I’m not a lawyer and so with respect to this post I’m a layman. But I have done a lot of work with startups for many years as a CFO and I work at a venture fund. Here’s what I’ve gathered about crowd-funding rules. (This of course only applies to the United States.)
First, let’s get Kickstarter and the like out of the way. These are crowd-funding sites, yes, but they aren’t crowd-funding sites for equity or debt. As the Kickstarter FAQ makes clear, “Kickstarter cannot be used to offer equity, financial returns, or to solicit loans.” Pretty clear, that.
What Kickstarter, Indiegogo and others offer is an opportunity to donate, most commonly either to an art project or to a company developing a product. In the latter case, you as the donor expect to get a product in return, at some point in the future. If a company is honest with itself, this is effectively debt. It should be thought of as deferred revenue (although technically it’s not). It constitutes an obligation to deliver a product in the future. (See post by Ben Einstein, “Kickstarter is Debt”.)
When people ask about crowd-funding, what they’re usually asking about is crowd-funding for equity. Up until September 2013, this was only possible by offering securities on the public markets. If you weren’t ready for that big step, you needed to follow rules that provided for an exemption from public solicitation. Typically this was the 506 exemption, or technically Rule 506 of Regulation D of the Securities Act, providing guidelines by which you could meet the requirements of the private offering exemption of Section 4(a)(2) of the Securities Act.
In response to the rare piece of bi-partisan legislation called the “JOBS Act” and the instruction from Congress to the SEC that crowd-funding should be made available to entrepreneurs, the SEC in September 2013 took a first step. They created new rules that provide a clear path for public solicitation of investments into private companies through a change to Rule 506. The original 506 rule was split into 506(b) and 506(c), the latter providing for public solicitation. Under 506(c), in exchange for the right to publicly solicit, an entrepreneur faces a greater regulatory burden. We’ll get to 506(c) in a moment but let’s clarify 506(b) first.
With 506(b) the SEC maintained the “old” 506 which does not permit public solicitation or what some might consider “crowd-funding” (more on this distinction later). Under 506(b) you can get investment from private accredited investors with relatively minimal paperwork. For instance, you don’t need a Private Placement Memorandum.
However, just like the old 506 you can not speak publicly about the fact that you are selling stock in your company. This means that when you present at a venture forum or business plan competition, for example, you should not in any way suggest that you are selling stock.
I’m using the phrase “talk publicly” in this post but it’s really that you can’t “generally solicit” if you want to fall within 506(b). This means you can’t advertise or publish information about your offering of securities or present the offering in any seminar or meeting where attendees have been invited by any general solicitation or general advertising. Note that this means you probably also can’t even generally solicit accredited investors, although the SEC hasn’t ruled on activities such as mass mailing a list of venture capitalists.
If you are sure you’re speaking at a private meeting that didn’t involve general solicitation you can talk about your stock offering. Standard practice has become to additionally limit such discussions to only accredited investors. A new standard practice among angel investor groups is to make doubly sure that in fact all their investors are accredited and private venture forums are starting to have investors sign an accredited investor declaration.
(The definition of “accredited” is on the SEC site. It basically means the investor meets certain wealth or income minimum requirements.)
Note that under 506(b) you CAN technically accept money from up to 35 non-accredited investors. The rules against public solicitation and securing funds from non-accredited investors are conflated. However, the level of disclosure required to take funds from non-accredited investors is often an undue burden and may be too great an expense.
By creating 506(c) the SEC effectively tightened up 506(b). People used to talk publicly about raising money from investors in the context of their business strategy, as part of a pitch at a public event, even though it wasn’t technically allowed. Today in a public event — for example, a TechStars public forum — you no longer see companies mentioning or even suggesting that they are raising money, even though everyone knows that they probably are. If they do talk publicly about raising money they risk falling into 506(c).
Under 506(c) you can solicit publicly from anyone but you can only accept money from accredited investors. If you purposely or accidentally publicly solicit — through a business plan competition pitch, Facebook, whatever — you may have dropped yourself into 506(c) territory whether you like it or not. The rub is that you’ll then face an additional management burden and some indeterminate bit of risk.
The burden is that it’s now on you to verify that your investors are accredited. This is how the SEC summarizes it, saying that in complying with 506(c) a company has…
…taken reasonable steps to verify that its investors are accredited investors, which could include reviewing documentation, such as W-2s, tax returns, bank and brokerage statements, credit reports and the like.
Under 506(b), the entrepreneur doesn’t have the same burden of verification that investors are telling the truth about their accredited investor status. Under 506(c) the entrepreneur must verify accredited investor status and that’s what produces an indeterminate risk — the risk is that if this verification isn’t accurate, it could put the whole offering at risk of rescission and could freeze the company out of doing any offerings for one year. To do it right, your investors should submit to you tax returns or have verification in writing from a lawyer or accountant. Some entities such as Angelist provide a service in which investors who go through their platform are certified as accredited. Many investors don’t want to have to tell entrepreneurs about their net worth and so they rely on third parties to provide this verification or they only invest in 506(b) offerings.
Last point: you’re probably wondering how a friends and family offering from non-accredited investors works? There is a Rule 504 that allows a company to raise up to $1 million over a 12 month period. The investors must be people you know. You can’t generally or publicly solicit. Further, unlike 506, under 504 you are not exempt from state securities filings. With 504 you need to worry about the securities rules in each of the jurisdictions of your investors. This may not be a big issue if all your friends and family reside in your state. But the legal costs of this compliance can add up. More on this subject can be found in this post by Alexander J. Davie: “Can a friends and family round include non-accredited investors? Should it?” Note that this post predates the changes in 506 but it’s still relevant.
Technically, general solicitation, permitted under 506(c) isn’t actually crowd-funding, at least as it’s defined in the JOBS Act. In October 2015 the SEC announced new rules that will govern public solicitation of investment from non-accredited investors in private companies — crowd-funding as defined in the Act. This isn’t yet an option because the procedures aren’t yet in place. But it will be an option soon. I’ll write more about this in a later post but important to note that it most likely isn’t a good option for high growth potential technology companies. Additionally, you need to think about whether you should take money from people who are non-accredited because by definition this means they probably can’t stand to lose those funds. The same applies to friends and family who are non-accredited.
Some folks have asked me about Regulation A+. This is in a sense a public offering “lite”. But it still requires $50k-100K of legal work and the use of a broker dealer. It’s an option if you want to attract a lot of accredited and unaccredited investors and make the offering available to those who want to make small dollar investments. But it’s not the type of offering that is relevant to an uncapitalized company and most likely isn’t for a high growth technology company, even one that is able to throw a bit of change at the offering. A good example of what it would be good for is an early funding round that Ben & Jerry’s did in Vermont, long ago. First, this funding round was restricted to Vermont. That’s good because the lower regulation tier of Reg A+ doesn’t allow you to get around state filings where your investors reside. Second, it was a campaign soliciting consumers who were already familiar with the product and therefore likely to be supportive of the offering. That’s good because even today marketing to people who don’t know you already is going to be expensive. Third, Ben & Jerry’s already had some coin at the time of the offering. Also important because Reg A+ isn’t a free ride and will require more ongoing management and overhead than a normal startup can or wants to spend.