Monday, November 14, 2011

House Passes “Crowdfunding bill”… the fine print

As I mentioned in my last post, Crowdfunding is the latest trend for raising capital. The U.S. House of Representatives has noticed and, on November 3, passed legislation intended to help foster the ability of early-stage companies to use Crowdfunding to raise capital. It also passed other legislation that may, as a practical matter, be more significant…but more on that below.

My last post detailed some of the potential pitfalls of Crowdfunding under the current regulatory scheme. The new legislation was proposed to eliminate some of these hurdles.

It’s great that Congress is recognizing the need to update (to quote the House bill’s sponsor, Representative Kevin McCarthy) “Depression-era regulations that are outdated because they not only predate Twitter and Facebook but cell phones and color television.” However, before you all run off and start contacting the masses for capital through a "general solicitation" (without advice from your lawyer), you need to look at the “fine print” in the details that were added to the legislation and companion legislation that have been passed by the House.

First, the good news: the legislation has recently been placed on the Senate calendar and has President Obama’s support, so it appears that something will ultimately pass. It does address some of the key issues we’ve been wondering about (like interaction with state law and integration with other federally exempt offerings). A quick summary of the key provisions:

  • An issuer can raise up to $1,000,000 in a 12-month period ($2,000,000 if it has audited financials)
  • Investors can invest the lesser of $10,000 or 10% of their annual income in such an offering
  • Issuers aren’t precluded from raising capital under other exempt offerings as a result of their offerings under the crowdfunding legislation
  • Shareholders who invest under the crowdfunding exemption are not counted toward the maximum number of shareholders that a private company can have (currently 500, but there’s proposed legislation to raise that to 1,000) before it must become a reporting company
  • State regulators are preempted from regulating these offerings (although they retain their enforcement rights against unlawful conduct)
Now, the not so good news—many additional requirements on issuers were added to the original proposed legislation. These include:

  • Requiring an issuer to post a warning on its web site regarding the speculative nature of the investment
  • Taking “reasonable measures to reduce fraud” (whatever that means)
  • Providing the SEC with notice (prior to any offering) and a bunch of other information (including addresses, principals, employees, use of proceeds, and targeted offering amount), which the SEC is required to share with state regulators
  • Requiring investors to answer questions demonstrating their suitability to invest in areas “as the [SEC] may determine” (more about that in a minute)
  • Having a web capability for the issuer and investors (and the SEC) to communicate with each other
  • Outsourcing “cash management” in the deal to a qualified third-party custodian (broker-dealer or insured depository institution)
  • Requiring that proceeds be withheld from the issuer by such custodian until at least 60% of the targeted offering amount has been raised
  • Maintaining books and records as the SEC determines appropriate
As you can see from the above, there are a host of issues for the SEC to address. In fact, the legislation requires the SEC to adopt rules within 180 days to “carry out” the law. Six months doesn’t sound long, right? Well, if you’ve been following the Dodd-Frank financial reform legislation at all you probably know that regulators have missed 77% of all deadlines under that law, including 53 deadlines missed by the SEC alone. Anyone want to bet how successful the overburdened regulatory agency will be in enacting rules within the deadline that is in the final legislation? 

The Silver Lining: Notwithstanding its shortfalls, the legislation is a step in the right direction.

Maybe MORE importantly, at least when I think of things that get in the way for my clients (many of whom seem like they spend a majority of their time and energy raising capital), the House also passed the Access to Capital for Job Creators Act. This legislation removes the prohibition from general solicitation for offerings to accredited investors made under Rule 506 of Regulation D. The majority of equity financings I’ve worked on in the last decade fall into this category. As a result, with the right structure, companies will be able to use general solicitation (e.g., web sites, advertisements, PR) to publicize their offerings and they won’t have to hear me explain why they need a pre-existing relationship with investors in order to take their money.

Because the impact on many of my clients is potentially so significant, I’ll be monitoring both bills as they (I hope) make their way through the Senate and to the president’s desk. Somehow, I can’t think about it without humming the "I'm Just a Bill" song from my childhood spent watching Schoolhouse Rock.


  1. I believe a requirement to specify the $ amount of a round and wait for 60% of funds raised before cash flows is a problem. Companies looking for seed funding need funds of any amount immediately. It seems convertible debt would enable the funds from a crowd to flow better. It sounds like the law would not allow a convertible debt mechanism and would force a company in the seed stage to establish a valuation, which can be limiting. I would want to set a target amount for the round, probably set minimum investment amounts ($500 or $1000), and communicate that the investment converts to shares when the company gets an A round.

  2. As you can see from my post, I agree there are limits to the utility of the Crowdfunding legislation passed by the House. I don't see anything in the legislation that limits the type of security you are selling (whether convertible debt or equity). The most important point may be that, if the final laws end up being the same as the legislation approved, companies will be able to structure 506 offerings to accredited investors as they currently do BUT will be able to use general solicitation to connect with investors. Rule 506 has requirements, but they don't include waiting for 60% of the funds to be raised. Hopefully, what we end up with will help entrepreneurs in their ability to raise capital.