Equity Crowdfunding in the US
By Sparsh Khosla, for Legal Corner LLP. Sparsh is a second year student of NALSAR University of Law and will be graduating in 2024.
The views expressed here are not to be considered as legal opinion. You may not rely on this article as legal advice. You should reach out to me (chetana@legalcornerllp.com) to get legal advice that is specific to your business needs.
Since the beginning of the 21st century, there has been an exponential increase in the digitisation of most activities. So much so, that purely financial activities such as transactions which need high security have shifted to the online mode. This has been used by some businesses to break the conventional methods of raising capital, particularly by small companies who might want to raise capital in exchange of securities as debt financing is not a good option for them. This method of raising capital in exchange of securities is called equity funding. When it is done on a platform where it is accessible to a large number of people, it is called Equity Crowdfunding.
Equity Crowdfunding under the JOBS Act
Title 3 of the Jumpstart Our Business Start-ups (JOBS) Act is wholly devoted to Equity Crowdfunding for Start-ups. The Equity Crowdfunding operation under the JOBS Act has two parties and an intermediary. The two parties are the investor and the start-up, which is known as the issuer. The issuer sells securities over an internet platform to an investor with the help of an intermediary, a broker or a funding portal. A securities transaction would require registration with the commission and compliance arising out of the same under the Exchange Act. But there is an exemption under the JOBS Act for registration of the securities offered through Equity Crowdfunding. This exemption will only be applicable if the investor and start-ups have followed the SEC’s monetary restrictions.
Restrictions for the Investor
The monetary restrictions are in place for both the investors and the issuer. With respect to the investors, the SEC’s significant restriction is on the amount of money invested by an individual in a one or more issuers over a year. The limitation is as low as 2000 dollars or 5 per cent of the annual income/net worth, whichever is higher, for individuals whose annual income or net worth is lower than 100,000 dollars. This stringent rule has been put in place because the shares of small businesses have higher volatility and are considered to be high-risk investments. Even if an individual has an annual income higher than 100,000 dollars, he can only invest 10 per cent of the annual income or net worth, whichever is lower.
Balance of interests
There are two interests which the US Securities and Exchange Commission (SEC) has to balance while formulating the rules for Equity Crowdfunding. The first is the start-up’s interest which is to raise money to expand its operations or in some cases, survive. The second interest is of the investors to earn profits from the money that has been invested by them. The mandate of the SEC motivates the commission to prioritise the investor’s interests. Hence, most of the rules have been formulated to protect the investor’s interest in such transactions which increases the compliance requirements for the issuer.
Compliance for the issuer
The compliance for the issuer is manifold. First, there are the requirements to disclose certain information in order to gain access to crowdfunding as stipulated by section 4 of the Securities Act. This information concerns the basic functioning of the start-up. It includes a wide array of topics from the issuer’s legal status and address to the issuer’s financials. This data is collected to give the investors an idea about the standing of the start-up. Additional compliance requirements relate to the disclosure of ongoing activities at the start-up in the form of annual reports and filling out other forms. These rules have been put in place to ensure that the investors are well-equipped with the information regarding the issuer before buying the securities. Such a requirement does increase the overall time taken and costs involved for raising capital. But the issuer is the entity seeking investment, and it is incumbent upon the SEC to ensure that the investors are not making ill-informed decisions.
Role of Funding portals and their role
The funding portals are intermediaries which are specific to equity crowdfunding. The SEC has made the registration of these funding portals mandatory in its supplementary rules. The existing brokers were also given the rights to become intermediaries in such transactions after complying with the regulations. There is one obvious stipulation to eliminate bias and chances of collusion. This stipulation is that the intermediary or its directors should not have a financial interest in the issuer. One exception is made to this rule where the issuer can compensate the intermediary for its services. This compensation has to be in the form of securities similar to those issued in the crowdfunding operation. The benefit of this exception is two-fold. First, the exception gives the smaller start-ups who could not have otherwise afforded the funding portals’ services, a chance to conduct a crowdfunding operation. Second, alignment of the interests of the investor and the intermediary reduces the scope for fraud or collusion between the intermediary and the issuer.
Provisions for tackling fraud
Several restrictions have been put in place to ensure that the incidence of fraud is minimum in equity crowdfunding operations. These regulations include the requirement of a reasonable basis for the intermediary to believe that the issuer as complied with the rules and it has established a means to create a record of all the present and future security holders. Additionally, the rules also compel the intermediary to deny access to its platform if it has a reasonable basis to believe that the compliance is inadequate or the issuer is eligible for disqualification. Such provisions do make an effort in a decent direction but put a hefty burden on the intermediary to tackle fraud. This increases the chances of collusion between the intermediary and the issuer because of the absence of other actors keeping a check on fraud-related activities.
Conclusion
Internet-based Equity crowdfunding is an innovative way tuned to the modern needs of both the investors and start-ups. The SEC making rules for keeping illegal activities in check and requiring disclosure from the issuer makes this method, safer and more reliable. This creates another way of raising capital more lucrative and empowers small businesses, especially youth innovators and entrepreneurs. But the heavy compliance makes the whole process complicated and more expensive. This has motivated several scholars and lawyers to believe that the rules do more harm than good to the entrepreneurs. The effectiveness of this operation is highly uncertain, and there should be research conducted on the same. The publication of reports on its effectivity might help the SEC develop the rules, and the balance might shift towards the issuers. On the other hand, the SEC may keep the protection of the investors’ interest as its priority, and there is a chance that the rules may remain unchanged. In summation, the provisions and regulations have opened up a new avenue for raising capital, and comprehensive legal discussion on the same may lead to the development of the same in the future.
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