Crowdfunding (U.S.): Start-up panacea or regulatory quagmire? (Part II)

21 novembre 2013 | David Woolford

( Disponible en anglais seulement )

What is Crowdfunding?

Simply put, crowdfunding is the practice of funding a project or venture by raising small amounts of money from a large number of people, typically via the Internet. The concept of crowdfunding has been around for a long time; however, due to the rule prohibiting the general solicitation of securities under section 5 of the U.S. Securities Act of 1933 (the “1933 Act”), crowdfunding has been limited to non-profit organizations or non-equity investments. As a result, private startups have been unable to generally solicit funding from the public and instead have been limited to raising money from wealthy investors they already know.

The introduction of the Jumpstart Our Business Startups Act (the “JOBS Act”) on April 5, 2012, brought about significant changes to U.S. federal securities laws, including a requirement that the U.S. Securities and Exchange Commission (the “SEC”) amend section 4 of the 1933 Act, which sets out transactions exempted from the 1933 Act’s general solicitation prohibition. The JOBS Act required that such an amendment create a new exemption for equity-based crowdfunding from the general solicitation ban of the 1933 Act.

The JOBS Act further required the SEC to implement rules governing equity-based crowdfunding within 270 days of the JOBS Act becoming law. Although the deadline was not met, the SEC, on October 23, 2013, announced the proposed rules that will effectively lift (subject to certain limitations) the nearly 80-year restriction on how startups can market equity stakes to investors. The proposed rules will be open for public comment for 90 days before a final draft is adopted, which is expected on or around January 21, 2014. Once the final draft is adopted, startups and other business should be able to raise investment capital through crowdfunding.

History of Crowdfunding

The rule prohibiting general solicitation of securities arose during the Great Depression through the implementation of section 5 of the 1933 Act, as the United States felt compelled to ban soliciting investments from the general public by private companies due to the high levels of fraud that resulted from these ventures. Originally, the rule was designed to ban the general solicitation of securities through newspaper and radio advertisements, but as new technology mediums of widespread communication developed, the rule continued to apply to the general solicitation of securities through any and all mediums.

The restrictions that the 1933 Act imposed did more than merely limit advertising for the solicitation of securities; it also limited who could purchase shares in private companies that were not listed on a public stock exchange. Effectively, in order to invest in a private company in return for equity, an investor had to qualify as an “accredited investor”, which was determined by the income or total assets of such investor. Generally, people who were deemed able to afford the risk of investing in small privately held companies were deemed accredited investors. More recently, an accredited investor was defined to be an individual who had either: (a) an income of at least $200,000 in each of the two preceding years; or (b) a net worth of at least $1 million dollars.

How Crowdfunding will Work in the U.S.

Once the new SEC rules are official, small businesses and startups will have broader and easier access to capital. All crowdfunding transactions will have to take place exclusively though online platforms operated by an SEC-registered intermediary, which will either be a broker-dealer or a qualified registrant in the newly-developed “funding portal” category. In respect of the latter, members of the public will be able to sign on to a funding portal, browse through advertisements, make investment decisions and, if they so choose, actually invest in a company, all with the click of a button.

Under the proposed crowdfunding exemption, U.S.-based companies that are (a) not already reporting with the SEC, (b) not investment companies, and (c) have a business plan, may raise investment capital if:

  • in a 12-month period, a company raises no more than $1 million in the aggregate from crowdfunding portals;
  • the amount a company allows an individual to invest in a 12-month period is limited, based on the investor’s net worth. (Specifically, if an investor has an income and net worth of less than $100,000 then he/she can only invest $2,000 or 5% of his or her annual income or net worth, whichever is greater. If an investor has an income or net worth over $100,000, he/she would be able to invest up to 10% of their income or net worth, but no more than a total of $100,000. These limits apply to the aggregate of crowdfunding investing by an individual investor, not just to each investment in one company); 
  • equity in a company purchased through crowdfunding must be held for one year.

The SEC’s fear of fraud has not vanished completely. Under the proposed rules, businesses that wish to raise capital from the public via crowdfunding will have to submit certain filings in advance. Specifically, this includes an offering statement that discloses:

  • information about officers, directors and shareholders holding more than 20% of the shares in the company to which securities are being offered and sold;
  • a description of such company’s business and business plan;
  • the use of the proceeds of the offering;
  • information about the price of the securities being offered, the target amount, the deadline and whether such company will accept capital in excess of the target amount; and
  • depending on how much equity is sold, a copy of such company’s tax returns.

How U.S. Crowdfunding Affects Canadians

Currently, for U.S. equity-based crowdfunding, each investor must have a Social Security Number. However, the Crowd Fund Intermediary Regulatory Advocates (CFIRA), a lobbyist group for the regulatory environment that will facilitate effective equity-based crowdfunding, is pushing to bring foreign capital to the U.S. via crowdfunding. Rather than requiring foreign citizens to have a Social Security Number, the CFIRA argues foreigners should be able to invest with an Individual Taxpayer Identification Number, which Canadians can apply for from the Internal Revenue Service.

It is conceivable that the crowdfunding regime in the U.S. will not only help shape the laws in Canada moving forward, but could also become a viable investment opportunity for those ready to dive or “dip their toes” into American innovation. For information on crowdfunding in Canada, please see Crowdfunding (Canada): Start-up panacea or regulatory quagmire? (Part I).

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