Crowdfunding securities.

AuthorSchwartz, Andrew A.

INTRODUCTION

The new federal CROWDFUND Act authorizes the "crowdfunding" of securities, defined as the sale of unregistered securities over the Internet to large numbers of retail investors, each of whom only invests a small dollar amount. (1) This method of selling securities had previously been banned by federal securities law. The CROWDFUND Act, enacted in 2012, overturns that prohibition. (2)

Securities crowdfunding is a new idea, modeled on the recently introduced and highly successful concept of "reward" crowdfunding, which is practiced on Kickstarter, IndieGoGo, and other websites. In reward crowdfunding, artists and entrepreneurs use the Internet to obtain financing from strangers to produce a creative or consumer product, such as a CD or a wristwatch, and the funders are later compensated with the product itself. (3) In securities crowdfunding, by contrast, the participants receive no tangible product, but rather a share of stock, a bond, or some other security issued by the company. Part I.A below defines securities crowdfunding and identifies its precursors.

The primary goal of the CROWDFUND Act, described in detail in Part I.B, is to let startup companies and small businesses use the Internet to obtain modest amounts of capital, in much the same manner as reward crowdfunding. (4) In this it will likely succeed, primarily because the costs associated with crowdfunding securities will be so much lower than costs in a traditional IPO, as explained in Part II.A.

But the Act also has a second goal that may be just as important. Part II.B explores how the crowdfunding of securities will help democratize the market for financing startup companies and small businesses and allow investors of modest means to make investments that had previously been offered solely to wealthy, so-called "accredited" investors.

Finally, our long experience with public capital markets affords the opportunity to predict how securities crowdfunding will play out in practice. This Article makes two such predictions. First, in Part III.A, it predicts that companies that sell equity via crowdfunding may find themselves the subject of hostile takeovers, although founders can easily avoid that outcome if they act with a little foresight. Second, in Part III.B, it predicts that issuers may prefer to crowdfund debt securities, such as bonds, rather than equity, in part because debt better protects founders from potential personal liability. The Article concludes with a few words of advice for the SEC in implementing the Act in light of the risk of fraud.

  1. CROWDFUNDING SECURITIES

    1. Crowdfunding and its Precursors

      The concept of crowdfunding has its origins in "crowdsourcing," which is "a type of participative online activity in which an individual, an institution, a non-profit organization, or company proposes to a group of individuals ... via a flexible open call, the voluntary undertaking of a task." (5) Well known crowdsourced projects include Wikipedia, an online encyclopedia drafted and edited by millions of volunteers, (6) and Yelp!, a geographically based website comprised of user-drafted reviews of restaurants and shops. (7)

      Crowdfunding differs from crowdsourcing in that the crowd is asked to contribute capital, as opposed to labor, to the project. The funding participants, in return, receive the fruits of the project, such as a music CD or a consumer product. (8) This type of crowdfunding is called "reward" crowdfunding. An author with an idea for a manuscript, for instance, might offer 500 signed copies of the final book to those that pledge $100, thereby raising $50,000 to support herself while writing and cover the costs of printing and shipping. Once she completes the book, she ships the copies to the original investors.

      Reward crowdfunding has been practiced on websites including Kickstarter and IndieGoGo since about 2009, and its popularity and success has been phenomenal, growing into a $1.5 billion market in just a couple of years. (9)

      Securities crowdfunding is a new idea that takes the concept one step further. (10) Rather than receive a copy of the author's to-be-written book, the funding participants receive a share in the profits of the book, or some other security, such as a bond or preferred share, in the book. This was previously banned, or effectively so, by federal securities regulations. The CROWDFUND Act, however, creates a new exemption to those regulations, thereby blessing this novel method for entrepreneurs and investors to find one another on the Internet. (11)

    2. The CROWDFUND Act

      The federal CROWDFUND Act, signed into law in April 2012, provides a new means for companies to raise capital from investors by establishing an exemption to the Securities Act of 1933 for crowdfunded securities. (12) This is a major change in securities regulation. It opens up new opportunities for entrepreneurs, who will now have the ability to raise capital from investors without having to comply with the costly federal registration requirements, as well as for investors of modest means, who now have the ability to invest over the Internet in strangers' startup companies. (13)

      1. New Exemption

        The Securities Act has long exempted from its registration requirement securities sold to the founder's friends and relations, or unrelated wealthy investors. (14) Hence, financing for fledgling firms is generally obtained from the so-called "three Fs": "family, friends, and fools." (15) This last group includes angel investors, venture capitalists, and the like, though getting such arm's length investors on board is challenging due to the high risk involved in early-stage investing. (16)

        In sharp contrast to the clubby nature of those traditional exemptions, the idea of crowdfunding is to gather capital from large numbers of people in the "crowd" (i.e., the public), and have each individual provide only a very small amount. (17)

      2. Limits for Issuers and Investors

        The CROWDFUND Act includes monetary limitations for both issuers and investors. Issuers may not raise more than $1,000,000 annually via crowdfunding. (18) As for investors, the maximum annual aggregate amount of crowdfunded securities that any one investor may purchase is limited based on a sliding scale. If an investor's net worth or annual income is under $100,000, she can invest the greater of $2,000, or five percent of her annual income, in crowdfunded securities each year. (19) If her net worth or annual income is over $100,000, she can invest 10% of her annual salary, capped at $100,000, per year. (20)

        Furthermore, there is no limit on the number of shareholders an issuer can have, as another provision of the Act exempts all crowdfunding investors from being counted in the shareholder caps that are relevant in other areas of securities regulation. (21)

      3. Financial Intermediaries

        Crowdfunding transactions cannot be consummated directly between issuer and investor, but rather must be executed via a financial intermediary registered with the SEC. (22) The intermediary can register either as a broker-dealer, (23) or a "funding portal," which is a new classification of intermediary created by the Act. (24) Funding portals will be subject to a new regulatory regime to be established by SEC rulemaking. (25)

        The Act imposes a number of serious obligations on these financial intermediaries. They are required to ensure that each investor reviews investor-education information and positively affirms that they are risking the loss of their entire investment; to ensure that each investor answers a questionnaire demonstrating "[a] an understanding of the level of risk generally applicable to investments startups, ... [b] an understanding of the risk of illiquidity, and [c] an understanding of such other matters as the [SEC] determines appropriate, by rule;" to take measures to reduce the risk of fraud, including obtaining a background check on the issuer's officers, directors and substantial investors; and to provide such disclosures as the SEC shall determine, by rule, appropriate. (26) The Act also provides a catch-all, requiring intermediaries to "meet such other requirements as the [SEC] may, by rule, prescribe, for the protection of investors and in the public interest." (27)

        The intermediary cannot deliver the proceeds of the offering to the company until the target amount has been reached or exceeded, and must allow investors the opportunity to cancel investment commitments before then. (28) The intermediary has the obligation to make sure investors are not exceeding the amount they are allowed to invest under the Act. (29) It also must obey a three week waiting period after the SEC and potential investors are provided with required disclosures before commencing trade, (30) Finally, directors, officers, or partners of an intermediary may not have any financial interest in an issuer that has listed thereon. (31)

      4. Limited Secondary Market

        All of this pertains to the primary market, which is the focus of the Act. As for a secondary market, the Act makes almost no reference to such a market. The one exception is that it expressly provides that crowdfunded securities may not be transferred or sold by investors for one year after the date of purchase, unless being transferred to the issuer, an accredited investor, a family member of the purchaser, or as part of an offering registered with the SEC. (32)

        Moreover, as a practical matter there will be a very small secondary market for any given crowdfunded security. This is simply because the number of shares in the marketplace is likely to be orders of magnitude smaller for a crowdfunded issue than a registered one. Publicly traded companies issue millions or even billions of shares, making it easy to find someone who wants to buy or sell a few. (33) Crowdfunded companies, by contrast, are likely to have only thousands of securities outstanding, making it difficult and expensive to transact in them. For this reason...

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