The Startup Law Blog

The SEC has proposed amendments to Rule 147.

The trouble is, the proposed rules would take away one of the federal law support beams for Washington State’s equity crowdfunding law.

Our statute requires compliance with Section 3(a)(11) of the Securities Act of 1933, as amended, and Rule 147, and the SEC has proposed that Rule 147 no longer be a safe harbor under Section 3(a)(11), but its own stand-alone exemption.

Section 3(a)(11) prohibits offers and sales to persons outside of the state of the local offering. The new Rule 147 would only prohibit sales, not offers. This is great. It means that companies crowdfunding could advertise on the Internet without having to worry about their advertising crossing state lines. They just couldn’t ultimately take money from someone who doesn’t live here.

But because our statute requires compliance with both Rule 147 and Section 3(a)(11)–if the SEC’s proposed rules are adopted as proposed–Washington companies would not be able to take full advantage of the new Rule 147. Plus, they would no longer have a safe harbor under Section 3(a)(11) to rely upon.

Here is what the SEC said about this quandary in the proposed rules:

If we were to adopt a rule in substantially the form proposed today, we believe that states that currently have statutes and/or rules that require compliance with Securities Act Section 3(a)(11) and Rule 147 would need to amend their provisions in order for issuers to fully avail themselves of the new rule.

The SEC’s proposals have a lot of good in them, and I think they should be adopted, but not as a replacement to the existing Rule 147 safe harbor.

Once the SEC’s new rules are in place, the Washington State legislature will want to amend our crowdfunding law to take full advantage of it.

But statutory amendments sometimes take years to get through, if ever.

We should write comment letters to the SEC asking them not to do this.

I will write a draft letter and share it.

We have until January 11, 2016 to submit comments.

Here are instructions on how to submit comments:

DATES: Comments should be received by January 11, 2016.

ADDRESSES: Comments may be submitted by any of the following methods:

Electronic Comments: • Use the Commission’s Internet comment forms (http://www.sec.gov/rules/proposed.shtml); • Send an e-mail to rule-comments@sec.gov. Please include File Number S7-22-15 on the subject line; or • Use the Federal Rulemaking Portal (http://www.regulations.gov). Follow the instructions for submitting comments.

Paper Comments: • Send paper comments to Brent J. Fields, Secretary, Securities and Exchange Commission, 100 F Street, NE, Washington, DC 20549-1090.

All submissions should refer to File Number S7-22-15. This file number should be included on the subject line if e-mail is used. To help us process and review your comments more efficiently, please use only one method.

The Commission will post all comments on the Commission’s website (http://www.sec.gov/rules/proposed.shtml). Comments also are available for website viewing and printing in the Commission’s Public Reference Room, 100 F Street, NE, Washington, DC 20549, on official business days between the hours of 10:00 am and 3:00 pm. All comments received will be posted without change; we do not edit personal identifying information from submissions. You should submit only information that you wish to make available publicly.

The SEC has finalized the Title III crowdfunding rules. Now it is time to see how people will use the new rules.

One thing that I think might have been overlooked in all of the excitement over the final rules is the possibility of doing a Title III equity crowdfunding at the same time as you pursue a Reg D or Reg A offering.

The SEC made this possibility clear in a number of different places in the final rules.

In one place, in talking about the economic impacts of the rules, the SEC said this:

The costs associated with not increasing the investment limit above $1 million are mitigated in part by the ability of issuers to concurrently seek additional financing in reliance on another type of exempt offering, such as Regulation D or Regulation A, in addition to the offering in reliance on Section 4(a)(6).

Issuers that go through with the pain and difficulty of a Title III offering might consider doing a Reg A at the same time.

In another place, the SEC had this to say.

We also provided guidance clarifying our view that offerings made in reliance on Section 4(a)(6) will not be integrated with other exempt offerings made by the issuer, provided that each offering complies with the requirements of the applicable exemption that is being relied upon for the particular offering.

But the SEC was careful to note it wasn’t providing a blanket exemption from integration.

While we recognize this concern, we note that the final rules do not provide a blanket exemption from integration with other private offerings that are conducted simultaneously with, or around the same time as, a Section 4(a)(6) offering. Rather, we provide guidance that an offering made in reliance on Section 4(a)(6) is not required to be integrated with another exempt offering made by the issuer to the extent that each offering complies with the requirements of the applicable exemption that is being relied upon for that particular offering. As mentioned earlier, an issuer conducting a concurrent exempt offering for which general solicitation is not permitted will need to be satisfied that purchasers in that offering were not solicited by means of the offering made in reliance on Section 4(a)(6). Alternatively, an issuer conducting a concurrent exempt offering for which general solicitation is permitted, for example, under Rule 506(c), cannot include in any such general solicitation an advertisement of the terms of an offering made in reliance on Section 4(a)(6), unless that advertisement otherwise complies with Section 4(a)(6) and the final rules.

One piece of really interesting language above is the following: “an issuer conducting a concurrent exempt offering for which general solicitation is not permitted will need to be satisfied that purchasers in that offering were not solicited by means of the offering made in reliance on Section 4(a)(6).”

This language is interesting because it implies that you can avoid blowing the prohibition of general solicitation if you can be “satisfied that purchasers in the offering were not solicited by means” of a general solicitation. This is not guidance on the Reg D area, but I think it informs what might be some legitimate thinking about the parameters of the prohibition on general solicitation.

It will be interesting to see if issuers can actually navigate this pathway.

 

The final Title III Equity Crowdfunding rules contain a number of changes from the proposed rules. Some of the changes are good, and some are arguably not so good.

On the good side:

• First time issuers raising more than $500,000 and up to $1 million will not have to have their financial statements audited. Instead, they can rely on reviewed financial statements.
• The annual report will not have to include reviewed or audited financial statements.

On the bad side:

• The final rules adopt stricter limits on the amounts that individuals can invest.
• The Section 12(g) rules may force some companies on to the path of becoming full-blown public reporting companies.

Financial Statements

All issuers have to provide in their offering materials financial statements prepared in accordance with U.S. GAAP.

But, depending on the amount to be raised in the offerings, issuers either have to provide “financial statements of the issuer that are certified by the principal executive officer of the issuer to be true and complete in all material respects,” provide financial statements that have been reviewed by an audit firm, or provide audited financial statement.

The proposed rules would have required issuers raising up to $100,000 to disclose their tax returns. The final rules changed this requirement.

Instead of mandating that issuers offering $100,000 or less provide copies of their federal income tax returns as proposed, the final rules require an issuer to disclose the amount of total income, taxable income and total tax, or the equivalent line items from the applicable form, exactly as reflected in its filed federal income tax returns, and to have the principal executive officer certify that those amounts reflect accurately the information in the issuer’s federal income tax returns.

Ongoing Reporting

The proposed rules would have required issuers to “disclose information similar to that required in the offering statement, including disclosure about its financial condition that meets the highest financial statement requirements that were applicable to its offering statement.”

But the SEC backed off this requirement:

After considering the comments, we are persuaded by the commenters that opposed requiring that an audit or review of the financial statements be included in the annual report that meet the highest standard previously provided, the final rules require financial statements of the issuer certified by the principal executive officer of the issuer to be true and complete in all material respects. However, issuers that have available financial statements that have been reviewed or audited by an independent certified public accountant because they prepare them for other purposes must provide them and will not be required to have the principal executive officer certification.

Investment Limitations

The final rules resolve an ambiguity in the statutory limitation on amounts that can be invested. Here is how the statute described the investment limitations.

the aggregate amount sold to any investor by an issuer, including any amount sold in reliance on the exemption provided under this paragraph during the 12-month period preceding the date of such transaction, does not exceed—(i) the greater of $2,000 or 5 percent of the annual income or net worth of such investor, as applicable, if either the annual income or the net worth of the investor is less than $100,000; and (ii) 10 percent of the annual income or net worth of such investor, as applicable, not to exceed a maximum aggregate amount sold of $100,000, if either the annual income or net worth of the investor is equal to or more than $100,000;

But what if your income is greater than $100,000, but your net worth is less than $100,000? What is your limit then?

The final rules opt for the lesser amount. So, if your income or net worth is less than $100,000, you are subject to the $2,000 or if greater 5% test.

Here is how the SEC described this change from the proposed rules, which would have opted for the “greater of” approach.

After considering the comments received, we have decided to adopt a “lesser of” approach. Thus, under the final rules, an investor will be limited to investing: (1) the greater of: $2,000 or 5 percent of the lesser of the investor’s annual income or net worth if either annual income or net worth is less than $100,000; or (2) 10 percent of the lesser of the investor’s annual income or net worth, not to exceed an amount sold of $100,000, if both annual income and net worth are $100,000 or more.

Under this approach, an investor with annual income of $50,000 a year and $105,000 in net worth would be subject to an investment limit of $2,500, in contrast to the proposed rules in which that same investor would have been eligible for an investment limit of $10,500. 

12(g) Reporting

The final rules set up a situation where crowdfunding companies may be essentially putting themselves on a forced path to becoming a public reporting company. I wrote a blog post about this that you can find at this link.

Integration

Crowdfunding offerings under Title III will not be integrated with other offerings, provided all of the offerings comply with their applicable exemptions. Here is how the SEC described their final say on this point:

[W]e note that the final rules do not provide a blanket exemption from integration with other private offerings that are conducted simultaneously with, or around the same time as, a Section 4(a)(6) offering. Rather, we provide guidance that an offering made in reliance on Section 4(a)(6) is not required to be integrated with another exempt offering made by the issuer to the extent that each offering complies with the requirements of the applicable exemption that is being relied upon for that particular offering. As mentioned earlier, an issuer conducting a concurrent exempt offering for which general solicitation is not permitted will need to be satisfied that purchasers in that offering were not solicited by means of the offering made in reliance on Section 4(a)(6). Alternatively, an issuer conducting a concurrent exempt offering for which general solicitation is permitted, for example, under Rule 506(c), cannot include in any such general solicitation an advertisement of the terms of an offering made in reliance on Section 4(a)(6), unless that advertisement otherwise complies with Section 4(a)(6) and the final rules.

Summary

I still think the crowdfunding rules are too complex. I think issuers are going to be spending a lot of money trying to comply. And my hunch is that many issuers are going to take a pass on equity crowdfunding under Title III altogether because of the complexity.

Perhaps one of the most interesting aspects of the new Title III Equity Crowdfunding Rules is Rule 303(c).

Rule 303(c) of Regulation Crowdfunding requires an intermediary to provide, on its platform:

• Channels through which investors can communicate with one another and with representatives of the issuer about offerings made available on the intermediary’s platform.
• An intermediary that is a funding portal is prohibited from participating in communications in these channels.
• Rule 303(c) also requires the intermediary to:
  • make the communications channels publicly available;
  • permit only those persons who have opened accounts to post comments; and
  • require any person posting a comment in the communication channels to disclose whether he or she is a founder or an employee of an issuer engaging in promotional activities on behalf of the issuer, or is otherwise compensated, whether in the past or prospectively, to promote the issuer’s offering.

To my knowledge, this will make crowdfunding offerings unique. I am not sure of another type of securities offering exemption or registration process that has these types of requirements built into it.

The idea behind these communication channels is that the “wisdom of the crowd” will become known. As the final rules say:

[T]hough communications among investors may occur outside of the intermediary’s platform, communications by an investor with a crowdfunding issuer or its representatives about the terms of the offering are required to occur through these channels on the single platform through which the offering is conducted. This requirement is expected to provide transparency and accountability, and thereby further the protection of investors.

What is nice/no-so-nice about the rule?

• These channels will be on intermediaries’ web sites, not the web sites of companies doing crowdfunding offerings.
• These channels will be open to the public.
• To post a comment, you will have to open an account, but you will not have to be an investor.
• These communication channels do not have to be kept open post-offering.
• The rules “prohibit an intermediary that is a funding portal from participating in any communications in these channels, apart from establishing guidelines for communication and removing abusive or potentially fraudulent communications.”

As far as monitoring the chatter on these channels:

A funding portal can, for example, establish guidelines pertaining to the length or size of individual postings in the communication channels and can remove postings that include offensive or incendiary language. Also, although we understand the reasons for commenters’ suggestions that there should be more privacy or control in the manner in which comments are posted, we believe that aside from intermediaries removing abusive or potentially fraudulent communications, investor protection is better served by providing the opportunity for uncensored and transparent crowd discussions about a potential investment opportunity.

We will have to wait and see how “wisdom of the crowds” develops.

 

You might be wondering what I am talking about when I say that there is a 12(g) problem with equity crowdfunding.

What is Section 12(g), anyway?

Section 12(g) is a section of the Securities Exchange Act of 1934 that requires companies to start reporting as a public company if they allow themselves to have too many stockholders and too much in assets.

Right now, a private company has to start reporting to the SEC if it has over 2,000 securities holders of record, or 500 persons who non-accredited investors and more than $10M in assets.

Here is how the SEC put it in the Final Crowdfunding Rules:

As amended by the JOBS Act, Section 12(g) requires, among other things, that an issuer with total assets exceeding $10,000,000 and a class of securities held of record by either 2,000 persons, or 500 persons who are not accredited investors, register such class of securities with the Commission.

You see the problem. In an equity crowdfunding  you may very well bring on more than 500 non-accredited shareholders. And if you raise $1M in cash, you may well be on your way to the $10M threshold.

Congress saw this problem too, and provided an accommodation for issuers that crowdfund under Title III. But Congress’s accommodation says nothing about issuers who crowdfunding under state equity crowdfunding laws. When the JOBS Act was being put together, I don’t think anyone anticipated state-level equity crowdfunding at all. 

In the final crowdfunding rules, the SEC summarized the final rule’s approach to this issue as follows:

Holders of these securities do not count toward the threshold that requires an issuer to register its securities with the Commission under Section 12(g) of the Exchange Act if the issuer is current in its annual reporting obligation, retains the services of a registered transfer agent and has less than $25 million in assets.

But this isn’t so great, really. A successful equity crowdfunded company will probably exceed the 500 non-accredited investor threshold and if it is a successful company exceed the $25M in assets test before too long. So, one thing issuers are going to have to consider carefully as they prepare to do an equity crowdfunding offering is how they may be effectively putting themselves on the path to having to report as a public company.

Here is how the SEC described how a company in this situation would have to proceed:

An issuer that exceeds the $25 million total asset threshold, in addition to exceeding the thresholds in Section 12(g), will be granted a two-year transition period before it will be required to register its class of securities pursuant to Section 12(g), provided it timely files all its ongoing reports pursuant to Rule 202 of Regulation Crowdfunding during such period. Section 12(g) registration will be required only if, on the last day of the fiscal year the company has total assets in excess of the $25 million total asset threshold, the class of equity securities is held by more than 2,000 persons or 500 persons who are not accredited investors. In such circumstances, an issuer that exceeds the thresholds in Section 12(g) and has total assets of $25 million or more will be required to begin reporting under the Exchange Act the fiscal year immediately following the end of the two-year transition period. An issuer entering Exchange Act reporting will be considered an “emerging growth company” to the extent the issuer otherwise qualifies for such status.

I am not sure $25M was the right threshold to set, but it is what was done.

This is just something companies are going to keep in mind as they consider equity crowdfunding as a financing alternative.

The SEC has proposed changes to Rule 147. You can find the proposed amendments here.

Rule 147 is one of the federal securities law rules that makes state-level equity crowdfunding more difficult.

The reason? Rule 147 is the rule issued pursuant to Section 3(a)(11) of the Securities Act of 1933. Section 3(a)(11) is the statutory basis for avoiding the application of the federal Securities Act in a state-level equity crowdfunding.

Rule 147 says that if you offer your securities across state lines, your offering is no longer “intrastate.” It has been interpreted by the SEC to mean you can’t post anything on the Internet that might be read in another state. Because if you do, you have “offered” the security in that other state, your offering is no longer intrastate, and then your offering doesn’t qualify for the 3(a)(11) exemption.

The SEC issued guidance right after states started enacting state-level equity crowdfunding laws. Here is this guidance from the SEC, which is issued before it issued the proposed Rule 147 amendments.

Question 141.03

Question: If an issuer plans to conduct an intrastate offering pursuant to the Section 3(a)(11) exemption, may the issuer engage in general advertising or a general solicitation?

Answer: Securities Act Rule 147 does not prohibit general advertising or general solicitation. Any such general advertising or solicitation, however, must be conducted in a manner consistent with the requirement that offers made in reliance on Section 3(a)(11) and Rule 147 be made only to persons resident within the state or territory of which the issuer is a resident. [April 10, 2014]

Question 141.04

Question: An issuer plans to use a third-party Internet portal to promote an offering to residents of a single state in accordance with a state statute or regulation intended to enable securities crowdfunding within that state. Assuming the issuer met the other conditions of Rule 147, could it rely on Rule 147 for an exemption from Securities Act registration for the offering, or would use of an Internet portal necessarily entail making offers to persons outside the relevant state or territory?

Answer: Use of the Internet would not be incompatible with a claim of exemption under Rule 147 if the portal implements adequate measures so that offers of securities are made only to persons resident in the relevant state or territory. In the context of an offering conducted in accordance with state crowdfunding requirements, such measures would include, at a minimum, disclaimers and restrictive legends making it clear that the offering is limited to residents of the relevant state under applicable law, and limiting access to information about specific investment opportunities to persons who confirm they are residents of the relevant state (for example, by providing a representation as to residence or in-state residence information, such as a zip code or residence address). Of course, any issuer seeking to rely on Rule 147 for the offering also would have to meet all the other conditions of Rule 147. [April 10, 2014]

Question 141.05

Question: Can an issuer use its own website or social media presence to offer securities in a manner consistent with Rule 147?

Answer: Issuers generally use their websites and social media presence to advertise their market presence in a broad and open manner so that information is widely disseminated to any member of the general public. Although whether a particular communication is an “offer” of securities will depend on all of the facts and circumstances, using such established Internet presence to convey information about specific investment opportunities would likely involve offers to residents outside the particular state in which the issuer did business.

We believe, however, that issuers could implement technological measures to limit communications that are offers only to those persons whose Internet Protocol, or IP, address originates from a particular state or territory and prevent any offers to be made to persons whose IP address originates in other states or territories. Offers should include disclaimers and restrictive legends making it clear that the offering is limited to residents of the relevant state under applicable law. Issuers must comply with all other conditions of Rule 147, including that sales may only be made to residents of the same state as the issuer. [October 2, 2014]

So, the trouble with trying to raise money in a state-level equity crowdfunding is that you want to let people know about your offering. You would, if you could, like to post about the offering on Internet, without having to “implement technological measures to limit communications that are offers only to those persons whose Internet Protocol, or IP, address originates from a particular state or territory and prevent any offers to be made to persons whose IP address originates in other states or territories.”

Now the SEC appears ready to modernize Rule 147. This is good. Interested parties should read the proposed rule carefully and put their comments into the SEC.

I like this statement from the proposed rules.

The proposed amendments to Rule 147 would amend these requirements and revise the rule to allow an issuer to engage in any form of general solicitation or general advertising, including the use of publicly accessible Internet websites, to offer and sell its securities, so long as all sales occur within the same state or territory in which the issuer’s principal place of business is located, and the offering is registered in the state in which all of the purchasers are resident or is conducted pursuant to an exemption from state law registration in such state that limits the amount of securities an issuer may sell pursuant to such exemption to no more than $5 million in a twelve-month period and imposes an investment limitation on investors.

And here is another quote from the explanatory materials in the proposed rules:

Rule 147, as proposed to be amended, would require issuers to limit sales to in-state residents, but would no longer limit offers by the issuer to in-state residents. 40 Accordingly, amended Rule 147 would permit issuers to engage in general solicitation and general advertising that could reach out-of-state residents in order to locate potential in-state investors using any form of mass media, including unrestricted, publicly available websites, to advertise their offerings, so long as all sales of securities so offered are made to residents of the state or territory in which the issuer has its principal place of business

Yesterday was a good day for crowdfunding.

What should Congress or the SEC do next? We need Congress or the SEC to extend the same exemption from ’34 Act reporting for companies that crowdfunding under state law that Congress extended to companies crowdfunding under Title III.

As part of Seattle Startup Week I am giving a talk on equity crowdfunding.

The talk will be this Friday.

There is a link about the event on the Seattle Startup Week calendar.

Washington State was one of the first state’s to have a state-level equity crowdfunding law.

In fact, Washington State might have been the first state in which a state legislator proposed a state crowdfunding statute. Thank you Cyrus Habib.

Regulators in Kansas and Georgia put in place regulatory crowdfunding exemptions before the JOBS Act.

But after the JOBS Act, I think Washington State might have been the first state to have a legislator propose an actual crowdfunding statute.

Now 20+ states have put in place state-level equity crowdfunding laws. You can find a good slide showing which states have put in place state-level equity crowdfunding laws in this slide deck.

In my talk Friday, I plan to talk about a number of things, including:

• how state-level equity crowdfunding compares to the traditional Rule 506(b) offering, and the new Rule 506(c) offering.
• how state-level equity crowdfunding will be impacted by the SEC’s long-awaited adoption of the federal equity crowdfunding rules.
• the requirements of Washington’s statute.
• the future of equity crowdfunding.

How State-Level Crowdfunding Compares to Rule 506(b) and (c)

You might wonder, how is state-level equity crowdfunding different from traditional fund raising paths, and in particular Rule 506(b) and (c).

The primary difference between Rules 506(b) and (c) and state-level equity crowdfunding is the promise to be able to sell shares to non-accredited investors without a huge legal hassle.

Rule 506(b) allows sales of up to 35 non-accredited investors, but only if a company provides registered offering level disclosure. This is impractical for most companies, and so most Rule 506(b) offerings are accredited investors only.

State-level equity crowdfunding laws allow the sale to non-accredited investors. But these laws comes with a variety of challenges. For example, Washington State’s law allows the sale to non-accredits, but before you can proceed you have to do the following:

• You have to file and have approved by the state a crowdfunding form
• You have to have a target minimum fundraising and hire an escrow agent
• For as long as the securities are outstanding, you have make regular disclosures to the public of executive officer and director compensation

Once the state approves your crowdfunding form, you can raise up to $1M during a 12-month period. There are individual investment limitations that mirror the same limitations in the JOBS Act.

Impact of Finalization of Federal Law

The SEC is about to adopt the federal crowdfunding rules. Will the finalization of federal equity crowdfunding negatively impact the operation of state laws?

No.

The various state-level equity crowdfunding laws that have been adopted carefully avoid the application of the federal law.

So even after the federal rules are finalized state laws will still be in place and available.

The Future of Equity Crowdfunding

Although I am excited about the SEC’s meeting on Friday to consider whether to adopt final crowdfunding regulations, the federal statute is complex. Companies will have to spend a lot of money to do a federal crowdfunding offering. State-level equity crowdfunding will be substantially less costly. This is a competitive advantage point for the state laws.

However, most companies will probably continue to pursue the traditional fundraising path–Rule 506(b).

The big problem with both the federal and at least the Washington statute is that both require significant cost expenditures before any deal is certain.

The great thing about a Rule 506 offering is you can avoid incurring much in the way of legal or accounting expenses at all until you know you have a deal. Then, if you have investor interest lined up, you can then spend the money on legal fees to prepare the final documents. In a Rule 506 offering, as long as you are selling to only accredited investors, you do not need audited financial statements.

So, for many startups and early stage companies–the idea of spending even say $10,000 to get the state to approve a crowdfunding form before you even know if you can line up investor interest doesn’t seem like a great approach. Especially when you can go and shop a 1 page term sheet with a slide deck to accredited investors for almost no legal expense at all.

Still, crowdfunding has great promise. Perhaps Washington will update and fix its statute to remove the pre-approval requirement. Oregon law does not require pre-approval, but only a pre-filing which is not reviewed. This would make the Washington law more easily usable by companies.

The SEC has scheduled a meeting for this coming Friday to vote on the final equity crowdfunding rules under the JOBS Act.

The SEC’s notice of the meeting says:

Notice is hereby given, pursuant to the provisions of the Government in the Sunshine Act, Pub. L. 94-409, that the Securities and Exchange Commission will hold an Open Meeting on Friday, October 30, 2015 at 10:00 a.m., in the Auditorium, Room L-002.

The subject matter of the Open Meeting will be:

The Commission will consider whether to adopt rules and forms related to the offer and sale of securities through crowdfunding under Section 4(a)(6) of the Securities Act of 1933, as mandated by Title III of the Jumpstart Our Business Startups Act.

The Commission will consider whether to propose amendments to Securities Act Rule 147 and Rule 504.

If you are desirous of doing some reading in advance of this meeting, you can go back and read the proposed rules.

It is great that the SEC is finally getting around to this. Hopefully the SEC makes the process for companies easier in the final rules.

Unfortunately, because of the way the statute was written, I still think equity crowdfunding under the JOBS Act is going to be too complex for most early stage and startup companies.

What are the big hangups under the law?

In my opinion, the big problems are:

• the requirement of audited financials for offerings over $500,000. Given the expense and time and effort involved in doing a crowdfunding offering, it hardly seems worth the effort to do one if you are not raising more than $500,000. If that is the case, then I can’t see a lot of startups and early stage companies taking this path. Instead, I think most will continue to stick to Rule 506(b) or 506(c).
• The requirement that companies pay an expensive intermediary to conduct an offering.

In general, I am a huge fan of the idea of equity crowdfunding. But I am concerned that the rules are going to be too complex and cumbersome for most companies to use.

If you are going to spend the time and effort required to do a Title III equity crowdfunding, perhaps a Reg A+ offering would be a better choice.

In any event, it will be fun to see how things unfold.

The SEC’s Advisory Committee on Small and Emerging Companies recently issued recommendations regarding the regulation of finders.

If you are not familiar with the rules, the SEC takes a very narrow view of who can help companies find investors without having to register as a broker-dealer.

Broker-dealer registration is so onerous that people won’t engage in an activity if it would trigger broker-dealer registration.

Here is how the Committee described the problem:

Capital raised in private offerings using SEC Regulation D is large when compared to other exempt offerings and registered offerings. However, only 13% of Regulation D offerings reported using a financial intermediary, such as a broker-dealer or finder, between 2009 and 2012. This is due, in part, to lack of interest from registered broker-dealers given the legal costs and risks involved in undertaking a small transaction and ambiguities in the definition of “broker.”

One of the reasons fundraising is so hard today is because of all of the regulations in place.

As the Committee says:

Failure to address the regulatory issues surrounding finders and other private placement intermediaries impedes capital formation for smaller companies.

I believe, as the Committee says, that “[a]ppropriate regulation would enhance economic growth and job creation.”

The Committee’s letter continues:

The Committee is of the view that imposing only limited regulatory requirements, including appropriate investor protection safeguards, on private placement intermediaries that limit their activities to specified parameters, do not hold customer funds or securities and deal only with accredited investors would enhance capital fonnation and promote job creation.

I like the components of the above:

• limit activities to specified parameters;
• do not hold customer funds or securities; and
• deal with only accredited investors.

I agree with the Committee: the SEC ought to reduce the regulatory hurdles that small and emerging companies have to jump over to raise capital.

You can find the Committee’s full recommendations in the Committee’s letter to SEC Chair Mary Jo White.

But here they are, at least in part–the parts I find interesting.

First, the Committee recommends:

The Commission take steps to clarify the current ambiguity in broker-dealer regulation by determining that persons that receive transaction-based compensation solely for providing names of or introductions to prospective investors are not subject to registration as a broker under the Securities Exchange Act.

This is really interesting. Notice the parameters:

• solely for providing names of or introductions to prospective investors.

Then the Committee goes on:

The Commission exempt intermediaries that are actively involved in the discussions, negotiations and structuring, as well as the solicitation of prospective investors, for private financings on a regular basis from broker registration at the federal level, conditioned upon registration as a broker under State law.

This is important.

• intermediaries actively involved in the discussions, negotiations and structuring, as well as the solicitation of prospective investors, on a regular basis, would have to be registered–but under state law.

These are clear lines.

I hope the SEC takes action on the Committee’s recommendations.

If you are administering a private company stock option plan, you need to do what is referred to as “the Rule 701 math” before every grant of stock options or equity awards.

What is “the Rule 701 math”?

Rule 701 contains a set of mathematical limitations on how many shares of stock you can offer service providers during any consecutive 12-month period. If you exceed Rule 701’s mathematical limits, you might not have a securities law exemption for the equity you award in excess of the limit (you couldn’t rely on Rule 701, but perhaps there are other exemptions you could find).

If you blew Rule 701 and issued securities without a securities law exemption, this would be a serious issue for your company. You don’t want to do this for all sorts of reasons. One reason is that it might cause the delay of your company’s public offering (this actually happened to Google).

The Mathematical Limitations

There are three mathematical measures under Rule 701. You get to choose the greatest of the 3 measures. The three measures apply during any consecutive 12-month period. The three measures are:

• $1M;
• 15% of balance sheet assets; or
• “15% of the outstanding amount of the class of securities being offered and sold in reliance on this section.”

The $1M test is the easiest to apply because you don’t have to refer to the company’s balance sheet or cap table. If you are a startup, and you are granting stock options at $1.00 a share, then during any consecutive 12-month period you can’t grant options on more than 1M shares.

So, the $1M test is especially helpful to early stage companies, whose common stock price per share might be low.

But as your price per share increases, you might find yourself having to rely on one of the 15% tests.

In particular, you might want to know–how do you determine 15% of the outstanding amount “of the class of securities being offered and sold in reliance on this section”? And what is meant by “class of securities being offered”?

If you are like most companies, your founders own common stock, and your option pool is common stock, but you have issued your investors convertible preferred stock.

If you keep reading Rule 701, you will find a rule explaining how you go about “calculating prices and amounts.”

In particular, Rule 701(d)(3)(iii) says as following:

In calculating outstanding securities for purposes of paragraph (d)(2)(iii) of this section, treat the securities underlying all currently exercisable or convertible options, warrants, rights or other securities, other than those issued under this exemption, as outstanding.

The above language is helpful.

Let’s suppose your company has a typical cap structure. The Founders own 4M shares, there is an option pool of 1M shares, and your Series Seed Preferred investors own 1.5M shares of Series Seed Preferred. Your cap table thus looks as follows:

Common	4,000,000	61.54%
Pool	1,000,000	15.38%
Series Seed Preferred	1,500,000	23.08%
	6,500,000

Say you want to rely on the 15% of the outstanding class of securities being offering test. How do you determine the 15%? Is it 15% of the Founder Common Stock? Or is it 15% of the Founder Common Stock AND the Series Seed Preferred.

Well, if you read the rule on how to calculate prices and amounts it told you:

Rule 701(d)(3)(iii): In calculating outstanding securities for purposes of paragraph (d)(2)(iii) of this section, treat the securities underlying all currently exercisable or convertible options, warrants, rights or other securities, other than those issued under this exemption, as outstanding.

This is helpful. The Series Seed is convertible to common by the holders at any time, and the Series Seed wasn’t issued under Rule 701 but Rule 506. So, it would make sense to include the preferred as well as the common in doing your math.

But what about the “class” of securities being offered component of the test? The “rules for calculating prices and amounts” don’t say anything about the “class” question. In fact, the only place the word “class” appears in Rule 701 at all is in the 15% of outstanding securities rule. There is no other mention of class.

There is an SEC no-action letter on the “class” issue. But what is odd about the Arclight no-action letter is there is no reference in it to Rule 701(d)(3)(iii). As the letter requesting the no-action letter says:

Rule 701 does not contain a definition of “class” of securities for the purpose of determining whether the A, B and C Units should be considered a single “class” of securities in calculating the amount of offers and sales Arclight may make under Rule 701.

Perhaps the lawyers writing the Arclight letter simply didn’t think Rule 701(d)(3)(iii) relevant because it says nothing about “class.”

Perhaps the word “class” is not to be given any special significance? This is probably too hopeful of an interpretation.

In trying to understand this issue a little more, I found this series of letter exchanges between the SEC and a company trying to go public helpful and informative.

Here is what happened:

The company filed a draft registration statement with the SEC. In the draft registration statement, the company’s statement of stockholders’ equity showed the issuance of common stock in exchange for services.

The SEC asked about this in its comment letter.

The Company submitted another draft registration statement, and a reply to the SEC’s letter.

In its response letter, the company said the following:

But the SEC still wasn’t satisfied, and asked in its next letter, a little more pointedly, the following question:

Please expand your response to prior 44 to provide us your analysis of the applicability of the authority on which you rely to conclude that you may consider “securities convertible into common stock” as part of the number of shares of “outstanding” common stock for purposes of Rule 701(d)(2)(iii).

In its response, company simply quotes Rule 701(d)(3)(iii), and rests its case.

19. Please expand your response to prior 44 to provide us your analysis of the applicability of the authority on which you rely to conclude that you may consider “securities convertible into common stock” as part of the number of shares of “outstanding” common stock for purposes of Rule 701(d)(2)(iii).

RESPONSE:    The Company respectfully advises the Staff that Rule 701(d)(3)(iii) provides as follows:

“In calculating outstanding securities for purposes of paragraph (d)(2)(iii) of this section, treat the securities underlying all currently exercisable or convertible options, warrants, rights or other securities, other than those issued under this exemption, as outstanding.”

As such, the Company included outstanding common stock, outstanding convertible preferred stock and outstanding warrants to purchase shares of convertible preferred stock and common stock not issued pursuant to Rule 701 as part of the number of shares of outstanding common stock for purposes of Rule 701(d)(2)(iii).

It would be nice if the SEC issued a telephone interpretation putting any potential lingering questions here definitively to bed.