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| Amy Wan |
Regulation Crowdfunding
Regulation Crowdfunding (Reg CF) became effective on May 16, 2016, and has raised some $12.5 million in its first six months. As of the date of writing, Reg CF allows issuers to raise up to $1 million from retail investors, though it contains several restrictions:
- All offerings much be conducted through a registered funding portal
- Although general solicitation is allowed, any advertising done off-portal is largely restricted to ”tombstone advertising”
- Some offerings may require reviewed financial statements or audited financial statements, though as a practical matter, most issuers voluntarily opt for reviewed financials since they hope to raise more than $500,000
At the time of writing, many industry experts expect some version of the Fix Crowdfunding Act to be passed by the Senate. Depending on which version is passed, the maximum offering amount of a Regulation Crowdfunding offering could be raised to $5 million every 12 months.
Reg CF Issuers Tend to Be Newer Businesses with Lower Valuations
As a practical matter, most issuers contemplating a Reg CF offering tend to be new or early-stage companies for the simple reason that the $1 million funding cap deters more established or valuable companies. Companies looking to raise substantially more than $1 million often will not bother to spend the time, energy or resources needed to conduct a Reg CF offering. For example, if a company aims to raise funds in exchange for equity, the maximum offering amount of $1 million would correspond to the crowd’s ownership in 50 percent of a company with a $2 million valuation, or the crowd’s ownership of 20 percent of a company with a $5 million valuation. Few founders want to give away much of their company, so the lower fundraising limit on Reg CF effectively limits usage of the exemption to newer companies with lower valuations.
Acceptance by a Funding Portal Often Governs Whether an Issuer May Utilize the Reg CF Exemption at All
Another bar on Reg CF’s usage is the requirement to be listed on a registered funding portal. Although there are several registered funding portals (with many more to come), there are only a few that have a serious track record of being able to help their issuers raise capital. Many of the more serious funding portals receive a number of applications from potential issuers and accept less than 1 percent of all applications. Thus, the chances of being accepted on a top-rated funding portal are low, and issuers sometimes will decline to use a less selective funding portal, citing lack of confidence that they will be able to conduct a successful crowdfunding campaign. “If the top portals don’t have confidence that we’ll have a successful campaign, I don’t have confidence that we’ll have a successful campaign on a lower-tier funding portal,” said one client.
Successful Reg CF Issuers Tend to Be Consumer-Facing
Because Reg CF issuers typically sell their securities to retail investors, it’s important for the crowd to easily understand the issuer’s business. As a result, Reg CF issuers tend to be consumer-facing business-to-consumer (B2C) businesses instead of business-to-business (B2B) companies. Although there are always exceptions, an enterprise B2B SaaS (software as a service) platform may have a more difficult time raising funds from the crowd as compared to, say, a restaurant, a company that makes unique selfie sticks, or a technology dating app. The retail crowd has a much easier understanding of the latter companies than the former.
Reg CF Issuers Sometimes Make a Philosophical Decision to Create Brand Evangelists
Highly sought-after companies often have little or no need for capital. As a result, many quality Reg CF issuers are companies that have made a strategic and/or philosophical decision to offer a stake in their company to consumers, in order to create brand evangelists. Some of the first successful Reg CF issuers, such as Legion M and Youngry, have explained that building consumer engagement and ownership were key to their overall business missions. Legion M, a fan-owned movie studio that raised $1 million from over 3,000 investors, sees those backers as a guaranteed audience and evangelists of future releases from the studio. While some issuers might limit the number of investors they allow — usually by taking the commitments with the highest dollar amounts, Legion M’s aim was to take as many investors as possible. As a result, they limited the amount of investment for some larger investors.
Explains Youngry CEO Ash Kumra, “With Regulation Crowdfunding, you’re now asking your core customers, audience members, users — people who believe in your idea — to fund you. But, instead of just getting some perk or reward, which may become outdated, contributors potentially get an ownership stake in the business. It causes a paradigm shift for the contributor — they begin to think like an owner and will more likely find ways to help the business grow. Case in point — during Youngry’s Regulation Crowdfunding campaign, we did over 20 events. The majority of those events were actually set up by our own backers because they were invested as owners, and wanted to give us opportunities to talk about our company and campaign and, thus, gain more exposure.”
Reg CF Issuers Must Be Willing to Dedicate Resources to the Campaign
Companies may first envision crowdfunding as a method that makes money rain from the sky with relatively little effort; this fantasy could not be further from the truth. Reg CF campaigns — and any fundraising campaign for that matter — require diligence, time, money and resources. Most successful crowdfunding campaigns — whether Reg CF, Reg A or even rewards-based campaigns on Kickstarter — engage digital marketing companies to advertise their crowdfunding campaign, and spend the better part of the campaign doing interviews and events to attract investors. Some funding portals give issuers an allowance for digital advertising or find other ways of supporting their issuers, aside from e-mail blasts to their investor mailing list. Companies that are unable to support a certain marketing spend or unwilling to devote significant time toward promotion of the crowdfunding campaign are strongly advised against undertaking a Reg CF campaign.
The Amended Regulation A — Modified Small-Cap Initial Public Offerings
Title IV of the Jobs Act became effective on June 19, 2015, and provided amendments to the old and rarely used Regulation A (sometimes called “Reg A-Plus”), which allows nonaccredited investors to participate in a company’s “mini-IPO.” Whereas the old regulation only allowed issuers to raise a maximum of $5 million per year and required a long and grueling process, the amended regulation raises the funding cap to $50 million every 12 months, and has a much more streamlined process.
It is important for all service providers of Reg A-Plus issuers, including attorneys, to carefully evaluate the suitability of companies for a Reg A-Plus offering. All too often, companies that cold-call an attorney after having Googled the regulation make for poor Reg A-Plus candidates.
Reg A-Plus Tends to be Suitable for More Mature Companies
Regulation A-Plus is often termed a “mini-IPO” for good reason. In contrast with Reg CF, which is largely geared toward newer businesses trying to prove a concept or gain early traction, Reg A-Plus is better suited for more established companies that have already proven a concept, gained significant traction, and are looking for growth capital or an early or partial exit. A potential Reg A-Plus issuer would be advised to meet all or most of the below criteria:
- Capital raised to date: more than $3 million
- Annual revenue/presales: more than $2 million
- Number of customers/e-mails: 5,000 or more
- Number of authentic social media followers: 5,000 or more
- Number of employees: 10 or more
- Number of physical locations: one or more
- Marketing budget: $150,000 or more
The three most important criteria are capital raised to date, annual revenue/presales, and number of customers. While it is helpful for a company to have significant organic social media followers and large customer e-mail lists, a larger marketing budget can help issuers make up for weakness in these areas; conversely, an issuer with a larger e-mail list and influential social media presence may not need to spend as much on marketing.
There are exceptions to the rule, however; companies with moonshot ideas that excite and intrigue retail consumers, and which require large amounts of capital to get started, could conceivably use Reg A-Plus to get off the ground.
Reg A-Plus Issuers Should Have Businesses Understandable to Lay Investors
Additionally, because an issuer is trying to attract retail investors, it’s helpful to have a product that consumers love and easily understand. For example, consumers understand automobiles, video games and real estate, but may have a more difficult time understanding and evaluating B2B software, biotechnology, stem cell research, or licensing schemes to patent portfolios. Although it’s not impossible to do a Reg A-Plus offering in these latter products, until Wall Street analysts begin regularly evaluating and providing recommendations on these securities, issuers may have a more difficult time conveying esoteric technical information to retail investors.
Tier 2 is Vastly Easier to Utilize Than Tier 1
Tier 2 of Reg A-Plus allows an issuer to raise up to $50 million every 12 months, as opposed to Tier 1, which restricts the maximum offering amount to $20 million every 12 months. While Tier 2 has heightened disclosure requirements, in practice, it is a much easier exemption to utilize because it allows for federal preemption. This means that issuers utilizing Tier 2 of Reg A-Plus need only be qualified at the federal level by the U.S. Securities and Exchange Commission, and that review will be on a disclosure basis instead of a merit basis.
Tier 1 offerings do not enjoy federal preemption. Issuers utilizing Tier 1 will need to subject their offering to both review by the SEC and the states in which they plan to sell their offering. Although the states now use a new and improved “coordinated review process” to more efficiently review the offering, anecdotally, many attorneys still find the Tier 1 state process harrowing. Some states employ a merit-based review regime instead of a disclosure-based review regime, meaning that some state regulators may make it very difficult to qualify a Reg A-Plus offering. In one recent case, a filing that garnered fewer than 10 comments from the SEC drew more than 90 comments and questions from state regulators.
Ironically, this means that Tier 2 offerings end up being both easier and less expensive to qualify than Tier 1 offerings, even though Tier 1 offerings have a lower maximum offering amount. Many law firms — including some big law firms — have moved toward a flat-fee basis for Reg A-Plus offerings generally, but either refused to file Tier 1 offerings or bill on an hourly basis for comments received during the Tier 1 process.
Reg A-Plus Requires Preplanning
Unlike Regulation D and Regulation CF offerings that allow for more immediacy in raising funds, Reg A-Plus offerings require qualification by the SEC (and sometimes, state regulators). Issuers should plan for a four- to six-month process that will include preparing financials, drafting the offering circular, and a back-and-forth comment process with the SEC (and states, if a Tier 1 filing). Novel filings may take an even longer period of time. Companies with more immediate capital requirement needs should not use Reg A-Plus, or should consider a bridge financing round in the interim.
—By Amy Wan, Trowbridge Sidoti LLP
Amy Wan is a partner at California-based Trowbridge Sidoti.
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