As I noted in a previous article, this past summer the Securities and Exchange Commission (“SEC”) issued a report on its study of the impact of Regulation Crowdfunding (“Reg CF”) on capital formation and investor protection.
To recap, Reg CF helps start-ups raise capital by making low-dollar securities offerings to “the crowd,” including less-sophisticated investors who don’t qualify as “accredited investors.” Reg CF offerings are limited in several respects:
- a $1.07 million total offering cap (over 12 months);
- limits on investable amounts (based on the investor’s income and/or net worth);
- prescribed issuer disclosures; and
- offerings must be conducted via registered crowdfunding portals.
Part I Recap
Part I of my review outlined the high-level statistics on Reg CF offerings from the SEC report. In that installment, we learned that Reg CF usage is on the rise, it is used mostly (but not exclusively) by young, cash-strapped companies, it is typically used by pre-revenue companies with some debt on their balance sheets, about half of the offerings are of equity securities and about a quarter are of debt securities, and the offerings usually extend three to four months and have significant financial and human resource costs.
Part II Intro
This Part II covers compliance by issuers and intermediaries, the incidence of fraud in Reg CF offerings, data on offering limits, investment caps and intermediary fee structures, all as reflected in the SEC’s report.
Issuer Compliance
For issuers, the SEC found the biggest compliance gaps with financial statements, annual reports (Form C-AR) and final progress updates (Form C-U). The report acknowledges that some non-compliance may be due to limited involvement of specialized outside counsel or independent auditors or the inexperience of service providers with Reg CF and/or because some of these start-ups may simply have failed (causing them to miss filing obligations, for example). The report also shares the opportunity areas cited by some market participants that could help issuers improve their Reg CF compliance, such as requiring reviewed rather than audited financial statements and a “test the waters” option to allow issuers to gauge market interest before launching a costly offering.
Intermediary Compliance
While intermediaries are generally aware of and attempt to satisfy their compliance obligations, due to the novelty of Reg CF and the fact that many intermediaries are relatively new businesses not ever before subject to regulatory oversight, there are compliance gaps. Some intermediaries believe that compliance is too costly (and may pass costs onto issuers in the form of higher fees), including complying with Financial Industry Regulatory Authority (FINRA) requirements and examinations.
Issuer Offering Limits
The report considers whether the $1.07 million offering limit is appropriate. A few key data points that support keeping the limit at its current level are: (1) for the majority of Reg CF issuers, cumulative amounts reported did not reach the 12-month offering limit; (2) an estimated 29 offerings raised at least $1.07 million; and (3) only three Reg CF issuers reported raising over $1.07 million, but in two or more offerings. Interestingly, 244 issuers used Regulation D (mostly under Rule 506(b)) to raise money before and/or after their Reg CF offerings, with an average per-offering amount raised under Regulation D of $908,780 and a median per-offering amount raised of $200,000. However, the report highlights the varied opinions of market participants on this point, with some believing the limit is so low that it deters “high-quality, high-growth issuers with substantial financing needs” and limits investment opportunities for non-accredited investors.
Investor Investment
Of 31,500 unique investors in a sample provided by one intermediary from May 2016 through September 2018, approximately 9% of investors were accredited, although they accounted for 40% of amounts invested. In this sample, the average amount invested by non-accredited investors was $600 per issuer, whereas the average amount invested by accredited investors was $2,030 per issuer. The average number of non-accredited investors and accredited investors per issuer was 349 and 67, respectively. While reliable, comprehensive data was not available, some of the available information suggests that most non-accredited investors do not come close to reaching their per-investor limits.
Incidence of Fraud
There appears to be a low incidence of fraud on the part of issuers, at least as reflected in available SEC litigation releases and in FINRA and NASAA data.
Intermediary Fee Structures
Most intermediaries received a percentage-based fee paid in cash or securities (with 37% receiving some amount in securities) contingent on a completed offering. The average cash compensation was 5.7% of the offering proceeds (although it ranged from as little as 0.1% to as much as 10% of the proceeds). On average, an intermediary getting compensation in securities received 2.9% of the proceeds. The average fee paid to a broker-dealer-affiliated intermediary was 7.1%, whereas the average fee paid to a crowdfunding portal was 5.5%.
Please reach out to me (caz@kjk.com or 216.736.7275) or one of our experienced Securities attorneys if you need help structuring or executing your company’s capital raise or need help with any related corporate needs.
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