A few days ago, someone posted a question on the Seattle Tech Startups email list about crowdfunding. The gist of the question was, “Hey, I’m seeing a bunch of advertisements for workshops on selling securities through crowdfunding. Wouldn’t this be illegal under the Securities Act of 1933?”
I think the Seattle Tech Startups email list is fantastic. It is a good list full of helpful discussions on a variety of topics and participants can discuss questions like the one posed above. (You can learn more about this mailing list and subscribe to it here: http://seattletechstartups.com/doku.php)
The Current State of the Law on Crowdfunding
The answer to the crowdfunding question is “yes.” Under current law, crowdfunding to sell securities is illegal.
Why? To issue securities you either have to register those securities with the SEC (a very expensive process; read Facebook’s S-1 to get a sense of the complexity and expense), or find an “exemption” from registration. For startups, the most common exemption for raising funds in non-public offerings is Rule 506 of Regulation D under the Securities Act of 1933 (Rule 506 offerings account for approximately 95% of all venture and angel financings –see here). Rule 506 prohibits:
- using advertising, or general broadcast media, to solicit investments;
- taking money from non-accredited investors–unless you provide public offering level disclosure.
So don’t post to your blog or Facebook or LinkedIn stating that you are trying to raise angel or venture money. Even if you don’t ultimately take any money from investors, you could still face regulatory action from the SEC and other federal and state authorities. For a recent example of the SEC cracking down on crowdfunding, some folks got in serious trouble for trying to use online social media, including Facebook and Twitter, to try to raise money for a brewery in exchange for an interest in the brewery (See the SEC Order here: http://www.sec.gov/litigation/admin/2011/33-9216.pdf). The SEC took action despite the fact that no money was ever collected.
The Necessary Components of a Good Crowdfunding Bill
The House of Representatives has passed a crowdfunding bill by a large bipartisan majority. But although the House is taking positive steps towards creating a good crowdfunding bill, the Senate is more reluctant. One bill introduced in the Senate only allows startups to issue securities through a “crowdfunding intermediary,” which would presumably prevent use of social networking sites like Facebook or Twitter to raise money. The other Senate bill only allows the issuance of securities through a registered “funding portal” and would require companies to deliver audited financial statements to the SEC if it wants to raise more than $500,000.
In my opinion, a workable crowdfunding bill that can significantly benefit entrepreneurs would contain only the following three components (consider these the 3 legs of the stool):
- First, the crowdfunding bill must preempt state law regulation of the solicitation for the sale of securities in crowdfunding offerings, just as federal law preempts state law in Rule 506 offerings. State regulator pre-approval of crowdfunding offerings would significantly hinder crowdfunding as a viable fundraising method. Witness the lack of success of Rule 504 offerings; almost no one uses Rule 504, even though you can theoretically raise up to $1M from non-accredited investors, because complying with different state regulations is costly and time consuming. In contrast, the reason why Rule 506 works so well and is used so often is that the federal law preempts state law and doesn’t allow state regulators to pre-approve or subject to merit review securities offering documents.
- Second, crowdfunding legislation must allow startups to engage in general solicitation, such as by advertising for funds on the internet. The House is already taking a step in the right direction by passing a bill repealing the ban on general solicitation in all accredited investor offerings. Also, if Congress repeals the ban on general solicitation for crowdfunding offerings it should also do the same for Rule 506 offerings. Otherwise startups would be unable to raise funds through crowdfunding and Rule 506 offerings simultaneously.
- Third, a successful crowdfunding bill must allow startups to take money from non-accredited investors, up to caps of say $1,000 or $500 (and aggregate caps), without triggering public offering type disclosure obligations. These caps allow startups to raise significant funds while also minimizing the risk to investors.
With these 3 elements, crowdfunding could in fact become a “real” reality.
Unfortunately, with the way crowdfunding legislation is shaping up in Congress, any crowdfunding securities law exemption from registration could end up being a mirage — something to get the hopes up of the entrepreneurial community, only to dash them later upon the hard rocks of a reality full of overly complex rules and expensive compliance requirements.
But if we can convince Congress to concentrate on passing a bill based solely on the three priorities outlined above, a new crowdfunding exemption could in fact create a better reality for startups.