This piece originally appeared on the Malartu Funds blog.
Crowdfunding may be the biggest buzzword in the startup world right now.
With the passage of new regulation on the state and federal level, it’s beginning to get confusing. Different titles, exemptions and rules are all blurring together. Here are a few key differences between the five major methods of online funding (notice I didn’t use the word ‘crowdfunding’).
In 2013, legislation was passed to split rule 506 into two parts: 506(b) and 506(c). Here’s the difference.
506(b) is the traditional private offering.
This is where a company privately pitches its offering to investors in its immediate network. These pitches have to be to people whom the founders reasonably believe are accredited or ‘sophisticated’. You may only have up to 35 sophisticated unaccredited investors in a 506(b) offering, but you can have an unlimited number of accredited investors. There is no limit on what you can raise, so long as the offering is private.
As we’ve seen for many, many years, this can be a solution for mostly any startup and small business.
506(c) means you’re generally advertising a traditional private offering.
With one major difference—all the investors in the deal must be accredited and the issuer must verify that the investors are accredited. There are a number of ways to verify an accredited status, including tax records and a third party verification letter.
Just as 506(b) is a solution for startup and small business, 506(c) takes this solution to the next level. The ability to advertise a traditional fundraise means greater reach and greater exposure to a larger investor base. These raises are suitable for mostly any company, especially considering there is no cap on the amount raised.
States are capable of passing their own equity crowdfunding exemptions.
These exemptions, known as “intrastate exemptions,” are passed by individual state governments and allow for equity crowdfunding in its true sense within state lines. This generally means that all residents of the state (over the age of 18) can invest in companies registered in that state. Investments cannot cross state lines. Caps on investments exist within each state and vary on a state-by-state basis. Many states have begun passing their own exemptions. 15 states have already passed an exemption, while many more have their bills in legislation.
Title III of the National JOBS Act is not passed yet, and will not be passed for the foreseeable future.
This is the legislation that allows true, national crowdfunding in the sense most people imagine it: Unaccredited investors all over the US invest in startups and small business in exchange for equity. It’s simple and untamed, and that’s why the regulators have had their hands full. Under proposed rules, investors are capped at a maximum investment of $2,000 per deal or 5% of their income if their annual income is less than $100k, or 10% of their income if their income is greater than $100k. Issuers can raise a maximum of $1,000,000 per year.
These proposed rules, if finalized, would make Title III exclusively a seed-level or, in some small cases, a Series A solution. The caps on investment and amount raised means it is only a viable solution for a smaller company or seed-level startup. The risky nature and lack of regulatory oversight leave many experts pessimistic that Title III rules will be released soon, if ever.
Title IV of the National Jobs Act (Reg A+) was recently passed, and should be thought of as a small IPO.
Offerings under Reg A+ fit into one of two tiers. Tier I offerings allow raises up to $20 million from unaccredited investors. Tier II offerings allow raises up to $50 million. The equity crowdfunding regulation we have been speculating and hearing about for the last two years is actually the still-not-passed Title III version. So why isn’t Reg A+ a bigger, better version? To be approved to fundraise under Tier I Reg A+ offerings, you have to submit reviewed financials and a circular review (think similar paperwork to an IPO) to the SEC, then be approved by each state in which you’ll be selling securities. The good news is that the SEC and NASAA have introduced a “coordinated review” for Tier I. This is intended to expedite the process of state review, making it much more efficient to gain approval than in previous Regulation A offerings. If everything is correct and each state approves the offering, the coordinated review process can be as short as 21 days.
Under Tier II offerings, there is no state review, but SEC approval and audited financials are required, along with ongoing disclosure requirements like annual disclosure filings, a semi-annual report, and current reports.
The biggest caveat to Reg A+ is the upfront cost of both tiers, and the ongoing cost of Tier II. The disclosure documents involved in these offerings are incredibly extensive and the review process is strict. It is best to compare this to a small IPO, for which it’s neither cheap nor easy to ‘ring the bell.’
But of course, there is an upside – Similar to an IPO, shares in a Reg A+ offering are unrestricted, so shareholders can sell to other individuals freely. Caveat number 2? Currently, there is no efficient secondary market. This being said, there’s a tremendous incentive for a few brilliant minds to work full-time on creating one following this regulation.
Regulation A+ is a terrific resource for mid-sized and high-growth companies to raise tremendous amounts of capital from the public. Considering the maximum raise of $50 million, this legislation means a company could feasibly raise funds online from startup to the private equity/ pre IPO stage.
Key Takeaway: It is now legal and feasible to fund a company online for its lifetime in the private sector.
With the passage of Reg A+, one could realistically (and legally) fund a company through an online portal from startup to an official IPO. What’s more, after a Reg A+ offering, a company could use a portion of the fundraise, within limits, to liquidate early-stage investors. This new regulation provides opportunity for a secondary market and liquidity for private investors, two things we have never experienced before.
Over the last three years the private funding landscape has dramatically shifted. These continue to be exciting times for business in the United States and all over the world and we’re eager to see what’s next.
