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Equity Crowdfunding: Issuers Assemble

By Douglas J. Gorman

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More than five months have passed since enactment of the Jumpstart Our Business Startups Act (the JOBS Act), and its much-heralded third article, the Capital Raising Online While Deterring Fraud and Unethical Non-Disclosure Act (the CROWDFUND Act). 

Only four months remain until the acts’ provisions are scheduled to go into effect, and for a business contemplating an equity crowdfund offering, now is the time to decide if such an offering is a viable option. And if so, it’s time to assemble business plans, documents, and an expert team of management advisers, so when the curtain rises on equity crowdfunding, the company will be prepared for the spotlight.

The JOBS Act will allow small businesses, under certain conditions, to publicly offer their equity securities over the Internet without being required to register those securities with the U.S. Securities & Exchange Commission or state securities commissions. 

This exemption from the registration requirements of the Securities Act of 1933 and its state counterparts is the first to recognize the power of the Web in raising capital. And, it is the final piece of the crowdfunding landscape that will complement debt-based crowdfunding, donation-based crowdfunding, and reward-based crowdfunding — all of which made waves this past year via online organizations such as Kiva, IndieGoGo, and Kickstarter, respectively. A given company will be permitted to raise up to $1 million in any 12-month period from an unlimited number of investors, each of whom will be subject to an individual investment cap based on yearly income.

At the outset, it cannot be stressed enough what a departure equity crowdfunding will be from a traditional private capital-raising model that essentially requires that an issuer know the investors being solicited. An issuer, under the equity crowdfunding model, won’t be required to know any wealthy investors or even how to find them. So the success of an offering will depend less on who a business knows than on the viability of the company’s product, which will be a huge equalizer for small businesses with no real connections to capital. However, to take advantage of this new model, a prospective issuer must first decide whether it is comfortable with the investment of time, attention, and capital, set forth below, that an equity crowdfund offering will require, and whether that investment is likely to yield substantial benefits. 

In order to participate in an equity crowdfund offering, an issuer will be required to submit to prospective investors, via an online “funding portal,” a battery of documents and information, all designed to protect those investors from “fraud and non-disclosure.”

Specifically, each issuer will need to provide: 

• its legal status, address, and website; 

• names of its directors, officers and 20 percent stockholders, and their shareholdings; 

• a description of its business and a business plan; and,

• a target offering amount, price per share, deadline to reach the target amount, and a description of the intended use of offering proceeds. 

An issuer must also disclose its ownership and management structure, including: 

• a description of the terms of the offered securities and each other class of the issuer’s securities; 

• how the issuer’s principal stockholders could negatively affect the purchasers of the new securities; 

• how the offered securities are being valued, and methods for how the issuer may value its securities in the future; and, 

• the risks associated with minority ownership in the company, including dilution, additional share issuances, a sale of the issuer, or transactions with related parties. 

Finally, an issuer must describe its financial condition in varying detail depending on the size of the proposed offering. For offerings totaling less than $100,000 in a 12-month period, an issuer need only provide income-tax returns for its most recently completed fiscal year and financial statements certified by the principal executive officer.

For larger offerings less than $500,000, an issuer must provide financial statements reviewed by an independent public accountant; and for even larger offerings up to $1 million, the issuer must provide audited financial statements.

Aside from the above statutory requirements for an equity crowdfund offering, a company must also consider an offering’s practical aspects to determine if equity crowdfunding is a desirable option. Specifically, issuers will be subject to criminal and civil penalties, under Section 10b-5 of the Security Exchange Act of 1934 and Section and 12(a)(2) of the Securities Act of 1933, for any fraudulent or deceitful act or omission. And, they will be subject to enforcement actions by individual state attorneys general in similar instances. 

Issuers will have ongoing disclosure requirements to their shareholders regarding operations and financial condition, and those individual shareholders will retain all statutory corporate rights such as access to company books and records and rights to dissent in certain large corporate transactions. Companies will also, due to the large number of independent shareholders, need to strictly follow corporate formalities such as holding annual shareholder and director meetings and maintaining share and transfer ledgers, actions which many closely-held companies fail to take on a regular basis. 

In addition to the time and attention the above requirements will entail, they will obviously also lead to ongoing legal and accounting costs. And, that is also something a business should consider when contemplating an equity crowdfunding capital raise. Further, like all equity capital, crowdfunded capital will be significantly more expensive than traditional debt financing because a company will have to pay its investors a percentage of its profits rather than a predictable interest rate. 

Finally, beyond the time, costs, statutory requirements, and practical considerations associated with an equity crowdfund offering, certain types of companies as a rule may not be well suited at all for wide equity investment. These include family-owned businesses, which are reticent to involve outsiders in company ownership; professional-services organizations, which by law are restricted to ownership by certain licensed individuals; publicly traded companies, which are not eligible to participate in a crowdfund offering; and companies that anticipate future investment from venture capitalists, who may be reluctant to invest in a business with a large number of shareholders.

In short, equity crowdfunding is not a decision to be taken lightly. But, balanced against all of the potential risks is the promise of the JOBS Act itself, which by its own preamble aims to “increase American job creation and economic growth by improving access to the public capital markets for emerging growth companies.” In the event a company determines that the potential benefits of equity crowdfunding outweigh its potential risks, a company must take the next steps: 

• compile the information above; 

• perform all the due diligence required and determine whether any third-party agreements, government permits, statutory requirements, or internal restrictions prohibit the offering; 

• research the market risk factors, market share prices, and reasons why the company is a superior offering to all others; 

• amass an expert legal and accounting team qualified to advise on the structure, size, and value of the offering; 

• round out a management team to demonstrate to potential investors the strength and vision of the company’s leadership; and,

• polish the corporate books, records, taxes, and operating history to a high shine. 

T minus four months and counting.    

 

Douglas J. Gorman is a New York and Delaware business attorney specializing in corporate matters, emerging business, business succession, and commercial law. He is a founding member of Crisafulli Gorman, PC, a boutique law firm based in Fayetteville. Contact Gorman at djg@cg-lawyers.com

 

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