The mood was hopeful, but really quite somber at the Marketplace Lending and Crowdfunding seminar hosted by the Practising Law Institute in New York Thursday. The topic of well-hidden dismay was Regulation Crowdfunding, the newest of the JOBS Act exemptions. Sebastian Gomez Abero, the Chief of the Office of Small Business Policy in the Division of Corporation Finance of the Securities and Exchange Commission, did his best to draw a positive trend from the statistics collected on the completed offerings, but with every quoted number:
the question of viability of this newest exemption loomed larger and larger. And given the $1,070,000 limit on fund raising, the nuisance of running into Section 12(g) Exchange Act registration issues and the unreliability of disclosure coming out of the opportunistically unconscientious portals, who can blame the panelists, or anyone else looking at Regulation Crowdfunding as a potential fund raising alternative, from throwing their arms up in frustration and walking away?
Let’s pause here and take this one sigh at a time.
Ah, all through the session I tried really hard to picture the little mom and pop shops who would consider $1,070,000 a worth-while amount to spend their time and energy on filing the Form C with the SEC, entangling themselves with an oft unscrupulous funding portal and immersing themselves into the quagmire of securities laws. No luck.
The panelists kept mentioning local breweries, auto shops and the like who seem to be the early Regulation Crowdfunding adopters. But they kept coming back to the idea that the limit seems small, ridiculously small for the funds needed for a startup these days and doubly so if you were to consider the fees typically charged by lawyers, accountants and investment banks to facilitate a fund raising exercise for a typical issuer. Effectively, the fund raising limit eliminates access to sophisticated advisers and leaves the mom and pop shop on its own or at best (or at worst) at the mercy of a funding portal. We’ll come back to the funding portals in a minute, but for now, it is worth mentioning that in setting the low fundraising limit the SEC was trying to fill a specific gap in the financing market for startup founders who have exhausted their personal finances, cannot get a bank loan due to the post-recession tightening, and need that extra $100,000 push to tie them over until the next round of available financing. A worthy cause, no doubt.
Not denying the worthy cause, another panelist, Samuel S. Guzik of Guzik & Associates, advocated for increasing the limit, citing higher limits in the U.K. and postulating that an increase, say to $4 or $5 million, would bring more sophisticated players into the market space, thereby improving the number and quality of offerings. So let’s take one more look at this sophistication issue and the related question of the funding portals.
Regulation Crowdfunding requires issuers to use FINRA registered and SEC approved funding portals to issue their securities. So far, FINRA has approved 29 funding portals, some with names like DreamFunded Marketplace, Funding Wonder Crowd and First Democracy VC. One of the panelists, Douglas S. Ellenoff of Ellenoff Grossman & Schole LLP, seemed to place great trust in the ability of the FINRA-chosen funding portals to elicit sufficient and useful disclosure from the issuers. He reported that the funding portals he works with go through an extensive due diligence process when they bring on an issuer and that they do so because they are very worried about their reputation and good name. All good thoughts, and perhaps some of the 29 portals are indeed conscientious, but I wasn’t convinced. The rest of the panel seemed skeptical too and got into a discussion of whether the funding portals are liable for faulty disclosure.
Mr. Ellenoff mentioned that he aggressively lobbied to prevent the SEC from imposing liability on the funding portals. He argued that because funding portals make very little money on an individual issuer’s offering, they would go out of business if they had to take serious preventative due diligence steps to protect themselves against potential liability. So if the funding portals don’t make enough to cover serious due diligence on each potential issuer, I wondered what kind of due diligence they do do, if any.
My colleague, Peter Rasmussen, wondered the exact same thing and went on a virtual stroll through the Regulation Crowdfunding funding portal marketplace. What he found, described in this blog, is unlikely to convince you of the reliability of the average funding portal. I grant that FINRA has been somewhat vigilant in shutting down the most obnoxious offenders, but I think that the typical funding platform has a long way to go to achieve the level of legal compliance expected by the more sophisticated securities market players.
Section 12(g) of the Exchange Act requires issuers to register their equity securities with the SEC, and continue periodic reporting thereafter, if they have more than $10 million in assets and if their securities are held by more than 2,000 persons or 500 non-accredited investors. The SEC granted a conditional exemption from the 2,000 person or 500 non-accredited investor limits for securities issued under Regulation Crowdfunding as long as the issuer: (1) is current in its ongoing Regulation Crowdfunding-required annual reporting, (2) has $25 million or less in total assets as of the end of its last fiscal year, and (3) uses an SEC-registered transfer agent. However, Mr. Guzik pointed out that a “gazelle-like company may have serious reservations” about the possibility of running into Section 12(g) requirements if the company wants to continue staying private and avoid all the costly periodic reporting typically required of public companies.
Mr. Abero did mention that the SEC is continuing to monitor the developments in the Regulation Crowdfunding market, is mandated to issue a look-back report in May of 2019, and may consider relaxing the Exchange Act registration requirements. He made no promises.
The speculation as to the best fundraising options for a startup is at its peak. All startups have their unique needs and funding options proliferate, often to the point of absurdity. Aside from traditional banks loans, there are direct lenders, angel investors and VCs pushing the often unsafe SAFEs and equally unpalatable KISSes. There is Regulation Crowdfunding, there are Kickstarter campaigns, there’s Regulation D, and even the recently trending ICOs. The panel kept safely away from discussing these alternative methods, but Mr. Guzik spoke of many issuers choosing a hybrid Title II and Title III offering. A hybrid offering may allow issuers access to an unlimited amount of financing through a placement agent under Rule 506(c) of Regulation D and the public exposure to the crowd under Regulation Crowdfunding. Mr. Guzik mentioned that a simultaneous use of several exemptions that don’t run afoul of integration issues could be a very useful strategy for many companies.
And perhaps that is a good lesson to take away from all these rules, issues and problems. Ultimately, each company needs to pick the route that fits it the best: be it via a traditional loan, by risking an entanglement with overbearing VCs or by holding its breath and immersing itself in the sea of securities law rules. Like many moms and pops, I just wish those rules were a little less daunting and a little more accessible to the unsophisticated consumer. As things are, I fear the crowd is getting somewhat lost in the crowdfunding.
For more guidance and additional information on the ins and outs of a Regulation Crowdfunding fundraising process keep an eye out for the Regulation Crowdfunding Step-by-Step suite of materials coming soon to Bloomberg Law.
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