Crowdfund Insider | Amy Wan | May 17, 2016

Monday, May 16, 2016 is the first day that ordinary people—not just the super rich—will be able to invest in the next Uber or Snapchat. That’s because Title III of the JOBS Act, otherwise known as Regulation Crowdfunding or Reg CF, legalizes retail investment crowdfunding that day. This new regulation will open up the investor pool to over 300 million potential investors and aims to spur the growth of small businesses.

The Long Road to Investment Crowdfunding

In April 2012, President Barack Obama signed into law the Jumpstart Our Business Startups Act, or JOBS Act. The JOBS Act was so called because it aimed to facilitate access to capital for startups and small businesses, give more people the ability to participate in investment opportunities, and ultimately, create more jobs and stimulate economic growth. While other crowdfunding regulations from the JOBS Act, such as Title II and IV, were implemented more quickly, Title III is the third but most anticipated piece of crowdfunding regulation to become effective.

See:  SEC Approves Title III of JOBS Act, Equity Crowdfunding with Non-Accredited

For the first time, Title III will allow issuers to raise funds online from ordinary people for investment purposes. The regulation creates a new exemption to the Securities Act of 1933. This essentially means that, for the first time since being written 80 years ago, our securities laws will be updated to recognize modern modes of online capital raising.

Previously, generally only accredited investors could invest in early stage startups. Accredited investors are those who earn an annual income of at least $200,000 (or $300,000 if married), or those with a net worth of at least $1M (excluding one’s primary residence).

Going Beyond Kickstarter or GoFundMe Campaigns

You might argue that crowdfunding has been around for years now, which is true. Crowdfunding is essentially the act of raising capital from others via the Internet. Platforms like Kickstarter, IndieGogo, and GoFundMe have been around since at least 2008 and have given us the Pebble Watch, Veronica Mars, and every gadget imaginable. However, these portals practice rewards-based crowdfunding, or in the case of GoFundMe, donation-based crowdfunding. When backers give a crowdfunding campaign money, they either make a donation or get back a “reward”—maybe a thank you note, or the first edition of said widget.

Title III expands the possibilities to include investment crowdfunding, or the ability to buy equity in an early stage company and hopefully reap a monetary return on investment. On May 16, ordinary Americans don’t need to settle for just a Pebble watch (though that would be a great additional perk); instead, they can own a piece of the company that makes the Pebble watch. Title III democratizes access to startup investment opportunities, while greatly expanding the pool of available capital to small businesses and startups. And while the crowd may not replace angel investors and venture capital, they may now invest alongside them.

Here’s What You Need to Know

Issuers, or those looking to raise funds, should know the following basics about Title III:

• You may only raise $1M in a rolling 12-month period
• You must use an online intermediary (more on this below)
• You must be a U.S. entity
• You must disclose certain financial information, and depending on how much you plan to raise, your financial statements may need to be reviewed or audited by an accountant
• You must fulfill certain ongoing reporting requirements
• You may raise funds from both accredited and non-accredited investors, although investors are limited to investing a certain dollar amount based on their income or net worth.

Title III is historic in that it specifically recognizes a new type of intermediary for crowdfunding transactions, called a funding portal. At least 30 applications for funding portals have been received as of April, with likely many more to come. Funding portals are essentially modern online connectors between issuer companies and investors and amongst investors, and these platforms will be regulated by the SEC and FINRA.

But It Wont Be A Smooth Liftoff

Despite high hopes around a vibrant Title III crowdfunding industry, Title III may encounter some turbulence at takeoff following its May 16 debut. Although it took the SEC three and a half years to issue the final rules on Title III, regulators were said to be scrambling in the final days of the regulatory process to get the final rules out. And in doing so, the final rules came out short of optimal and, in the opinion of some, not workable.

Critics point out that the SEC’s final rules on Title III do just the opposite of its regulatory intent. That is, instead of creating a mechanism that would allow attractive startups to include retail investors, the SEC’s zealous concerns over small investor protection resulted in unrealistically high regulatory burdens that would disincentivize any company from using the regulation, except as a last resort. And that’s the opposite of what small investors should want to invest in—the companies otherwise rejected by accredited investors.

High Costs and Low Success Rate

One of the major concerns around Title III is the high transaction costs required to raise $1M. Issuers will find themselves with bills in the tens of thousands of dollars right out of the gate to pay for legal and accounting services—and will then have to spend at least a couple thousand dollars after fundraising to comply with ongoing reporting requirements. Several industry experts have publicly criticized the final rules, including OneVest/1000 Angels co-founder and Chairman Alejandro Cremades who issued an open letter condemning Title III and publicly stating that his company would stay “far away” from utilizing the regulation.

See:

• Perspective on Crowdfunding: This New Industry Will Flourish

• OPEN LETTER: Lifting the Veil on Peer-to-Peer Lending in Canada

Even with low cost solutions like iDisclose and Crowdcheck, the upfront costs to conduct financial audits—before an issuer may even determine whether it will be able to raise financing at all—is a gamble.

And issuers must all the while acknowledge the likelihood that its campaign will fail. If we take lessons from analogous models, Kickstarter has a 36% success rate for fully funded campaigns, while AngelList has testified that less than 10% of companies that list on its platform succeed in a raise. Some platforms that lean towards “listing” rather than “curating” may find that very few campaigns overall will reach their funding goal. Issuers will want to ensure that they surround themselves with good advisors and counsel, and to associate themselves with well-performing funding portals, or else they may find themselves in the red if they’ve raised less money than needed to even cover transaction costs.

But It’s Not Dead Yet

Currently, Congressman McHenry has introduced proposed legislation called the Fix Crowdfunding Act (HR 4855) that has yet to be voted on by the House or Senate. The amendment fixes a number of issues with Title III to make it more workable, if approved and implemented. HR 4855 makes the following changes:

Testing the Waters

Issuers would be able to solicit interest prior to actually spending money on lawyers and accountants. Given that companies must brace themselves for the scenario in which they cannot cover transaction costs or loss money as a result of not having raised enough funds, the ability to gauge investor interest up front may save a number of issuers from being in the red on day one (and may encourage other companies to boldly steam forward).

Raising the Funding Cap From $1M to $5M

In his open letter, Cremades wrote “Nowadays startups on average raise, at a Seed stage, in the neighborhood of $2M+. The fact that startups will have a limit of $1M per year will either force them to be under capitalized or conduct another type of offering in parallel to raise the remaining capital from accredited investors, which means more costs from a legal perspective.” Raising the funding cap to $5M would make the transaction costs more justifiable and allow companies to raise the capital they need.

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The National Crowdfunding Association of Canada (NCFA Canada) is a cross-Canada non-profit actively engaged with both social and investment crowdfunding stakeholders across the country. NCFA Canada provides education, research, leadership, support and networking opportunities to over 1300+ members and works closely with industry, government, academia, community and eco-system partners and affiliates to create a strong and vibrant crowdfunding industry in Canada. Learn more at ncfacanada.org.

Crowdfund Insider | Doug Ellenoff | May 3, 2016

Two years after Title II of the JOBS Act, known as 506(c), went into effect well over one billion dollars of financings have been closed through online funding portals under this provision and 506(b).

The year over year growth has been substantial.  Entrepreneurs and real estate professionals have benefited and so have investors.  Even with all that activity so far, there has been very limited reported fraud- one maybe two at most, representing significantly less than 1% of the capital raised. This is not to suggest that there won’t be more and no doubt other legitimate investor losses as well, but online 506(b) and (c) has thus far delivered on the promise of an alternative way for entrepreneurs to raise capital, for investors to participate in opportunities not previously available to them, and equally importantly, for this not to become a regulatory burden.

The data suggests that nearly two thousand such entrepreneurs have received such funding, which inevitably creates jobs.  The key being that the balance of interests between capital formation and investor protection (from fraud, not losses) has been more than satisfied so far.  The voiced concern of overwhelming fraud has not materialized and regulators generally acknowledge this reality.

See:  SEC Approves Title III of JOBS Act, Equity Crowdfunding with Non-Accredited

All crowdfunding constituents continue to need to remain vigilant and keep the problems limited.  We all share this responsibility if we want to benefit from this considerable departure from old securities law conventions. Building on the strength of this new approach to permitting capital formation, May 16 of this year marks the date upon which the third provision relating to crowdfunding under the JOBS Act, Regulation CF, makes available unregistered investment opportunities to all Americans.  This isn’t open to debate, it’s the law. You might be surprised at how many events that I attend where panelists and attendees continue to debate the issues as if we were still in a time warp prior to the JOBS Act enactment in 2012.

For all of the genuine concern, many of these folks have neither read the Regulation CF rules, don’t fully appreciate the construct of the statute and rules, nor care to recognize that these rules came to be after a bi-partisan congressional action, signed by the President and extensively considered and refined by both the SEC and FINRA after four years of comment letters by both supporters and detractors of the legislation have had full opportunity to share their comments.

As a participant and observer, I am proud of what Titles III Regulation III Crowdfunding represents, how thoughtful the final rules are, the care and consideration that the staff members of both the SEC and FINRA have put into making the final approved rules viable and the institutional restraint from being inflexible. Moreover, tremendous credit must be given to the perseverance of the industry and the individuals that stayed the course and engaged in the process- this truly was a crowdsourced effort.

- Doug Ellenoff is Managing Partner of Ellenoff Grossman & Schole LLP,

We are well aware that there are investor protection concerns and believe that the current rules are quite respectful of those interests.  We are also aware that some market participants must make a more concerted effort to fully recognize that this is a highly regulated industry for good reason and their business processes must become more compliant in order to protect investors even better.  Certainly, we also support continuing efforts to address aspects of the final rules which would make the final rules more commercially viable.  If the securities activity that gets transacted after May 16 under Regulation CF is as responsibly undertaken by the online 506(b) and (c) community, then legislators will have the necessary momentum to take additional positive action beneficial to the industry.

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The National Crowdfunding Association of Canada (NCFA Canada) is a cross-Canada non-profit actively engaged with both social and investment crowdfunding stakeholders across the country. NCFA Canada provides education, research, leadership, support and networking opportunities to over 1300+ members and works closely with industry, government, academia, community and eco-system partners and affiliates to create a strong and vibrant crowdfunding industry in Canada. Learn more at ncfacanada.org.