On June 18, 2019, the Securities and Exchange Commission (“SEC”) issued a report based on its study of the capital formation and investor protection impacts of Regulation Crowdfunding (“Reg CF”). Reg CF was adopted on October 30, 2015 as required by the Jumpstart Our Business Startups Act (“JOBS Act”), which empowered startups and small businesses to raise capital more cheaply through relatively low dollar offerings of securities to “crowds” of interested investors, including those who don’t qualify as “accredited investors.” The SEC analyzed data from May 16, 2016 to December 31, 2018 in the study.
The June report gives us a snapshot of how issuers are using Reg CF to raise money from investors:
- Reg CF is used by young, cash-strapped companies, many of which are based in California, New York and Texas.
- Reg CF offerings have significant costs, in terms of financial and human resources.
- Reg CF campaigns are concentrated in the three largest portals.
As background, Reg CF governs the offer and sale of securities under Section 4(a)(6) of the Securities Act of 1933 (the “Securities Act”), which exempts certain crowdfunding transactions from the registration requirements of the Securities Act. At a high level, Reg CF:
- Caps the total offering amount. It permits issuers (companies offering securities) to raise up to $1.07 million in a 12-month period;
- Caps investment amounts on a per-investor basis. Reg CF limits the dollar amount a single investor can invest based on annual income and net worth metrics, to:
- Requires SEC and investor disclosures. Reg CF requires issuers to file specific initial and annual disclosures (regarding their management, business, securities pricing, offering amount, timelines, related-party transactions, and financials, which in some cases must be audited) with the SEC and provide this information to investors and the participating crowdfunding portal; and
- Legitimizes crowdfunding portals. It creates a framework for crowdfunding portals to register with the SEC and requires sales of securities to go through registered intermediaries (i.e., portals or broker-dealers).
In a nutshell, Reg CF permits less mature companies to raise capital from a broad set of investors, including non-accredited investors, via registered intermediaries. However, this broader access to retail investors comes at the cost of satisfying burdensome compliance obligations designed to protect investors.
The SEC’s report on Reg CF gives us insight into the usage by issuers of the rule for fundraising since its inception. Below are some of the key learnings:
- Use of Reg CF increased substantially each year. Over the full period, there were 1,351 offerings seeking a minimum amount of $94.3 million and a maximum amount of $775.9 million (in the aggregate). The SEC estimates that there were 292 offerings initiated during the first year, 557 during the second year, and approximately 502 during the first part of the third year (May 16, 2018 – December 31, 2018). This reflects a year-over-year growth rate of 113% from the first to second year, and 80% from the second to third year (after annualizing the third-year data).
- Typical issuers were young, pre-revenue companies with some debt on their balance sheets. The median offering was by an issuer that was incorporated approximately two years prior to the offering (but the average was closer to 35 months) and employed about three people. Sixty-four percent of issuers were organized as corporations; most of the remainder companies were organized as limited liability companies. The median issuer had total assets of approximately $30,000, cash holdings of approximately $4,000, and no revenues (just over half had no revenues). Approximately 59% of issuers had some debt prior to the offering.
- Offering lengths tended to be 3-4 months. The average offering lasted approximately four months; the median offering duration was three months.
- Half were equity offerings, and a quarter were debt offerings. Measured by the number of offerings (as opposed to amounts raised), 48% of the offerings were of equity (common and preferred), 27% were of debt, 21% were of SAFEs, 4% were of other types of securities.
- Most Reg CF early adopters were in California, New York and Texas. Just under a third of the offerings were made by issuers located in California (with more than 100 Reg CF offerings, representing approximately 32% of the nationwide total), followed by New York (with more than 100 Reg CF offerings, representing approximately 11% of the nationwide total) and Texas (with between 21 and 100 Reg CF offerings, representing approximately 7% of the nationwide total). Like Texas, the number of issuers in Ohio who used Reg CF during the period was between 21 and 100, although the precise number is not known.
- The average number of investors was more than 100 per offering. For completed offerings on three large funding portals during the period, the SEC estimates the average number of investors per offering to be 113. This large amount of investors results in a very “busy” capitalization table, which could be quite onerous for the issuers to manage.
- Preparing an offering is time-consuming and costs about 5% of the total amount raised. According to this survey reviewed by the SEC, the average issuer employed three people who collectively spent 241 hours to launch the campaign. Based on the survey’s estimates, the total cost of a campaign amounts to approximately 5.3% of the amount raised. The table below shows the average costs, in both time and expense, of a Reg CF offering. These expense are not insignificant, and issuers should enter into a Reg CF offering reasonably expecting to forfeit 5% of proceeds, which could reach into the five-figure territory, to campaign costs.
- There are many registered crowdfunding portals but most offerings were done through the three largest portals. As of the end of the study period, there were 45 registered funding portals. Roughly 90% of offerings were conducted through funding portals, although nine broker-dealers also had participated in at least one crowdfunding offering. Two-thirds of completed offerings were concentrated in the three largest portals (the report did not indicate which portals these were).
Part II of our review of the SEC’s report is forthcoming and will examine the SEC’s analysis of compliance with Reg CF by issuers and portals, the incidence of fraud in Reg CF offerings and more. Please stay tuned for that update in the coming weeks.
In the meantime, please feel free to reach out to me (caz@kjk.com or 216.736.7275) or one of our experienced Securities attorneys if your company is considering using Reg CF, or another type of exempt securities offering, to raise funds from investors. We have the subject matter expertise to guide you through the compliance obligations and practical considerations involved in all types of securities offerings.
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