On November 2, 2020, the Securities & Exchange Commission (SEC) published its final rule entitled “Facilitating Capital Formation and Expanding Investment Opportunities by Improving Access to Capital in Private Markets.” The final rule is a 388-page indication of the current trend of the SEC to ease access to capital formation and the private capital markets for startups and early-stage companies interested in obtaining U.S.-based investors.
The final rule is just another example, as you will see in this article, of the SEC´s work to “adop[t] targeted improvements to a regulatory scheme that unnecessarily hinders capital formation [for a wide range of small- and medium-sized businesses] and unduly restricts investors’ opportunities to participate in economic growth.”
Of particular interest in the SEC’s final rule are the changes that the SEC has made to its now almost ten-year old crowdfunding rules. This article will detail these crowdfunding changes against a historical backdrop of the crowdfunding rules, and we will provide some preparedness suggestions for companies who are considering how they can leverage these important crowdfunding changes to raise additional capital for their businesses.
Crowdfunding – A Brief History
Regulation CF, or Regulation Crowdfunding, was adopted by the SEC using its authority under the U.S. JOBS Act of 2012 to provide a financing method for early stage companies and startups in which money is raised through soliciting relatively small individual investments or contributions from a large number of people most typically through an online portal. As originally adopted, the crowdfunding rules allowed companies to offer and sell up to $1.07 million of their securities without having to register the offering with the SEC as is typically required when companies look to raise capital from U.S.-based investors.
Almost as quickly as it was adopted, companies looking to rely on the crowdfunding rules to raise capital confronted its limitations. Most challenging, were the limitations placed on the amounts that companies could raise from individual investors. Prior to the adoption of the final rule in November, in the case of those investors considered “accredited investors” (typically high income/high net worth individuals) there was a limit of $107,000 per person in any 12-month period. Additionally, and prior to the adoption of the final rule, the investment limitations on the amount persons not qualifying as accredited investors could invest were even more burdensome and complex, using a “lesser of” formulation that left many industry professionals without clear guidance. These limitations stemmed from the SEC´s outdated and arbitrary (even in the SEC´s own admission) tendency to judge investor financial intelligence on the basis of the investor´s income or net worth irrespective of education, profession, experience or other relevant criteria.
On top of all this, was a general limitation restricting companies to raising no more than $1.07 million from any contingency of investors in any 12-month period, a figure substantially below the capital needs of many startups and early-stage companies with heavy capital expenditure and growth needs.
Crowdfunding – What has changed?
Contained in the final rules, are changes to these limitations that positively impact the ability of startups and early-stage companies to tap into the U.S. private capital markets. These changes include:
- Companies are now able to raise $5.0 million annually rather than the $1.07 million.
- There is no limitation (other than the $5.0 million cap) that companies can raise from any one investor who is an accredited investor.
- Substantial clarity has been given to companies and counsel on the ability to raise money from non-accredited investors, with the investment test changing to a “greater of” analysis.
The final rule, in our opinion, is still not perfect. Companies looking to take advantage of crowdfunding as a means for tapping into the U.S. private markets will still need to be mindful of, among other things, the filing, disclosure and financial statement requirements of the crowdfunding rules. Companies that view crowdfunding as a potential funding option for their businesses should begin now to work with knowledgeable advisors to ensure that they can satisfactorily meet these disclosure and financial statement requirements. For most companies interested in crowdfunding their next capital raise, should they be looking to raise more than $535,000, a one to two-year period of preparation and readiness will be required.
Conclusion on New Crowdfunding Rules
The SEC´s changes to the crowdfunding rules and its most recent proposed rules, including with respect to permitting commission-based payments for those who help companies raise capital and its changes to the “accredited investor” definition, show a clear trend towards a relaxation of the historically burdensome requirements for small companies to solicit investor capital in the U.S. public markets. We expect this trend to continue, with more companies and a wider pool of investors participating in the already-existing annual $1.7 trillion U.S. private markets. We rely on the SEC´s own words to draw our conclusion that we are only beginning to see the SEC open U.S. private markets to more companies and investors:
“[We] view today’s work on harmonizing, simplifying, and improving the exemptive framework [to the SEC´s existing rules] to be a positive step, but we have more work to do to ensure that small- and medium-sized businesses . . . can raise capital in a way that works for them, supports economic growth, and is consistent with investor protection.”
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*This publication/newsletter is for informational purposes and does not contain or convey legal advice. The information herein should not be used or relied upon in regard to any particular facts or circumstances without first consulting a lawyer. Any views expressed herein are those of the author(s) and not necessarily those of our clients.