delay due to concerns about investor protections and ensuring proper disclosure requirements were in place.
When it finally launched four years later, it became exceedingly popular, and its growth has not slowed down. According to Grand View Research, "The global crowdfunding market is expected to grow at a compound annual growth rate of 16.7% from 2023 to 2030 to reach USD 5.53 billion by 2030."
The regulation of crowdfunding also benefits institutions and entrepreneurs by providing a streamlined avenue to raise capital outside traditional methods like venture capital or angel investing. This accessibility makes it easier for startups and small businesses to launch and expand.
Additionally, regulating the crowdfunding process enhances transparency and accountability. Companies and entrepreneurs are required to disclose substantial information to investors, fostering trust and confidence in the crowdfunding ecosystem.
History & Attributes
Regulation Crowdfunding (Reg CF) in the United States, introduced under the JOBS Act of 2012, allows smaller companies to raise capital from the public through approved online platforms. This regulation opened up investment opportunities in startups and small businesses to non-accredited investors, broadening access beyond traditional venture capital and private equity (such as Regulation D 506(b) and 506(c)). Here are key aspects of Regulation Crowdfunding:
1. Investment Limits
- To protect non-accredited investors, Reg CF places limits on the amount individuals can invest, which depends on their income and net worth.
- Investors with annual income or net worth below $107,000 can invest up to the greater of $2,200 or 5% of the lesser of their annual income or net worth over a 12-month period.
- Investors with both an income and net worth above $107,000 can invest up to 10% of their income or net worth, with a maximum limit of $107,000 annually.
2. Offering Limits
- Under Reg CF, companies can raise up to $5 million over a 12-month period.
- This limit has been increased over time to help companies meet growing capital needs while still being subject to regulatory safeguards.
3. Platform Requirements
- Reg CF offerings must be conducted through SEC-registered crowdfunding platforms, also known as funding portals, or FINRA-member broker-dealers.
- These intermediaries play a key role in providing investor protections by ensuring compliance, transparency, and investor education.
4. Disclosure Requirements
- Companies raising funds through Reg CF must file a Form C with the SEC, which provides information on the business, its financial condition, use of proceeds, target amount, and the offering terms.
- Annual reports are required to keep investors informed of the company’s performance and updates.
5. Resale Restrictions
- Securities purchased through Reg CF are typically restricted from resale for one year after the purchase, with limited exceptions, such as sales to accredited investors or back to the issuer.
- This is intended to protect the issuer from market fluctuations and provide a stable environment for growth.
6. Investor Protections and Risk Disclosure
- Platforms are required to educate investors about the high risks associated with early-stage companies, including the potential for loss of capital, illiquidity, and the speculative nature of such investments.
- Investors must affirm their understanding of these risks before committing to an investment.
7. Issuer Eligibility and Restrictions
- Certain companies, including non-U.S. entities, public reporting companies, and companies with specific compliance or legal issues, may not qualify to raise funds under Reg CF.
- Reg CF is intended for small, private U.S.-based companies seeking to raise growth capital.
8. Investor Communication and Advertising
- Issuers are limited in how they can advertise their offerings; they can direct potential investors to the platform but cannot promote investment terms outside of it.
- However, they can release basic information, such as the terms of the offering, the business description, and a call-to-action to visit the funding portal.
9. Liquidity and Exits
- Due to the one-year resale restriction, Reg CF investments are generally illiquid. The secondary market for crowdfunded securities is limited, impacting the ease with which investors can exit their positions.
10. Audit and Financial Statement Requirements
- The financial statement requirements depend on the size of the raise. For offerings up to $107,000, companies need only to provide certified financial statements. For larger raises, reviewed or audited financial statements are required.
- This ensures some degree of accountability, though these requirements remain less stringent than those for public offerings.
Notable Caveats
While Reg CF provides significant advantages for raising capital, it also has notable drawbacks for both companies and investors. Here are some key disadvantages:
1. Investment Limits for Non-Accredited Investors
- Although investment limits protect non-accredited investors, they can restrict potential funding, particularly for high-growth companies aiming to raise larger amounts.
- Investors with limited funds may also find it challenging to diversify, exposing them to greater risk. Additionally, some company minimum investment thresholds may exceed a non-accredited investors 5% limitation.
2. High Compliance and Disclosure Costs
- Complying with Reg CF requires companies to provide detailed disclosures, including financial statements, offering terms, and an annual report, which can be costly.
- Smaller startups may struggle with these expenses, especially if the amount they seek to raise is modest. The trade off in simply raising more capital to cover these ongoing expenses, dilutes profitability, which in consequence reduces the attractiveness of the investment.
3. Limited Fundraising Capacity
- Reg CF caps annual fundraising at $5 million, which may be insufficient for companies with larger capital needs or high-growth potential, pushing them towards more expensive capital-raising methods once they exceed this threshold.
4. Disclosure of Sensitive Information
- Companies must publicly disclose significant financial and operational information, which can benefit competitors or affect market positioning.
- The requirement for transparency may deter companies concerned about confidentiality or intellectual property protection.
5. Investor Illiquidity and Resale Restrictions
- Securities sold under Reg CF come with a one-year resale restriction, making these investments largely illiquid.
- The lack of an established secondary market for these securities limits exit options, which can be challenging for investors looking for liquidity.
6. Ongoing Reporting Obligations (& Compliance Standards)
- Companies must file annual reports with the SEC, adding ongoing administrative and financial burdens.
- Many startups may lack the infrastructure or resources to meet these ongoing requirements, leading to compliance risks or legal exposure.
7. Increased Regulatory Scrutiny and Liability
- Crowdfunding platforms are heavily regulated, which can slow down the fundraising process, requiring additional time for compliance review and approval.
- The possibility of investor lawsuits or SEC enforcement actions may deter some businesses from participating in Reg CF.
8. Platform and Transaction Fees
- Most crowdfunding platforms charge transaction and listing fees, which can reduce the total capital raised.
- For smaller campaigns, these costs can represent a significant portion of the funds raised, diminishing the financial benefit of the offering.
9. High Risk for Investors
- Many companies raising funds through Reg CF are in early development stages, carrying a high risk of failure and potential total loss of investment.
- Even with mandated disclosures, the speculative nature of many crowdfunding investments makes them risky, particularly for non-professional investors.
10. Difficulty Attracting Large Investors
- Regulation crowdfunding may be less appealing to institutional investors or large investors due to the relative size and structure of offerings.
- Larger investors often prefer more established funding rounds with direct influence, reducing the likelihood of significant capital inflow from major backers.
Conclusion
Reg CF’s benefits come with considerable trade-offs, especially in terms of compliance costs, fundraising limits, and investor protections. While it offers unique opportunities, these disadvantages may affect both the fundraising efficiency for businesses and the risk profile for investors.
The positive aspects of Regulation Crowdfunding have democratized access to capital and investment opportunities, while building a structured framework for both investor protections and transparency. However, it remains an evolving landscape, influenced by both regulatory developments and market demand for innovative financing solutions.
Structuring Your Capital Raise
Navigating the formation of your offering can be daunting and expensive -- some law firms and startup incubators charge between $50,000 - $350,000+ depending on which exemption your company files. As investors in companies ourselves, we {Poplar Equity Group} believe these costs are entirely unnecessary, and even unwise for a startup venture to accumulate that much debt -- before you've taken on any capital!
We put our heads together and created a better way. If you've been considering raising capital for your business in a structured, compliant manner, we want to help. Send me a message and let's get to work!
Your best days are ahead! ??
-Blake E. Robbins
Reg CF, Reg D 506(B), Reg D 506(C), Reg A+ Reg S, Equity Crowdfunding, Capital Raising, startup, angel capital, venture capital, private equity hedge funds
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