By Amanda Morales
BC Law EIC Student
April 2023
Last summer, I received an email with a subject line asking: “Want to Own a Piece off Comrad?” In exchange for an investment of $100, I could enter in a Simple Agreement for Future Equity (“SAFE”), a type of security commonly used by start-up companies to raise capital. Upon the occurrence of certain conditions, the SAFE would convert into capital interest, or partial ownership, in the company[1]. This email solicitation was my first introduction to equity crowdfunding. Just a few weeks earlier, I had made a different kind of investment in the company through my seventy-dollar purchase of a 3-pack of Comrad compression socks– a hefty, yet reasonable price for socks promising me “happy feet.”[2]
Without knowing whether these socks would actually give me “all day energy, comfort, and support,” I pulled out my credit card and made my purchase. Globally, consumers use their buying power to support businesses that align with their values and interests [3]. In my own case, I was drawn to the company’s science-backed, proprietary sock design, impeccable branding, and glowing customer testimonials. Although I did not participate in the crowdfunding campaign due to my own lack of information, in the future, if given the chance to support an emerging company I believe in, I would make that investment.
Because of the well-known funding disparities faced by women and minority-founded companies, a successful round of crowdfunding can not only serve as a much-needed source of funding for these companies but can also, as Professor Darien Ibrahim suggests, signal to follow on investors, like venture capital (“VC”) firms and Angels, the company’s quality [4]. Lawyers advising emerging companies should be prepared to dispel misconceptions about equity crowdfunding and counsel clients through the required disclosures, as to ensure regulatory compliance, strengthen investor protection, and aid in democratizing access to capital.
Capital Raising Online While Deterring Fraud and Unethical Non-Disclosure (“CROWDFUND”) Act of 2012
The Jumpstart Our Business Startups (“JOBS”) Act, signed into law in 2012, contains a crowdfunding provision, Title III, that enables start-up companies and other small businesses to raise capital through equity crowdfunding [5]. Title III, or the CROWDFUND Act, amended the Securities Act of 1933 (“Securities Act”) by adding a “crowdfunding exemption” under Section 4(a)(6) [6]. Typically, securities must be registered with the SEC; however, some securities and transactions may qualify for an exemption from the SEC registration requirements. By 2015, the Securities and Exchange Commission (“SEC”) had adopted Regulation Crowdfunding, a regulatory framework which permits emerging companies that meet certain requirements to offer and sell securities. Regulation Crowdfunding (“Reg CF”), promulgated under Section 4(a)(6), allows private start-up companies to bypass some of the regulatory burdens that often accompany large offerings of securities to the general public, such as filing a registration statement, prohibitions on general solicitation, or limitations on the size of an offering [7]. Because of the risks inherent in a general offering of securities to the public, Reg CF contains several requirements aimed at bolstering investor protection.
Many may be familiar with popular crowdfunding platforms like GoFundMe where users can fundraise for charity or Kickstarter where users can support creative projects and later receive rewards. In contrast, equity crowdfunding allows companies to raise capital by broadly offering or selling securities to any investor, regardless of their level of sophistication. Prior to the adoption of Reg CF, companies that required capital investments had to proceed under existing exemptions, like Regulation D [8]. Regulation D offerings, which may proceed under Rules 506 or 504, are subject to restrictions that make it more difficult for emerging companies to effectively raise capital. For example, Rule 506 offerings place a limit on the number of non-accredited purchasers who may participate in an exempt offering, which may necessitate a start up’s reliance on accredited investors, like VC firms, for capital [9]. For context, accredited investors are presumed to be sophisticated, unlike non-accredited investors for whom the securities laws are aimed at protecting from market abuses and other information asymmetries [10].
Crowdfunding Basics
Reg CF exempts from registration transactions involving the offer or sale of securities by emerging company issuers, if the offering amount does not exceed $5,000,000 [11]. The maximum aggregate amount eligible to be sold was recently raised from $1,000,000 to $5,000,000 in 2021 [12]. There are also restrictions on how many securities may be sold to an individual investor depending on whether the individual’s annual income or net worth is below or exceeds $100,000. Typical forms of equity securities sold include SAFE’s or common stock [13]. Additionally, all crowdfunding transactions must be conducted through a broker or funding portal registered with the SEC and the Financial Industry Regulatory Authority (“FINRA”). Examples of registered funding platforms include Republic [14] or SeedInvest [15].
Both issuers and intermediaries facilitating the transactions are tasked with providing certain disclosures to investors [16]. The disclosure requirements in a private placement of securities are less burdensome than traditional offerings, but nonetheless require a special level attention to detail and candor. Intermediaries must answer investor questions and ensure that investors participating in an offering review investor-education information and affirm their understanding of the risks involved [17]. Issuers are also required to prepare a Form C and file it with the SEC. Information detailed on the Form C disclosure that may be of importance to investors includes details about the company’s ownership and capital structure, the purpose of the offering, the terms of the investment commitment, and, of course, risks related to the investment [18]. Issuers can be held liable for omissions or misstatements of material fact, so it is important for issuers to pay special attention to the disclosure requirements [19].
The State of Crowdfunding
In a 2019 report on Reg CF by staff at the SEC, the authors assessed the “impact of the regulation on capital formation and investor protection [20].” The report revealed that despite Reg CF’s loosened disclosure requirements, many issuers still found the requirements to be complex and expensive [21]. Further, in the year following the enactment of Reg CF, participation in crowdfunding campaigns by women owned businesses was low and data on minority owned businesses was difficult to measure [22].
It should come as no surprise that while start-up companies led by women and minority founders, on average, spent more time fundraising, those teams still raised less from VC investors than all-male teams [23]. Although there have been significant increases in VC engagement and funding for women and minority-founded start-ups, biases in early-stage fundraising still exist and reinforce the status quo. Founders that are ready to elevate their emerging company to its next stage of growth should consider equity crowdfunding as either a promising starting point for their company’s fundraising journey or a potential solution for filling in any financing gaps. With the knowledge that a start-up client may perceive Reg C-F disclosures as an impediment to their participation in a crowdfunding campaign, attorneys advising emerging companies should be prepared to allay client concerns about this form of capital fundraising.
Footnotes;
[1] https://republic.com/comrad
[2] https://www.comradsocks.com/
[3] See Andrea Willage, People prefer brands with aligned corporate purpose and values, World Economic Forum (December 17, 2021), https://www.weforum.org/agenda/2021/12/people-prefer-brands-with-aligned-corporate-purpose-and-values/
[4] See Ibrahim, Darian, Crowdfunding Signals, 53 Ga. L. Rev. 197 (2018).
[5] Jumpstart Our Businesses Start Up Act, 112 P.L. 106, 126 Stat. 306, https://www.govinfo.gov/content/pkg/BILLS-112hr3606enr/pdf/BILLS-112hr3606enr.pdf
[6] Securities Act of 1933, 15 U.S.C. 77d(a)(6), https://www.govinfo.gov/content/pkg/COMPS-1884/pdf/COMPS-1884.pdf
[7] Regulation Crowdfunding, 17 C.F.R. § 227, https://www.ecfr.gov/current/title-17/chapter-II/part-227?toc=1
[8] James D. Cox, Robert W. Hillman, Donald C. Langevoort, and Ann M. Lipton, Securities Regulation: Cases and Materials, tenth edition, at 245 (2022).
[9] See id. at 249.
[10] See id. at 234.
[11] Regulation Crowdfunding, 17 C.F.R. § 227, https://www.ecfr.gov/current/title-17/chapter-II/part-227?toc=1
[12] SEC Rule, Facilitating Capital Formation and Expanding Investment Opportunities by Improving Access to Capital in Private Markets (January 14, 2021) https://www.federalregister.gov/documents/2021/01/14/2020-24749/facilitating-capital-formation-and-expanding-investment-opportunities-by-improving-access-to-capital
[13] SEC, Investor Bulletin: Be Cautious of SAFEs in Crowdfunding, https://www.investor.gov/introduction-investing/general-resources/news-alerts/alerts-bulletins/investor-bulletins-52
[14] https://republic.com/
[15] https://www.seedinvest.com/
[16] 17 CFR Part 227 Subpart B, https://www.ecfr.gov/current/title-17/chapter-II/part-227/subpart-B/section-227.201
[17] 17 CFR Part 227 Subpart C, https://www.ecfr.gov/current/title-17/chapter-II/part-227/subpart-C
[18] 17 CFR 227.203 https://www.ecfr.gov/current/title-17/chapter-II/part-227/subpart-B/section-227.203
[19] Securities Act of 1933, 15 U.S.C. 77d-1(c), https://www.govinfo.gov/content/pkg/COMPS-1884/pdf/COMPS-1884.pdf
[20] Report to the Commission on Regulation Crowdfunding (June 18, 2019) https://www.sec.gov/files/regulation-crowdfunding-2019_0.pdf
[21] See id. at 30.
[22] See Lindsay M. Abate, One Year of Equity Crowdfunding: Initial Market Developments and Trends, U.S. Small Business Administration Office of Advocacy Economic Research Series, at 5, 13 (March 29, 2018) https://advocacy.sba.gov/2018/03/29/one-year-of-equity-crowdfunding/
[23] See Dropbox DocSend Research Report, The Funding Divide: Tracking Systemic Bias in Early-Stage Fundraising (2022) https://docsend.com/view/ytshcechjuufnp27/d/gbh34gv8v8reep5m