The ABC’s of equity crowdfunding: What founders should know

When an individual or entity invests in a startup, they typically do so in return for an ownership stake, otherwise known as equity. 

In 2012, President Obama signed the Jumpstart Our Business Startups Act (JOBS Act). Title III — Regulation Crowdfunding (or Reg CF) — allowed smaller companies to crowdfund investments online from many smaller investors. 

Reg CF allowed everyone into the world of private-company investment, including companies not registered or trading shares on national exchanges. Previously, the Securities and Exchange Commission (SEC) allowed only “accredited investors,” aka people who meet certain wealth or income thresholds, to invest in private companies. 

The SEC finalized the Reg CF rules in May 2016, and in less than a decade, equity crowdfunding grew from curiosity to a major force in equalizing access to startup capital. 

Now early or mid-stage companies seeking investment can use the power of the internet and their existing networks to raise capital and, just as importantly, awareness. 

Other benefits unique to this model include the ability to:

• Broaden your investor base
• Turn your customers into marketers
• Incentivize your investors
• Prove value to institutional investors

Equity crowdfunding equalizes access to startup capital

So how does it work? Companies (issuers) can raise up to $1.07M over a 12-month period by selling different types of securities that represent ownership, future ownership or debt obligations.

Issuers set minimum and maximum ranges for the overall raise and individual investment minimums (SEC regulations limit maximum individual investment through an income/net-worth formula). Issuers must file CPA-reviewed financial statements and a legal document (Form C) with the SEC, which contains certain disclosures about the company. They also must file at least one year-end report.

Issuers sell their securities over a portal approved by FINRA (Financial Industry Regulatory Authority). There are currently around 55 portals. The biggest ones have lists that contain hundreds of thousands of potential investors, along with media and industry insiders.

Securities sold pursuant to Reg CF are restricted, meaning investors must generally hold them for one year before selling them, though there are exceptions.

Regulatory compliance

Whenever you raise a round of financing, whether a SAFE, Convertible Note or Priced Preferred (or Common) Stock round of financing, one of two things must happen from a regulatory perspective:

• You file a full “Registration Statement” with the Securities and Exchange Commission. Similar to an IPO filing, it’s very expensive and time consuming.
• You qualify for an exemption to avoid filing a Registration Statement. For example, you are exempt and file under 506(b) or 506(c) of Regulation D (“Reg D”) of the Securities Act.

If you do not file a Registration Statement or qualify for an exemption such as 506(b) or (c) under Reg D, and are not otherwise exempt under Section 4(a)(2), YOU HAVE VIOLATED THE SECURITIES LAWS.

Federal securities regulations (dealing with the SEC)

The Securities and Exchange Commission (SEC) is a federal agency tasked with administering the Securities Act of 1933, as amended, along with others. The Securities Act of 1933, as amended, is also known as the Securities Act or ’33 Act.

Even when your offering of securities is exempt, you often will need to file a form of some kind with the SEC to perfect the exemption. Careful attention must be given to selecting the correct form and properly completing it.

All forms are filed with “EDGAR”, the SEC’s Electronic Data Gathering, Analysis, and Retrieval System.

Blue Sky laws (dealing with states)

State-level securities statutes and regulations are commonly referred to as “Blue Sky laws.” The Blue Sky laws of each state are different, and generally require some action be taken at the state level to perfect your exemption.

Blue Sky issues relating to securities offerings arise primarily in three areas:

1. Securities exemptions and filing requirements.

2. Antifraud liability that may arise from a securities offering.

3. Licensing and registration requirements for securities industry personnel participating in a securities offering.

It is recommended to seek legal counsel on regulatory compliance whenever you raise funding.