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On March 27, 2012, Congress passed the Jumpstart Our Business Startups Act (the “JOBS Act”), which President Obama signed on April 5, 2012. While this is a great deal for smaller companies, many of these provisions address companies of a much larger size than our normal business client. There is a provision for the nascent crowdfunding means of raising capital. “Crowdfunding” is the practice of using the Internet to solicit a large number of investors, who generally invest in relatively small amounts. Although the practice has been around for the last couple of years, questions regarding the lawfulness in utilizing such a procedure, under both federal and state securities laws, made it somewhat suspect for small business owners, who do not need the additional legal issues of an investigation by the securities commissioner of any particular state, or worse, the SEC itself. Under the JOBS Act, the SEC is to issue rules within 270 days of enactment to carry out the crowdfunding provisions.

In short, the JOBS Act provides that a private company may sell its securities, now expressly exempt from registration, subject to compliance with a variety of requirements including, but not limited to:

  • Not more than $1 million may be sold during the preceding 12 months under the crowdfunding rule;
  • The maximum amount, in the aggregate, sold to any investor, including amounts sold pursuant to the crowdfunding rule during the preceding 12 months, may not exceed: (i) the greater of $2,000 or five percent (5%) of the annual income or net worth of such investor, if either the annual income or net worth is less than $100,000, and (ii) ten percent (10%) of the annual income or net worth of such investor, not to exceed $100,000, if either the annual income or net worth is equal to or greater than $100,000; and
  • The company must conduct the offering through a compliance broker or funding portal.

The rules have yet to be issued, but it should be expected that not only the company, but also the brokers or funding portals, will have to comply with additional requirements still to be drafted in order to comply with the requirements of the JOBS Act.

As a nod to the potential for fraud and overreaching in this area, brokers and funding portals that provide the means for crowdfunding will be required themselves to comply with substantial requirements to include SEC registration, disclosures as may be required by the SEC, and investor protection provisions. These brokers and funding portals will have to, at a minimum:

  • Confirm that investors: (i) review investor-education materials; (ii) positively affirm their understanding the risks of the investment; and (iii) answer questions demonstrating and understanding the risks of such investments;
  • Institute steps to reduce risk of fraud, including obtaining background checks on directors, officers and twenty percent (20%) stakeholders in the offering company;
  • Make available to investors, and the SEC, any information provided by the offering company;
  • Aggregate all the offering proceeds and release them only after the targeted offering amount is reached, and provide the investors, during the interim, to cancel their funding commitments; and
  • Prohibit promoters and finders from being compensated or being rewarded for locating or providing personal identification information relating to any potential investor.

It should be expected that a company using the crowdfunding rule will be required to file with the SEC and provide to both the potential investors and intermediaries basic information including the names of directors and officers and holders of twenty percent (20%) or more of the equity in any company, a description of the company’s business, a proposed business plan and financial condition, to include income tax returns and, if the offering is in excess of $500,000, audited financial statements.

While the JOBS Act provides companies a means to raise capital in a short period, the time commitment to comply with the requirements and investor safeguards will have to be dealt with. But, on balance, crowdfunding allows small businesses the means to raise needed capital and to disseminate their ideas to the public. The company, and its officers and directors, however, should realize that there are no confidentiality provisions, and thus anyone can be reviewing your company’s business plan, and thereby gain market information. In the right situation, this could be an excellent means to raise funds, but the risks of using such a program will have to be weighed carefully.