Are you an emerging entrepreneur with an underfunded venture? Could your business flourish with a gush of money and hype? Then, the unveiling of the Securities and Exchange Commission’s proposed equity crowdfunding rules reveals a panacea for growing your business’s coffers.
The SEC’s proposed rules (mandated by the JOBS Act of 2012) amend the Securities Act of 1933 and the Securities Exchange Act of 1934 to allow the offer and sale of securities through an internet crowdfunding campaign, similar in some respects to donation crowdfunding campaigns conducted on Kickstarter and Indiegogo.
Donation and equity crowdfunding both appeal to the public’s desire to participate collectively in fulfilling others’ entrepreneurial visions.
Whether launching the next internet sensation, filming a sci-fi fantasy, mass producing savory barbecue sauce, or creating a must-have tech gadget, entrepreneurs will witness this spirited support—not only from the public’s funding, but also from their subsequent purchases of the products they help forge.
If your business needs financing, consider equity crowdfunding; its distinctive traits will lure investors desiring the rewards of investment returns and investor protection, in addition to the goodwill generated by their support.
Equity crowdfunding vs. donation crowdfunding
Equity crowdfunding differs from donation crowdfunding in two major ways. Unlike donation crowdfunding, which allows merely nominal consideration in exchange for donations, equity crowdfunding entails the offer and sale of debt or equity securities in exchange for financial support.
Additionally, a fundraising business offering and selling securities must comply with the regulations of the SEC, the federal government’s securities watchdog. The SEC’s proposed equity crowdfunding rules regulate, in part:
- Your business (the securities issuer)
- The intermediary facilitating your business’ securities offering (the broker-dealer or funding portal)
- The investors
How to prepare for equity based crowdfunding
This article discusses the six action items that you can do now (plus one item you don’t want to do) to optimize your readiness for equity crowdfunding when these rules become effective.
Your compliance obligations will surge once your business starts the process of offering securities to potential investors—so start early.
1. Set a Fundraising Goal
The proposed equity crowdfunding rules allow your business to fundraise up to $1 million per 12 month period in its aggregate equity crowdfunding campaigns.
The proposed equity crowdfunding rules allow your business to fundraise up to $1 million per 12 month period…
Given this limitation, your business’s securities offering may not supply all of the funding your business needs; so, you should look at equity crowdfunding as only one of many tools in your business’s funding arsenal.
Furthermore, before you rush to fundraise any amount for your business, you must answer two questions pivotal for crowdfunding success:
- Is this a strategic amount for my business to fundraise?
- Does my business have the necessary resources to conduct this equity crowdfunding campaign?
Select a Strategic Target Amount:
Let’s suppose you own a craft brewery that needs financing to brew a new line of specialty beers, and your brewery has the requisite funds to participate successfully in equity crowdfunding.
First, you must set a minimum amount to fundraise and the deadline date to fundraise this amount. This minimum amount your business aims to fundraise is the target amount. If your brewery fails to fundraise its target amount by the deadline date, it collects nothing.
You determine that your brewery needs $250,000 to get its beers in various markets and you set a fundraising deadline to ensure your brewery’s first special project will be bottled and shipped by the start of the season. The three scenarios below illustrate the results of different tactics to fundraise $250,000.
Scenario 1: Your business sets a deadline date of 4/30/16 to fundraise its target amount of $250,000. As of 2/25/16, your business has fundraised $250,000. Your business collects $250,000. Congratulations!
Scenario 2: Your business sets a deadline date of 4/30/16 to fundraise its target amount of $250,000. As of the deadline date, your business has only fundraised $225,000. Unfortunately, because your business failed to fundraise the entire target amount by the deadline date, it cannot collect anything and all committed funds will be returned to investors. Accordingly, you are forced to postpone your brewery’s new product line.
A failed campaign results in an unrecoverable loss of time, money, and opportunity. To lessen the chances of failure, you should tactically lower your brewery’s optimal target amount and simultaneously declare a maximum offering amount. The maximum offering amount equals the target amount plus any additional amount your business seeks to fundraise after meeting its target amount.
Now let’s see what happens when your brewery employs the maximum offering amount tactic to fundraise $250,000.
Scenario 3: Your business sets a deadline date of 4/30/16 to fundraise its lowered target amount of $150,000. As of 2/25/16, your business has fundraised $150,000 (which it will collect). Your business then aims to fundraise an additional $100,000. The target amount plus the additional $100,000 equals the maximum offering amount. As of the deadline date, your business has only fundraised $75,000 of the additional requested $100,000. Even though your business failed to fundraise its entire maximum offering amount, it still collects an impressive $225,000. Success! Plus, most (if not all) of your brewery’s plans will be funded.
One rule dominates the equity crowdfunding realm—your business must fundraise its target amount at minimum to collect any funds. But as the scenario above shows, your business can collect funds even if it fails to fundraise its maximum offering amount.
Using the cautious maximum offering amount approach will generally reap the most long-term success, because the target amount could be reached at a lower dollar amount.
Evaluate Your Business:
As demonstrated above, your business’s success in collecting equity crowdfunding proceeds determines the worthiness of its campaign—and this occurs, in part, by setting an appropriate target amount.
Simply aiming to collect any proceeds typifies a deficient equity crowdfunding effort. A successful campaign collects enough proceeds both to justify your business costs and satisfy your key business needs. When setting an appropriate target amount, use the following checklist as an aid:
- Develop an internal spending plan for your prospective equity crowdfunding proceeds
- Itemize and prioritize needs within your internal spending plan to select a worthwhile minimum target amount (and maximum offering amount)
- Assess your business’s finances, administrative capabilities, compliance capabilities, regulatory obligations, and other business obligations
- Evaluate the amount your business can reasonably collect
- Evaluate the administrative and financial costs of running the campaign
To reiterate, costs can comprise a significant part of your business’s equity crowdfunding proceeds and their consideration drives any determination of an appropriate fundraising amount.
For example, the intermediary fee—one of the heftier mandatory business costs—may devour 15% of the securities offering, by the SEC’s estimate. Accordingly, intermediary costs for your brewery’s $250,000 securities offering may total $37,500. Other costs, including legal, promoter, and accounting costs, can also comprise a considerable amount of your crowdfunding budget.
Understand Your Business’s Value:
Additionally, you must set your business’s strategic funding goals in conjunction with your business’s valuation and share price.
What is your business worth? That is the essential question. At minimum, examine your business’s value from an analysis of its financial documents and the viewpoint of the likely investor. Your business’s intrinsic value or potential investors’ perception of your business’s value matters, too—what share value or share price prompts them to buy?
Additionally, you must consider what you are selling to investors, is it a portion of your business or a portion of your business’s specific assets? Also important, select your business’s methodology for pricing shares and consider the ideal number of investors for your business to manage.
Your notion of this value is intertwined in your business’s securities offering statement, which describes to potential investors the terms of their crowdfunding securities. Accordingly, material terms of your business’s securities offering statement will include the following:
- Securities type
- Cancellation and reconfirmation rights
- Share class
- Securities resales
- Purchase price
- Voting rights
Finalize the Equity Crowdfunding Spending Plan:
Equity crowdfunding campaigns trigger disclosure obligations linked to your business’s maximum fundraising goals. Concurrent with declaring a target amount (and maximum offering amount, if applicable), the proposed rules require your business to arm potential investors with a full understanding of any potential equity crowdfunding proceeds.
This will be your business’s final equity crowdfunding spending plan. Setting an indiscriminate target amount situates your business’s campaign poorly if the spending explanation falters under scrutiny from potential investors (or the intermediary).
Accordingly, be prepared to defend any funding request outlined in your business’s spending plan. For example, will the public rally around an emerging craft brewery striving to mass produce four slightly distinct squash flavored beers—pumpkin, acorn, butternut, and winter medley—to be shipped everywhere from Anchorage to Accra?
2. Develop Your Business Plan
The public convening (albeit, virtually) to weigh the value of your business’s securities offering forms the centerpiece of equity crowdfunding. To that end, the proposed equity crowdfunding rules require your business to release its business plan, to enable those prospective investors to have an informed discussion.
The proposed equity crowdfunding rules require you to release a business plan…
At minimum, your business must submit a description of its project, idea, or business for the public to probe (disclosure of a traditional business plan is not required).
Don’t use this minimum standard to justify withholding a meaningful picture of your business from the public—this defeats the purpose of equity crowdfunding and may dissuade prospective investors from buying your business’s securities.
When drafting your crowdfunding business plan, satisfy two objectives—complying with crowdfunding regulations and selling a sufficient amount of crowdfunding securities. To attract crowdfunding investors with your business plan, including the following may help them push the buy button.
Specify Permissible Reasons for Needing Funding:
Luckily, almost every business, idea, or project is fair game. You just need to specify one. Beware—detailing plans to engage in mergers or acquisitions with unspecified companies disqualifies your business from offering or selling crowdfunding securities.
Brand Your Business with a Pithy Mission Statement:
Communicate your business’s value in a few sentences, and with a style and plan that captivates. An impressive mission statement inspires the public to buy your business’s vision before they dig into your business’s value.
Your business plan is a great place to show your management and creative prowess, product innovation or usefulness, business or technology development talents, and demonstrated interest from relevant parties. Superiority in business skills excites prospective investors about your business’s crowdfunding campaign.
For many small and emerging businesses, minimal information exists to assist a securities buying decision. When information is thin, a call to pathos can work wonders.
Omit Proprietary and Confidential Information:
The SEC does not require inclusion of proprietary and confidential information in a crowdfunding business plan. Remember, the public (including your business’s competitors) will access disclosure about your business, so you must refrain from divulging proprietary and confidential information to satisfy the public’s quest for information.
3. Grow Your Network
Get a Network:
Your business’s equity crowdfunding campaign success largely depends on the power of your business’s network. Powerful business networks are ample, prosperous, and engaged.
Strive to develop a vast business network that will both buy crowdfunding securities in sufficient amounts and promote your business’s crowdfunding campaign to others.
Your business’s equity crowdfunding campaign success largely depends on the power of your business’s network.
So here’s the obvious question at hand—do you still have to develop a vast network if a few people buy prodigious amounts of securities? No, but only if your business’s network is affluent. For most, this is a mythical situation. The proposed equity crowdfunding rules limit each person’s total securities purchased per 12 month period in crowdfunding securities offerings—and these limits vary based on the person’s annual income or net worth.
- People with both an annual income and net worth less than $100,000 may invest the greater of $2,000 or 5% of annual income or net worth per 12 month period (or no more than $5,000).
- People with either an annual income or net worth at or above $100,000 may invest the greater of 10% of annual income or net worth per 12 month period, but no more than $100,000.
How many investors does your business need to collect its equity crowdfunding proceeds? Given the financial status of people in your business’s network, what average amount can each invest? You should also assume that these people will invest in other crowdfunding securities.
Once again, let’s pretend that you need to raise a significant amount of money for your brewery. Recall, your brewery collects equity crowdfunding proceeds only if it raises the target amount by the deadline. Let’s look at the four scenarios below to see how variations in network size and securities offering affects the average amount each person must invest for your brewery to meet its target amount.
Scenario 1: Each person invests an average of $2,000 in your brewery’s $1 million securities offering. Your brewery will need 500 network members to meet its target amount.
Scenario 2: Each person invests an average of $500 in your brewery’s $1 million securities offering. Your brewery will then need 2,000 network members to meet its target amount.
It is also important to note that a smaller equity crowdfunding campaign may not ease your duty to develop your network—smaller offerings may likely attract investors spending smaller amounts.
Scenario 3: Each person invests an average of $500 in your brewery’s $250,000 securities offering. Your brewery needs 500 network members to meet its target amount.
Scenario 4: Each person invests an average of $125 in your brewery’s $250,000 securities offering. Your brewery now needs 2,000 network members to meet its target amount.
Of course, don’t expect everyone in your business’s network to buy crowdfunding securities or that all of your business’s investors will come from its network. Once you have estimated the number of network members or investors necessary for crowdfunding success, ramp up networking with real life and internet contacts (both social and professional).
Look at these early network members as collaborators—engaged aptly, they can help pitch your equity crowdfunding campaign on the intermediary’s communication channel (the online space where the public will discuss your business’s securities offering).
Engage Your Network:
Developing an impassioned network that bankrolls your business’s crowdfunding securities offering must form the linchpin in your crowdfunding strategic plan. To keep people engaged with your business efforts, generate and spread news about your business. The internet offers an easy, economical, and ideal platform to share your business’s narrative. This critical and influential narrative operates as a magnet, retaining and attracting people to your business’s network. Also essential to your business’s narrative is a polished business website, which for many stands as a fundamental test of business credibility and viability.
Most of your network’s retention and growth presumably will come through your interactions and networking on social media platforms, such as Facebook, Google Hangout, and Twitter. They deliver a superior form of communication with the public because you alone can craft the message you want the public to know, and direct interactions allow the public to feel a deeper connection to your business.
The intermediary’s communication channel—another form of social media—will serve as the primary place that your business can discuss its crowdfunding securities with the public under the proposed rules (extremely limited advertisements of the offering are allowed outside of the intermediary’s communication channel).
Importantly, this limitation does not restrict business discussion and promotion unrelated to the crowdfunding campaign. Accordingly, your business may continue to use social media to build relationships and circulate information. Once your business begins selling crowdfunding securities, you can effortlessly inform your business’s engaged network that they may purchase and discuss those securities on the intermediary’s internet platform.
4. Perform Background Checks
Saving investors from the prospect of fraud and other misconduct entails, in part, evaluating your business for red flags. For this reason, the intermediary, under the proposed equity crowdfunding rules, must conduct a background and securities enforcement regulatory history check on some of your business’ covered persons. Due to this mandate, rethink your business’s foray into equity crowdfunding if its adverse background will prevent or deter the public from buying its securities. Feel free to proceed, however, if you can turn the adverse information to your business’s advantage.
Before selecting an intermediary to facilitate your business’s securities offering, launch your plan to overcome the fallout of the background check.
Three questions will help your business clear any hurdles:
- Has anyone in my business committed misconduct?
- Will this misconduct endanger my business’s securities offering?
- How would I handle any history of misconduct in my business?
Identify Persons Subject to Background Checks:
Entities and titled persons (and untitled persons performing similar functions) who are covered persons per the proposed rules include:
- Your business, and any predecessor of your business or affiliated business
- Your business’s directors, officers, and general partner or managing member
- Your business’s beneficial owners (those owning 20% or more of the business’s outstanding voting securities)
- Promoters connected with your business’s offering
- Compensated solicitors and their directors, officers, general partner or managing member
Passing the intermediary’s background and securities history check hinges on the past behavior of only some of your business’s covered persons—in particular, your business, and its officers, directors, and beneficial owners. Note that the past behavior of your business’s other covered persons could also derail your business’s securities offering.
Identify Adverse Backgrounds:
After you identify your business’s covered persons, vet them via a background and securities history check or other factual inquiry to uncover any history of criminal or civil misconduct (this also gives you a chance to correct any inaccuracies in the system) and to judge any misconduct’s impact on your business’s crowdfunding campaign.
Misconduct requiring either exclusion from equity crowdfunding or disclosure of such misconduct is known as a disqualifying event. Disqualifying events under the proposed rules include the following:
- Certain criminal convictions
- Certain court injunctions and restraining orders
- Certain final orders of specified regulators
- Certain USPS false representation orders
- Certain SEC disciplinary, and cease-and-desist orders
- Certain SEC orders and stop orders related to SEC Reg. A
- Suspension or expulsion from SRO membership or association with an SRO member
You can review a broader list of disqualifying events similar to the proposed equity crowdfunding rules on the SEC’s website.
If your business’s covered persons committed a disqualifying event before the legalization of the crowdfunding regulations, those disqualifying events do not unilaterally bar your business from offering crowdfunding securities.
Yet, you must continue identifying covered persons with adverse backgrounds for two reasons. First, your business must disclose these disqualifying events in its securities offering materials. Second, if an unknown disqualifying event materializes later, your due diligence may save your business from SEC sanctions.
Understand the Risks of Adverse Backgrounds:
Even if the misconduct committed by your business’s covered persons is not a disqualifying event, the intermediary and the public may deduce that those acts impute fraud or other transgressions to your business’s crowdfunding campaign. The intermediary and the public also can extend this reasoning to the problematic history of all persons associated with your business (not just covered persons).
The intermediary and the public wield great power under the proposed rules. This fierce power enables the intermediary to block or remove your business’s securities offering from its platform based on a judgment—not necessarily a reasonable belief—that the offering appears fraudulent or lacks a commitment to investor protection.
Equally important, the public with misgivings about your business can refrain from buying your business’s securities or worse—bash your business’s securities offering on the intermediary’s communication channel. How will your business respond to this type of judgment? Be prepared to respond civilly to the intermediary and the public about all issues (fair or not) that emerge about your business.
Overcome Problematic History:
Discovering all covered persons with a problematic history before selecting an intermediary pivotally allows you to strategize a favorable outcome. The following steps can help your business’s securities offering proceed by demonstrating a commitment to compliance:
- Construct a winning narrative supportive of your business (and the person, if still associated) for the intermediary’s and the public’s approval. This also rallies the public around your business’s securities offering before it manufactures its own story about your business’s adverse background.
- Demonstrate your business’s values of integrity and commitment to compliance—emphatically and enthusiastically.
- Reject the prior practices and culture that led to the past misconduct.
- Exclude affected persons from covered roles by 1.) restructuring share ownership to less than 20% beneficial ownership, 2.) changing their job responsibilities to non-covered functions within the business, or 3.) terminating them.
If the intermediary is unswayed by your business’s enhanced dedication to compliance, refine your pitch and select an intermediary receptive to your business’s securities offering (which includes your business’s adverse background).
5. Hire Attorneys and Accountants
Securities regulatory compliance plus rising profits equals long term equity crowdfunding success. Acquire assistance with the compliance requirements from attorneys and accountants with a securities regulatory purview. Applying this legal and accounting advice should demonstrate your conscientiousness in preparing a credible securities offering. Vitally, prioritizing legal issues helps your business deftly reduce the prospect of SEC investigations and sanctions, investor dissatisfaction, and intermediary disputes—the three primary legal risks inherent in securities offerings.
Ensure Understanding of the Securities Laws:
The SEC, in its investor protection mission, imposes obligations and restrictions on your business and its securities offering. Your business’s primary securities obligations comprise 1.) disclosing and reporting required information about your business’s securities offering, background, operations, plans, and finances, and 2.) filing that required information on various versions of Form C (the offering statement that crowdfunding securities issuers must use to disclose required information).
Additional crowdfunding regulations include limits on securities offering advertisements, and promoter compensation and activities. Managing investor expectations—through transparent and complete disclosure—limit investor dissatisfaction; although, either non-existent investment returns or a non-existent/uncertain secondary securities market predictably escalates such dissatisfaction.
Managing investor expectations—through transparent and complete disclosure—limit investor dissatisfaction
Sufficiently increasing your comprehension of the crowdfunding regulations substantially diminishes your business’s likelihood of non-compliance. Still, navigating the unknown landscape of the new equity crowdfunding regulations will be tricky and time-consuming, especially for the inexperienced entrepreneur.
Determine Terms of the Intermediary Agreement:
Your business’s choice of registered intermediary will be one of the principal decisions of your business’s crowdfunding campaign. There will be numerous broker-dealers and funding portals vying to be each business’s sole permissible intermediary.
The intermediary will, among other things, facilitate the securities offering, host discussion of the crowdfunding offering, and assess each business’s worthiness to issue securities. Leverage your options to get the most favorable intermediary agreement.
The intermediary agreement covers primarily the intermediary’s 1.) internet-based platform to conduct the securities offering and 2.) online communication channels to discuss the securities offering. Some issues you’ll want to review with the intermediary are:
- Facilitation of the securities offering
- Collection of investment proceeds
- Intermediary fees
- Provision of issuer disclosures
- Termination of securities offering
- Availability of communication channels
- Promotion of the intermediary
Consider that securities regulations disallow funding portals from offering all of the services normally provided by broker-dealers; both, though, may sell document preparation assistance, disclosure templates, securities regulatory consultations, and so on. Determine if your business needs the securities offering services provided by a broker-dealer.
Your business’s choice of accountant and disclosure of financial information may influence prospective investors’ assessments of your business’s credibility and viability—or their securities buying decision.
When your business hires accountants, establish 1.) whether they are independent or non-independent, and 2.) that your business’s financial statements are prepared using U.S. GAAP standards.
Under the proposed equity crowdfunding rules, elements of your financial disclosure (including the independence status of your accountant and accounting services required) are tied to your business’s maximum funding goals.
- Hire an independent auditor to audit financial statements
- Disclose audited financial statements
- Over $100,000 up to $500,000
- Hire an independent public accountant to review financial statements
- Disclose reviewed financial statements
- Hire an independent or non-independent accountant
- Disclose your business’ income tax returns and financial statements certified by one of your business’ principal executive officers
Importantly, make sure you comprehend your business’s financial statements. When the public questions the numbers in your business’s financial statements in the intermediary’s communication channel (and they will), can you respond capably?
Additionally, the proposed rules require your business to describe its financial condition, including your business’s historical results of operations, liquidity, and capital resources (as necessary).
If your business has no operating history, describe its financial milestones and operational liquidity and other challenges.
If your business has an operating history, describe whether the historical results and cash flows are indicative of future results.
Moreover, your business must include the effect the crowdfunding proceeds (and any other pending sources of capital) will have on its financial condition. For example, is this crowdfunding campaign “do or die” for the success of your business? Accountants can help navigate the instructions to these questions, ensuring you provide a transparent and material overview of your business’s prospects.
6. Cover Upfront Costs for Equity Crowdfunding Offering
Frankly, it’s going to take a sweet sum of money upfront to finance your business vision with equity crowdfunding. Moreover, the bigger the securities offering, the higher the upfront costs—although, some costs are fixed.
And, many of the huge crowdfunding bills—like accounting and legal services—will be due before your business collects one equity crowdfunding dollar. Fortunately, some bills can be delayed and paid for with crowdfunding proceeds (like intermediary services), so disclose these in your equity crowdfunding spending plan. Prioritize upfront costs based on both your budget and compliance needs.
Finally—Don’t Sell Securities to the Crowd, Yet:
Even if you forego acting on any suggested “do,” here is one “don’t” you must observe. Don’t attempt to sell crowdfunding securities before the crowdfunding regulations go into effect. Selling unregistered crowdfunding securities to the public will result in SEC repercussions that could undermine your business financing goals.
Disclaimer: This article is intended to be general information only. Nothing in this article constitutes legal advice. Please consult with an attorney before making any legal decisions.