Lucas Strakowski, Associate Member, University of Cincinnati Law Review
Crowdfunding is an increasingly important part of the Internet financial landscape. Many have already participated in or are familiar with this fundraising strategy, such as raising money for an individual’s emergency health care costs. A new crowdfunding option—called “equity” crowdfunding—provides a new capital-raising path for businesses and startups. Part II presents background on crowdfunding. Part III presents the requirements for a business to participate in the U.S. equity crowdfunding market. Part IV concludes.
II. What is Crowdfunding?
The U.S. Securities and Exchange Commission (“SEC”) defines “crowdfunding” as a “relatively new and evolving method of using the Internet to raise capital to support a wide range of ideas and ventures.” Crowdfunding campaigns use a large pool of smaller individual contributions to raise needed start-up funding for a project or business. Over time, two different crowdfunding sub-categories have emerged: “rewards-based” crowdfunding and “equity” crowdfunding. Rewards-based crowdfunding campaign examples include businesses raising funds to purchase new equipment or individuals raising funds to afford cancer treatment; these campaigns are typically found on platforms like GoFundMe or Kickstarter. Other “rewards-based” crowdfunding ventures instead provide early or first access to a product in exchange for funds, typically at a discount or with other perks, but do not provide any equity in the company. In contrast, equity crowdfunding allows private businesses to sell securities, such as stocks or bonds, in exchange for start-up capital.
Equity crowdfunding—like all capital-raising ventures—carries benefits and risks for both fundraising businesses and fund-contributing investors. One benefit is that investors can give feedback on a project’s progress to keep the business on track. The business can leverage investors’ personal interest in a project and can cultivate a “community” of investors during the project’s development and fundraising campaign. Early entry into an equity crowdfunding campaign allows investors to enter a project and contribute improvements or amendments as necessary. This earlier entrance provides an investor more insight into a nascent campaign’s potential, but also carries a higher risk of not receiving a return on the investment.
Equity crowdfunding campaign failure rates are slowly dropping but still significant. For businesses, equity crowdfunding campaigns have start-up costs, and successful fundraising campaigns require maintenance costs throughout an active campaign. The intermediary platforms also take a cut of the funds raised. Moreover, crowdfunding may not necessarily be the right choice in all situations. However, even with the risks, equity crowdfunding continues to gain popularity. Indeed, the crowdfunding market has been projected to grow by almost $90 billion from 2018 to 2022.
The SEC took several years to successfully promulgate rules for businesses to take advantage of equity crowdfunding. Following the 2008 financial crisis, President Obama and Congress passed the Jumpstart Our Business Startups (“JOBS”) Act of 2012 to “increase American job creation and economic growth by improving access to the public capital markets for emerging growth companies.” Title III of the JOBS Act, the “Capital Raising Online While Deterring Fraud and Unethical Non-Disclosure” (“CROWDFUND”) Act of 2011, included provisions for regulated equity crowdfunding. The CROWDFUND Act amended the Securities Act of 1933 to allow issuers that offer a sale of securities under $1 million through a qualified funding portal or broker to be exempt from some SEC registration requirements and prohibitions. Four years later, the SEC implemented “Regulation Crowdfunding” (“RCF”) to carry out the CROWDFUND Act’s mandate.
III. The Nuts and Bolts: Complying with SEC Requirements
The SEC’s rules were promulgated under 17 CFR §227. The statute is organized under several subparts, including a “General” subpart, an issuer requirements subpart, an intermediary requirements subpart, a funding portal regulations subpart, and a catchall subpart. The general, issuer requirements, and catchall subparts will be discussed below. First, the maximum aggregate offering amount through RCF for an issuer is $1,070,000 in a 12-month period. The aggregate offering amount includes amounts sold in the current offering and amounts already sold in reliance on RCF during the preceding 12-month period. Amounts sold by entities either controlled by or under common control with the issuer or sold by any predecessor of the issuer are also included in the aggregate offering amount.
RCF also imposes contribution limits on individual investors, determined by the individual’s annual income or net worth. If the investor’s annual income or net worth is less than $107,000, the investor’s limit is either $2,200 or 5% of the lesser of the investor’s annual income or net worth, whichever is greater. If both annual income and net worth are instead equal to or more than $107,000, the limit is 10% of the lesser of either annual income or net worth, up to $107,000. Spouses may calculate net worth and annual income jointly for purposes of investing in a RCF offering.
All transactions for a single RCF offering must be conducted through a single online platform. The intermediary operating as that platform must be registered with the SEC and FINRA as a broker-dealer or funding portal. The intermediary may determine an investor’s aggregate amount of purchased securities and whether that investor would exceed allowed limits if the investor purchased securities in the issuer’s offering. The issuer may rely on the intermediary’s judgment determining an individual investor’s eligibility to participate in the issuer’s RCF, as long as the issuer does not already know that the investor has or would exceed limits by participating.
Prospective RCF issuers must meet several other requirements. First, only U.S. companies may use RCF. Next, companies that are already Exchange Act recording companies cannot participate in RCF. Certain investment companies are also ineligible. Companies disqualified under the RCF disqualification rules or that have failed to comply with RCF annual reporting requirements during the two years preceding the offering statement filing are ineligible to participate in further RCF fund-raising. Further, companies that have no specific business plan—or have indicated that their business plan is to merger with or acquire an unidentified company or companies—are ineligible to participate.
The coronavirus pandemic has also added ineligibility requirements if a company has tried to initiate an RCF offering between May 4, 2020 and February 28, 2020. A company organized or operated less than six months prior to an offering initiated during this period is not eligible to use RCF. A company is also ineligible to participate in RCF during this period if the company has already sold securities in reliance on RCF but not fully complied with RCF requirements.
RCF issuers are also required to disclose a substantial amount of information. A prospective RCF participant must submit a “Form C” that functions as a disclosure form. Required disclosures include basic information such as a business description and the price of the offered securities as well as more complex information such as the issuer’s overall financial condition. The aggregate amount of funds that are offered and sold in reliance on RCF within the preceding 12-month period may also add or alter certain financial disclosures.
An issuer may amend its offering statement. Amendments are required for “material” changes, additions, or updates, and issuers must reconfirm outstanding investment commitments within 5 business days of an amendment, or the investor’s commitment is considered cancelled. An issuer is also required to issue progress updates within 5 business days of reaching 50% and 100% of the target offering amount, or if the issuer accepts proceeds in excess of the target offering amount. However, if the intermediary platform provides frequent updates about the issuer’s progress, an issuer does not need to provide a 50% or 100% update but must still file a final “Form C-U” disclosing the total amount of securities sold in the offering.
An issuer taking advantage of RCF is also required to provide an annual report, on “Form C-AR,” no later than 120 days after the end of the fiscal year. The report is required to contain similar information to the offering statement. The issuer must comply with the annual requirements until one of several situations occurs. The issuer is not required to annually file a Form C-AR if it is required to file reports under Exchange Act Sections 13(a) or 15(d), has at least one annual report and fewer than 300 “holders of record,” or has filed at least 3 annual reports and has total assets that do not exceed $10 million. The issuer is also not required to annually file a Form C-AR if it or another party purchases or repurchases all the issued RCF securities, including payments in full of debt securities or any complete redemption of redeemable securities, or another party does so, or the issuer liquidates or dissolves in accordance with state law. Any issuer who intends to terminate annual reporting obligations is required to file notice on “Form C-TR” reporting such intention.
Some limitations on RCF include limitations on advertising and promoters, as well as restrictions on resale. An issuer may not advertise the RCF offering terms except in a notice that directs investors to the intermediary’s platform. Moreover, the notice may only include: (1) a statement that the issuer is conducting an offering under Section 4(a)(6) of the Securities Act, (2) the name of the intermediary through which the offering is being conducted, (3) a link directing the potential investor to the intermediary’s platform, (4) the terms of the offering such as price and nature of the securities, and (5) factual information about the issuer’s legal identity and business location such as the issuer’s address, phone number, website, a representative’s email, and a brief description of the business. The issuer may, however, communicate with investors and potential investors through the intermediary’s communication channels as long as the issuer or people acting on behalf of the issuer disclose that fact.
Purchased RCF securities cannot be resold for at least one year. Exceptions to this one-year period include resale: (1) to the issuer itself, (2) to an “accredited investor,” or (3) as part of an offering registered with the Commission. The securities can also be resold to a purchaser’s family member or the equivalent, to a trust controlled by the purchaser or a trust created for the benefit of a purchaser’s family member, or in connection with the death or divorce of the purchaser or other similar circumstance.
In addition to all of the above requirements and limitations, an issuer may be completely disqualified from utilizing RCF through “bad actor disqualification.” The disqualification provisions only apply to “covered persons” when a “disqualifying event” occurs. “Covered persons” include (1) the issuer, including predecessors and affiliated issuers; (2) its directors, officers, general partners, or managing members; (3) beneficial owners of 20% or more of the issuer’s outstanding voting equity securities, calculated on the basis of voting power; (4) promoters connected with the issuer in any capacity at time of sale; and (5) persons compensated for soliciting investors such as general partners, directors, officers or managing members of such a solicitor. “Disqualifying events” include: certain criminal convictions, court injunctions, and restraining orders; certain final orders of state and federal regulators, certain SEC disciplinary or cease-and-desist orders; and other similar events. Many of these disqualifying events include a “look-back” period measuring from the date of the disqualifying event itself, not from the conduct that led to the disqualifying event.
There are exceptions to automatic disqualification. Disqualifying events relating to convictions, orders, judgments, decrees, suspensions, expulsions, or bars, that occurred before May 16, 2016—the effective date of RCF—do not automatically disqualify a covered person. The issuer may also avoid disqualification if (1) it can show good cause to not deny the exemption, (2) the court or regulatory authority that entered the relevant order, judgment or decree advises in writing that disqualification is an unnecessary consequence of the court order, or (3) if the issuer establishes it did not know of the circumstances of the disqualifying event and exercised reasonable care in investigating for such circumstances. Even though the issuer is not disqualified in these circumstances, the issuer must still disclose such a disqualifying event in its offering statement.
Regulation Crowdfunding could prove to be a valuable tool for some startups and businesses as it provides a path for U.S. businesses to participate in the newly emerging “equity crowdfunding” market. Since crowdfunding is ever-growing, access to the burgeoning industry is a necessity for U.S. businesses and start-ups to continue to thrive well into the 21st century. While RCF has many requirements to take advantage of its benefits, smaller businesses and start-ups can take advantage of a new path for capital fundraising that will hopefully become more refined and robust as more businesses take advantage of the exception.
 See Regulation Crowdfunding: A Small Entity Compliance Guide for Issuers, U.S. Securities and Exchange Commission, (May 13, 2016, updated Apr. 25, 2017), https://www.sec.gov/info/smallbus/secg/rccomplianceguide-051316.htm [hereinafter the “SEC Guide”].
 SEC Guide, supra note 1.
 Cary Springfield, Crowdfunding: One of the Decade’s Success Stories, International Banker (Feb. 20, 2020), https://internationalbanker.com/finance/crowdfunding-one-of-the-decades-success-stories/.
 Marks, Howard, What is Equity Crowdfunding?, Forbes.com (Dec. 19, 2018, 8:00 AM EST), https://www.forbes.com/sites/howardmarks/2018/12/19/what-is-equity-crowdfunding/?sh=52e4d0b33b5d.
 Springfield, supra note 4.
 Id. The success rates for crowdfunding companies is now almost 64% in 2018.
 Id. An example provided in the article of when equity crowdfunding may not be beneficial is if a single investor is interested in donating to a single organization instead of multiple organizations. Id.
 See Jumpstart Our Business Startups Act of 2012, 15 U.S.C. §78 (2012).
 Id. (at Title III).
 SEC Guide, supra note 2.
 See generally Regulation Crowdfunding, General Rules and Regulations, 17 C.F.R. §227 (2020).
 See 17 C.F.R. §227.100 (titled “Subpart A—General”).
 See 17 C.F.R. §227.201 to .205 (titled “Subpart B—Requirements for Issuers”).
 See 17 C.F.R. §227.300 to .305 (titled “Subpart C—Requirements for Intermediaries”).
 See 17 C.F.R. §227.400 to .404 (titled “Subpart D—Funding Portal Regulation”).
 See 17 C.F.R. §227.501 to .503 (titled “Subpart E—Miscellaneous Provisions”).
 Like for issuers, the SEC has created a guide for intermediaries and funding portals as well. See Regulation Crowdfunding: A Small Entity Compliance Guide for Crowdfunding Intermediaries, U.S. Securities and Exchange Commission (modified May 13, 2016), https://www.sec.gov/divisions/marketreg/tmcompliance/cfintermediaryguide.htm#requirements-for-intermediaries.
 §227.100(a)(2) (at instruction 2).
 §227.100(a)(2) (at instruction 3).
 §227.100(a)(2) (at instruction 3).
 §227.100(b)(4), (5).
 See generally 17 C.F.R. §227.201.
 For the full list of required inclusions, see 17 C.F.R. §227.201(a)-(z).
 See 17 C.F.R. §227.201(t).
 §227.203(a)(3)(i), (ii).
 §227.501(4). “Family member or the equivalent” is defined in 17 C.F.R. §227.501(c).
 See generally 17 C.F.R. §227.503.
 For the entire list of disqualifying events, see17 C.F.R. §227.503(a)(1)-(8).
 See e.g. 17 C.F.R. §227.503(a)(1) (requiring a “look-back” period of 10 years before the filing of the offering statement in evaluating felonies or misdemeanors).