The vision Behind Regulation Crowdfunding
Regulation Crowdfunding (Reg CF) allows any business to raise up to $1.07 million without a public registeration with the Securities Exchange Commission (“SEC”). The idea behind Regulation Crowdfunding is to enable small businesses and startups to leverage the advertising power of the internet to raise small amounts of money from large amounts of people in cost-effective way. Unlike prior Securities Act exemptions, which only allows the most financially well-off to invest, Regulation Crowdfunding opens investment opportunities to everyone.
To keep investors safe, companies raising money under Regulation Crowdfunding may only advertise on a single regulated intermediary, either a registered broker dealer or a funding portal. A “funding portal” is a website that is registered with the SEC and a member of FINRA. The intent of requiring an issuer—i.e., the company raising money—to advertise on a single funding portal is to create a single public location for potential investors in order to view all materials pertinent to the issuer’s offering and communicate with the company and each other in order to evaluate the merits of the offering.
Barriers Preventing Companies from Using Regulation Crowdfunding
Like all exemptions under the Securities Act, issuers seeking to raise money under Regulation Crowdfunding must follow a certain set of requirements. Before posting its offering on a funding portal, an issuer must prepare a Form C and file it with the SEC.
A Form C is a disclosure document intended to provide investors with information about a company, the type of security being offering, and the use of the offering proceeds, amongst other things, to help investors make an informed decision on whether to invest in a company. If the company is seeking funding over $107,000, the financials provided in the Form C must be reviewed by a CPA. Although funding portals provide some guidance on how to fill out a Form C, it is advisable for the Form C to be prepared or at least reviewed by a lawyer.
In addition to the Form C, issuers are required to open an escrow account to maintain investor funds. This is meant to provide investors’ funds in a safe place until the “targeted offering amount” is reached. The targeted offering amount is the minimum amount of offering proceeds that the issuer must raise before the proceeds are transferred to the issuer. If the targeted offering amount is not reached by a certain date, all of the potential investors’ funds are refunded to the investors.
Depending on the funding portal’s policies, the issuer may be responsible for paying for the costs of opening and maintaining their escrow accounts, meaning that even if an issuer does not successfully raise any money, in between the fees for preparing the Form C and paying for escrow, an issuer can find itself out of pocket thousands of dollars. By the SEC’s own estimate, an issuer raising $500,000 or more can expect upfront costs of $44,000 – $90,000 and annual fees of $3,000 to $13,000 for complying with ongoing disclosure requirements. Even if an issuer decides to forgo an attorney, it must pay an estimated $1,500 – $18,000 to have its financials reviewed if raising $500,000 or more.
Due to the SEC’s restriction on advertising anywhere but a registered funding portal, it is hard for a company to predict the success of its Regulation Crowdfunding campaign. Thus, a company attempting to raise money under Regulation Crowdfunding may find itself out a significant amount of money, either because it is unable to raise its targeted offering amount or not raising enough money to cover the cost of its campaign—a percentage of the total amount raised is used to cover the funding portal’s fee, meaning that the total amount raised is not equal to the total amount that the company will receive.
The reality of Regulation Crowdfunding starkly contrasts with its original vision
In an attempt to do a cost-effective offering, a company may take advantage of a funding portal’s tools to prepare a Form C and even a security instrument, such as a SAFE or a convertible note. These security instruments are contractual agreements between the issuer and its investors. Funding portals are not attorneys and cannot advise the company on how to prepare a Form C, choose the most appropriate type of security, or even advise on how to fill out the forms properly. Thus, issuers using a DIY solution may inadvertently subject themselves to civil and even criminal penalties.
Not only are DIY solutions potentially problematic for issuers, it also poses problems for investors.
For example, many issuers raise money through a SAFE (short for simple agreement for future equity) due to its simplicity. Unlike an equity offering, the company does not have to be valued until a future time and only if equity is ever offered. In addition, unlike debt, the issuer is not obligated to pay the investors back. A SAFE is merely a promise to sell equity to investors if certain events happen in the future.
As Michael Piwowar, a former Commissioner with the SEC, pointed out, “a SAFE is neither despite its name, a so-called SAFE is neither “simple” nor “safe.”” SAFEs were intended to be used for startups, which raise money through multiple equity rounds, allowing investors to lock in their shares at a more favorable price. Although some startups do raise money through Regulation Crowdfunding, the law was also meant to allow small businesses, such as local mom and pop shops, to raise money. However, these businesses may never raise equity, leaving investors with a meaningless piece of paper.
Although Regulation Crowdfunding started with great promise, it hasn’t lived up to its original vision or the SEC’s overarching self-proclaimed mission “to protect investors, maintain fair, orderly, and efficient markets, and facilitate capital formation.”
Editors Note: A Change.org Petition has been started to help encourage the SEC to act and improve Reg CF by raising the funding limit. You may support the movement here.
Onki Kwan is a partner at Vanguardium Legal LLP, a San Francisco-based law firm that advises blockchain and technology startups. Her expertise includes entity formation, capital-raising, blockchain-related securities and regulation issues, commercial transactions, and employment, technology, product, marketing, consumer protection and privacy related matters. In her previous role as a senior attorney and director at a public interest law firm, she launched and managed a SEC and FINRA compliant JOBS Act funding portal.