The Securities and Exchange Commission (the “SEC”) amended and expanded its capital raising rules for Regulation Crowdfunding (“Regulation CF”) in November 2020, effective in March 2021, to increase the amount that a company can offer for sale, increase the individual investor limits on purchases and permit certain special purpose vehicles to invest.  Since that time, there has been significantly more interest from start-ups to make use of the expanded investment opportunities. In light of this increased usage, this article discusses the exemption and highlights the drawbacks and key considerations for start-ups raising capital by crowdfunding.

What is Crowdfunding?

Crowdfunding is a means for companies to raise capital by soliciting small individual investments from a large number of people, or the “crowd”, via an SEC-registered intermediary or “portal.” The SEC has set certain limitations and requirements, which were amended this year, governing crowdfunding transactions and rules for ongoing reporting requirements for companies that have raised capital via crowdfunding.  In general, the regulations around crowdfunding have less stringent disclosure and investment sophistication requirements as compared with Regulation D and other commonly used venture capital exemptions from the Securities Act of 1933, as amended. The basic limitations and requirements for raising capital under Regulation CF are:

• Online Portal. A crowdfunding offering must be made through an SEC-registered intermediary, either a broker-dealer or an internet-based crowdfunding platform (funding portal).

• Offering Size Limit. Companies may raise up to $5 million in a 12-month period through one or more crowdfunding offerings, which represents an increase from the previous $1.07M limit when Regulation CF was originally adopted.

• Investor Limitations. Investors have certain limits to the amount they may invest in crowdfunding offerings based on income or net worth, though the amendments to Regulation CF have lifted those limits for accredited investors and changed the formula used for non-accredited investors.

• Resale Restrictions. Securities purchased in crowdfunding offerings generally cannot be resold for at least one year after purchase.

• Offering Disclosures. In connection with a crowdfunding offering, a company must file a Form C with the SEC providing certain information about the company, its principal stockholders and management, the offering, certain risk factors, and a discussion and analysis of the company’s financial performance. The company is required to amend the Form C and make additional filings during the crowdfunding offering, upon achievement of certain milestones and upon the closing of the offering.

• Ongoing Disclosures. Following a crowdfunding offering, a company must file annual reports on Form C updating the disclosures provided in the initial Form C filed in connection with the offering. The company is required to file annual reports on Form C until one of the following occurs: the company is required to file Exchange Act reports, the company has fewer than 300 holders of record and has filed at least one annual report on Form C, the company has total assets that do not exceed $10 million and has filed at least three annual reports on Form C, the company repurchases all of the securities sold in a crowdfunding offering, or the company liquidates or dissolves its business.

Benefits of Crowdfunding

Crowdfunding is appealing because it enables companies to directly and quickly access capital from a wide variety of investors on terms set by the company (rather than negotiated with the investors) and with less disclosure and filings as are required under certain other capital raising exemptions. Crowdfunding also creates a social and marketing aspect to raising capital, enabling companies to create awareness and momentum for their business and products or services. Crowdfunding is a non-exclusive method of raising capital, and, subject to certain limitations, a company may generally raise money under a different exemption at the same time it is conducting an offering under Regulation CF, for example under a Regulation D offering to accredited investors.

Drawbacks of Crowdfunding

While crowdfunding has its benefits and appeals to many start-ups as an efficient and accessible means of raising capital, it has its drawbacks. The reduced disclosure requirements make crowdfunding offerings less expensive to launch, but there are costs associated with the ongoing reporting obligations, auditing of financial statements, capitalization management and the fees and other ongoing arrangements with crowdfunding portals. There are also non-monetary costs, such as the reporting and disclosure requirements which can mandate that a company disclose private strategic information, potentially impacting its ability to raise money in the future or its competitive advantages. Furthermore, as the name implies, a large number of small investors creates a crowd of investors who may not be as sophisticated or as easy to manage as traditional investors, which may be unappealing to future institutional investors.

A Few Key Considerations for Crowdfunding Offerings

From our experience with Regulation CF offerings, we have seen that the following topics frequently come up, and these should be carefully considered when contemplating a crowdfunding offering:

• Is the company ready to make certain information about its business, management, risks and financials public? The disclosure requirements of Regulation CF are far less burdensome than those associated with registration of securities, but are often more burdensome than an early stage company is ready to take on.

• Is the company ready to engage and pay an accountant to meet the crowdfunding financial reporting requirements? Subject to certain limitations and thresholds, companies that have sold securities in a crowdfunding offering, or that are conducting a subsequent crowdfunding offering, are required to file reviewed and/or audited financial statements with the SEC.

• Is the company ready to file annual reports with the SEC? After selling securities in a crowdfunding offering, a company has annual reporting obligations on Form C, which can be time-consuming and expensive to comply with. Preparing annual reports may require the engagement of an auditor and other advisors.

• How will the securities be issued? There are different formats that crowdfunding portals use to issue the securities sold in a crowdfunding offering. The securities may be issued directly to investors, creating hundreds or even thousands of entries in the company’s ledger and cap table, or the securities may be issued to a special purpose vehicle or custodian that holds the securities for the benefit of the individual investors, and the recent amendment to Regulation CF expands the use of such special purpose vehicles.  A company should appreciate that the individual investors may not understand the format, complicating investor communications and relations.

• What type of securities will be issued? The securities sold in crowdfunding offerings vary depending on a company’s capital needs and timeframes, though we generally see offerings of convertible promissory notes and SAFE (simple agreement for equity) commonly used. The choice of security is an important consideration for the company and will impact future financings. Crowdfunding portals also often have promotions associated with early investments or larger investments, which are typically funded by the company itself and can increase the cost of raising capital.

• Will a crowdfunding offering impact the availability of future financing? Traditional venture capital investors may be deterred by the number of investors resulting from a prior crowdfunding round. Even with a cap table that has a special purpose vehicle or a custodian holding the securities sold in a crowdfunding offering, the complications relating to hundreds or thousands of beneficial owners may reduce the company’s attractiveness to future institutional investors.

• Will the company have access to the capital raised in a crowdfunding transaction when needed? Crowdfunding offerings often involve protections for the investors, including a right to cancel an investment or otherwise fail to fulfill a further commitment to invest, with many crowdfunding portals withholding funds for a period of time as a result of these risks. This can lead to uncertainty and the company not being able to immediately access all of the capital raised in the financing.

• Are there alternatives that may better fit the company’s needs? There are many ways for a company to raise capital, and crowdfunding is just one option. While traditional angel and venture capital investors are still attractive for many reasons, there are also other products and offering formats that crowdfunding portals provide outside of Regulation CF, which can provide greater access to more sophisticated investors. It is important to research and discuss the options with advisors to decide what is best for the company.

Regulation CF and the recent amendments have greatly increased the attractiveness of crowdfunding offerings and have facilitated greater access to capital for early stage companies, but should be considered carefully. Crowdfunding offerings may be right for some early stage companies, particularly smaller or customer-driven businesses where not much capital is needed, but those seeking to raise larger amounts of capital from sophisticated investors should proceed with caution.