What Would Derek Zoolander Say About Crowdfunding?

By Christina Chan & Joe Wallin

I don’t want to bring you back to your high school days (aren’t we all glad those days are over?), but remember when you sat down for a test and your teacher said “Remember to read the instructions before starting”?  Maybe you even had one of those particularly cruel teachers who actually put the answers in the instructions just to see who would read them. If you were anything like me, you probably rolled your eyes and ignored the advice.

When it comes to reading the new crowdfunding law under the JOBS Act, however, you would do well to listen to the words of your old high school teacher.  Before the JOBS Act was passed in March of 2012, there was a lot of excitement in the blogosphere anticipating the legalization of equity crowdfunding.  To the dismay of many in the startup world, the crowdfunding provisions in the JOBS Act  read like a list of what companies can’t do, rather than what they can.  (I’m reminded of that great scene in Zoolander when Derek is presented with a model of the ridiculously named “Derek Zoolander Center For Children Who Can’t Read Good And Wanna Learn To Do Other Stuff Good Too” and Derek’s response is angrily yelling “What is this?!”)

There are many limitations and qualifications on equity crowdfunding in the JOBS Act and it will be important to read and understand them all before embarking on an offering, when crowdfunding ultimately does become legal.

In this post I want to draw attention to a commonly misunderstood crowdfunding provision in the JOBS Act: the monetary limitations on how much investors can invest.

Section 302(a)[1] of the JOBS Act limits the aggregate amount an investor can invest in a company during a 12 month period through the following provision:

(B) the aggregate amount sold to any investor by an issuer, including any amount sold in reliance on the [crowdfunding] exemption provided under this paragraph during the 12-month period preceding the date of such transaction [must] not exceed —

(i) the greater of $2,000 or 5 percent of the annual income or net worth of such investor, as applicable, if either the annual income or the net worth of the investor is less than $100,000; and

(ii) 10 percent of the annual income or net worth of such investor.

This provision does not sound so onerous by itself; you might conclude that under this provision an investor can invest in a number of different crowdfunding offerings, as long as the investor does not exceed the cap with respect to any one issuer.

But keep on reading…

Section 302(b)[2] of the JOBS Act places certain requirements on persons acting as intermediaries in a crowdfunding transactions (a registered broker or funding portal).  This includes a requirement that the intermediary “make such efforts as the Commission determines appropriate, by rule, to ensure that no investor in a 12 month period has purchased securities offered pursuant to section 4(6) that in the aggregate, from all issuers, exceed the investment limits set forth in section 4(6)(B).” (emphasis added).

In other words, imposed on the intermediaries through which a company must conduct its crowdfunding offering[3] is an additional limitation to the dollar amounts investors can invest. The cap on investment described above applies to the aggregate crowdfunding investments made by an investor in a 12 month period, not just the investment made in a particular company.

It’s not clear how portals and brokers are going to coordinate keeping track of all the past crowdfunding investments made by a particular investor.  Nor is it clear yet what the SEC will actually require portals and brokers to do to ensure investors do not exceed the cap in the rule.  For now, just keep in mind Derek Zoolander.

 



[1] New Section 4(6) of the Securities Act of 1933.

[2] New Section 4A of the Securities Act of 1933.

[3] Remember under the new crowdfunding exemption, issuers can only sell stock through an intermediary: either a broker-dealer or registered crowdfunding portal. Section 302(a) of the JOBS Act (new Section 4(6)(C) of the Securities Act of 1933).

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About Joe Wallin

Joe Wallin focuses on emerging, high growth, and startup companies. Joe frequently represents companies in angel and venture financings, mergers and acquisitions, and other significant business transactions. Joe also represents investors in U.S. businesses, and provides general counsel services for companies from startup to post-public.
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  • http://www.venturedocs.com Bo Sartain

    I think that verification of investor limitations will be handled
    either through the honor system (which is not really verification at all,
    unless an investor blows the limits on a single crowdfunding portal), or
    through a centralized clearinghouse database (not sure who will perform that
    function), and that sounds like a big build to me that will cost a lot of money
    and cause even more delay.

    • http://startuplawblog.com/joewallin Joe Wallin

      Bo, that is a good comment. It is too bad Congress built such a contraption!

    • http://wac6.com/ William Carleton

      Bo, a possibly viable way for crowdfunding investors to self-regulate would be the Individual Crowdfunding Account concept. Would be interested in your thoughts. http://www.wac6.com/wac6/2012/12/a-better-way-to-regulate-equity-crowdfunding.html

      • http://startuplawblog.com/joewallin Joe Wallin

        Bill’s idea is a good one. IRA type accounts. In fact, why not just glom on to the IRA legal structure already in place. The key is this–we have to make it easy for people to invest in these companies. We need to do this to grow our economy, and to create jobs and opportunities for young people. Our laws should favor creators.

      • http://www.venturedocs.com Bo Sartain

        How did I miss that article! Good one, Bill. I like the ICA account idea. If the SEC wants to ensure that investors play by the rules, then it still needs to verify that an individual has only 1 ICA. Maybe then the SEC is the clearinghouse database that only has to verify investors’ social security numbers when setting up ICAs.

        But that’s only if the SEC requires a centralized clearinghouse. In my opinion that goes beyond justified paternalism. Let the investors self-regulate, with the help of an ICA managed by a financial institution to throw up some red flags when investors oversubscribe. I love it.

        • http://wac6.com/ William Carleton

          Good point, Bo, about the possibility an investor could set up more than one ICA. I hadn’t thought of that loophole!

  • CLeyerle

    Good post, Joe. Yet another reason why the JOBS Act turns out to be mostly worthless for entrepreneurs. It was clearly built with Wall Street in mind.

    • http://startuplawblog.com/joewallin Joe Wallin

      Thanks Chris. Yes, the JOBS Act has turned out to be a bust for startups so far. Crowdfunding? Not yet. General solicitation for startups? Not yet. Exemption from broker dealer registration for angel groups? Not so fast…

      What a sham. And a shame.

  • BC

    Good post. Does anyone know where to find information on any regulations that govern the individual that’s seeking the crowdfunding?

    • http://startuplawblog.com/joewallin Joe Wallin

      I don’t believe any have been issued yet.