Crowdfunding Strategy: Choosing the Right Exemption from Registration

Introduction

The Jumpstart Our Business Startups (JOBS) Act of 2012¹ was a bipartisan effort to create jobs by making it easier for small and growth businesses to deal with securities laws when raising capital. Most of the JOBS Act's provisions required the Securities and Exchange Commission (SEC) to enact rules to implement the JOBS Act's provisions before they become effective.

New capital-raising tools

We discuss in Part I that the fundamental purpose of the JOBS Act was to unleash the power of 21st Century communications systems in capital-raising. The recently created Public Private Placement exemption we describe in Part I includes multiple new technology enhanced capital-raising tools:

• Rule 506(c) authorized by Title II of the JOBS Act of 2012, allows issuers to raise unlimited amounts of capital using advertising and general solicitations with very flexible disclosure rules, if you sell only to verified accredited investors. We discuss Rule 506(c) in Chapter 11.
• Since 1997, some offerings that use SEC Rule 506(b) have been conducted on the same technology platforms that now also facilitate Rule 506(c) offerings. If only “pre-qualified” accredited investors have password access to the part of the platform that facilitates the Rule 506(b) offering, a Rule 506(b) offering technically is not a general solicitation, but to casual observers, it may look like the Rule 506(c) offerings that may be conducted on the same platform.² We discuss Rule 506(b) in Chapter 10.
• Amendments to Regulation A³ under Title IV of the JOBS Act, which have been nicknamed Regulation A+, because the amended Regulation A is a much more powerful capital-raising tool than the old Regulation A. Regulation A allows you to do a general solicitation and advertise and to sell to both accredited and non-accredited investors, if you comply with specified disclosure rules and have offering documents reviewed by the SEC. We discuss Regulation A in Chapter 12.
• Regulation Crowdfunding⁴ implements the provisions of Section 4(a)(6),⁵ which was added to the Securities Act by Title III of the JOBS Act. Regulation Crowdfunding creates a highly regulated environment for offerings of $1 million or less within any 12-month period to both accredited and unaccredited investors. We discuss Regulation Crowdfunding in Chapter 13.
• On October 30, 2015,⁶ the SEC proposed amendments to both SEC Rule 147⁷ and SEC Rule 504⁸ to facilitate their use by issuers who conduct state Crowdfunding offerings. Depending on the state, Crowdfunding laws can be used with federal exemptions for intrastate offerings using SEC Rule 147 for offerings that are limited to the issuer's home state or with the less restrictive SEC Rule 504, which permits offerings in more than one state. The proposed amendment to Rule 147 includes easing restrictions on advertising and the number of connections the issuer must have to the state where the offering occurs. The proposed amendment to SEC Rule 504 increases the maximum amount that can be raised during any 12-month period to $5 million and adds Bad Actor restrictions. We discuss Rule 147 state Crowdfunding offerings in Chapter 15 and Rule 504 state Crowdfunding offerings in Chapter 16.

Future securities law changes required

The foregoing exemptions will require some additional changes to allow issuers to maximize technology to raise capital, but the overall regulatory framework for issuer exemptions from registration has been substantially completed at the federal level. The remaining major changes required to facilitate Crowdfunding are likely to relate to the following:

• State Crowdfunding laws, including reciprocity laws among the states that will allow a business that qualifies its offering in one state under expedited registration procedures to conduct Crowdfunding offerings in multiple states using SEC Rule 504 as the Federal Exemption.
• Broadening exemptions from registration as a broker under Section 15 (a) of the Exchange Act⁹ to make it easier for Deal-Makers to provide cost-efficient services to both issues and investors.
• Facilitating investor resales of securities purchased in Crowdfunding offerings. Allowing millions of investors to purchase securities in small to midsize companies is a recipe for disaster, unless markets develop to facilitate resales by investors.
• Permitting small investment funds and investor syndicates formed by lead investors and platform operators, which have become popular in Rule 506 offerings, to participate in Crowdfunding offerings conducted under other exemptions.¹⁰

New tools require new strategies

All of the Crowdfunding exemptions from registration give you more capital-raising tools than you had several years ago. But be careful what you wish for. Both business people and lawyers have been marching to the tune of the same drummer for many years. A new beat can throw the team into disarray.

• New tools require new strategies to maximize the benefits.
• New choices also create the risk of making new mistakes.

As people begin dealing with less sophisticated and non-accredited investors and have many more investors than in the past, the nature of the business's relationship with its investors is changing. You no longer know who you are dealing with and their expectations. The new securities rules tell you what you are permitted to do, but these intangible factors should be taken into account when you plan your strategy for what you should do. Public relations before and after you close an offering will become much more important both to help you raise capital and to keep your investors satisfied.

This new capital-raising system is likely to penalize businesses that act without planning. Businesses that sell securities to anyone they can just to raise money to keep the doors open are likely to develop shareholder relations problems.

In this Part II, we will discuss the different choices you can make and how to develop strategies for maximizing the benefits and minimizing the downside risk of using these new capital-raising tools.

By Jim Verdonik. Jim Verdonik began practicing securities law with a large New York City law firm where he primarily represented investment bankers and venture capital funds in transactions with technology and science based businesses. Since relocating to Research Triangle, NC, he has counseled both companies and investors about securities, business and technology commercialization issues. Excerpted from Crowdfunding: A Legal Guide to Investment & Platform Regulation, 2016 ed., available for purchase on ThomsonReuters.com. This practical guide offers readers comprehensive and straightforward information so that they can make strategic decisions with regard to raising capital. The guide answers questions on a wide range of current and future crowdfunding issues.

^{1. H. R. 3606 (April 5, 2012).↵}

^{2. See SEC No-Action Letters Lamp Technology (1997) and Citizen VC, Inc. (2015).↵}

^{3. 230 C.F.R. §§ 251 et seq. Amendments to Regulation A SEC Release No 33-9741 (March 25, 2015) (80 Fed. Reg. 21,805) (the “Final Regulation A Release”).↵}

^{4. 227 C.F.R. §§ 100 et seq. Crowdfunding SEC Release No. 33-9974 (October 30, 2015) (80 Fed. Reg. 71,387) (the “Final Crowdfunding Rules Release”).?}

^{5. 15 U.S.C.A. § 77d (b) (6).↵}

^{6. Proposed Rule Amendments to Facilitate Intrastate and Regional Securities Offerings SEC Release No 33-9973 (October 30, 2015) (80 Fed. Reg. 69,785) (the “Proposed State Crowdfunding Release”).↵}

^{7. 230 C.F.R. § 147.↵}

^{8. 230 C.F.R. § 504.↵}

^{9. 15 U.S.C.A. § 78o (a).↵}

^{10. Regulation A, Regulation Crowdfunding, and Rule 504 all exclude investment companies from using these exemptions. As we discuss in Chapter 50, “private funds” rely on Section 3(c) (for issuers with not more than 100 beneficial owners) and Section 3(7) (for issuers that are owned only by “qualified purchasers”) of the Investment Company Act (270 C.F.R. § 80c-3(c)(1) and § 80c- 3(c)(7)) for exclusions from the definition of an investment company. Both exceptions specifically apply only to an issuer “which is not making and does not presently propose to make a public offering of its securities.” Section 3 offerings have been held to be exempt public offerings rather than “private offerings.” Gustafson v. Alloyd Co., Inc., 513 U.S. 561, 115 S. Ct. 1061, 131 L. Ed. 2d 1 (1995). Therefore, the intent to conduct a Section 3 exempt public offering by itself excludes the issuer from using the exemptions afforded by Section 3(c)(1) and Section 3(7) of the Investment Company Act (270 C.F.R. § 80c-3(c)(1) and § 80c-3(c)(7)), which causes issuers to be ineligible to use these exemptions. The Fix Crowdfunding Act (H. R. 4855 July 6, 2016), which passed the U. S. House of Representatives in July 2016, would add Section 3(c)(15) to the Investment Company Act. (15 U.S.C.A. § 80a-3(c)(15)). New Section 3(c)(15) would create a new category of fund called a “crowdfunding vehicle” that is exempt from the definition of “investment company.” “Crowdfunding vehicles” would facilitate investors using investor syndicates in Section 4(a)(6) Regulation Crowdfunding offerings by permitting special purpose vehicles to sell securities in Section 4(a)(6) offerings for the sole purpose of investing in a single “co-issuer” portfolio company that is conducting a Section 4(a)(6) offering. Because the definition of “crowdfunding vehicle” includes limitations on capital structure, managers and compensation, not all the types of special purpose vehicles used in Rule 506 offerings would qualify as “crowdfunding vehicles.” See Chapter 13.↵}