This article compares two avenues for North Carolina businesses seeking to raise private capital through crowdfunding. Roughly defined, crowdfunding refers to raising capital via small individual contributions from a large number of investors, often through the internet. In May of 2016, federal rules went effective allowing companies to raise up to $1 million in capital from small investors across all fifty states. However, the regulatory burden imposed by the federal rules makes compliance expensive and complex. Signed into law on July 22, 2016, the NC PACES Act provides an alternative avenue for businesses to raise capital via crowdfunding, albeit limited to North Carolina investors. While the exact timeline is still in flux, rules implementing the NC PACES act are expected to go live in 2017. The framework laid out in the NC PACES Act presents a platform to raise capital, in most instances, on terms more favorable than its federal counterpart.
I. The Securities Law Landscape
As this firm has previously warned, raising private capital can be a trap for the unwary.1 Both federal and state laws must be considered when contemplating a securities issuance.
On the federal side, the Securities Act of 1933 (the "Securities Act") requires offers and sales of securities to be registered with the SEC, unless an exemption is available. The penalties for selling non-exempt, unregistered securities can be harsh. While IPOs (registered offerings) often dominate financial headlines, the cost and complexity renders such avenue prohibitive for virtually all businesses.2 When selling securities, most small to mid-size businesses, instead, rely on private placements. Traditionally, in order to structure a cost-effective private placement, this meant limiting the sale the securities to accredited investors—that is, those investors with over $1 million in net worth, excluding the value of the primary residence. Obviously, this net worth threshold disqualifies a sizable portion of a business owner's potential investor pool. Similarly, raising capital through a traditional debt financing (i.e., a loan) rather than selling securities can be an unappetizing option for many small businesses.3
In order to break down this regulatory barrier to capital formation, Title III of the JOBS Act of 2012 added a crowdfunding exemption to the Securities Act,4 allowing unaccredited investors to directly invest relatively small amounts in businesses. Three short years and nearly 700 pages later, the SEC adopted final rules implementing the crowdfunding exemption (these rules have been dubbed "Regulation Crowdfunding").5 On May 16, 2016, Regulation Crowdfunding went effective.
As discussed in more detail below, after Regulation Crowdfunding was published, it was unclear if the regulatory burden (in terms of cost, complexity, and time) would outweigh the attendant benefits (namely, being able to raise capital on a national scale from unaccredited investors). While the market response to the Regulation Crowdfunding, ultimately, remains to be seen, the initial reaction has been tepid at best.
Without an intrastate (i.e., state level only) crowdfunding exemption, Regulation Crowdfunding presented virtually the only avenue for smaller businesses to broadly raise capital from unaccredited investors. While many states had enacted intrastate exemptions,6 North Carolina was, conspicuously, not part of the crowd.
Since as early as 2013, crowdfunding legislation had been pending in the North Carolina legislature. On July 28, 2016, the North Carolina House and Senate unanimously passed the Providing Access to Capital for Entrepreneurs and Small Business Act ("NC PACES Act").7 In short, the NC PACES Act allows North Carolina businesses to raise up to $1 million in capital from North Carolina investors. Issuers relying on the intrastate exemption can bypass the more onerous costs and complexities imposed by Regulation Crowdfunding. The North Carolina Secretary of State is currently in the progress of promulgating rules to implement the NC PACES Act. Once those rules are effective, North Carolina companies can begin to raise capital via crowdfunding.
What is Crowdfunding?
Roughly defined, crowdfunding describes raising capital through small individual contributions from a large number of investors, often through the internet.
Crowdfunding is similar in many respects to using existing online portals, such as Kickstarter, to raise money, except Regulation Crowdfunding gives investors the opportunity to have a profit interests in the company they fund. Several notable projects have been funded using Kickstarter—for instance, fans of the popular Veronica Mars TV series contributed over $5 million towards the creation of a spin-off movie. Instead of receiving a profits interest in the movie, the TV-turned-movie aficionados received t-shirts. As another example, Oculus Rift, a virtual reality company, raised over $2 million in a Kickstarter campaign. Several years later, Facebook purchased the crowdfunded start-up for $2 billion. The early "investors" did not see a penny of profit. Had the equity been raised under Regulation Crowdfunding rather than the donation-based Kickstarter campaign, investors would have realized a 1,000 to 1 return on their initial investment.
Regulation Crowdfunding and the NC PACES Act aim to make such broadly funded ventures available to everyday investors seeking to profit from their contributions.
Prior to Regulation Crowdfunding and the NC PACES Act, this type of broad solicitation and sale would, in virtually all cases, be unlawful if used by a company to raise capital without registering with the SEC or fitting within an exemption from registration.
II. Regulation Crowdfunding (i.e., the Federal Exemption)
How does it work?
Crowdfunding offerings utilizing the federal exemption must be conducted through an online portal (and must only use one portal per offering). The single platform allows the issuer to distribute information to prospective investors (i.e., the "crowd") in a centralized location. Investor contributions are held by the online platform in escrow until the offering hits a specified target amount. If the offering fails to meet its target amount, the offering fails and the raised capital is returned from escrow to the investors' accounts.8
The portals themselves must be registered with the SEC and FINRA. Several registered portals are currently available and in use by companies and prospective investors.
Capital Formation Limits
Issuer. A company issuing securities can raise a maximum of $1 million through crowdfunding, determined on a rolling 12-month basis.
Investors. The maximum amount sold to any single investor during such rolling 12-month basis depends on the income and net worth of the investor.
If either the investor's annual income or net worth is less than $100,000, the investor may contribute the greater of (1) $2,000 or (2) 5% of the lesser of the investor's annual income or net worth; or
If both the investor's annual income and net worth are $100,000 or more, the investor may contribute 10% of the lesser of the investor's annual income or net worth (subject to a $100,000 maximum sale).9
Based on these income and net worth limitations, the absolute minimum any investor can contribute under Regulation Crowdfunding during any 12 months is $2,000 and the absolute maximum is $100,000.
These limits are investor, not issuer, specific. The aggregate of all the investors crowdfunding exempt purchases are used when determining compliance with these thresholds. So long as the issuer does not have actual knowledge to the contrary, issuers relying on the crowdfunding exemption are able to rely on the crowdfunding intermediary's determination of the investor's eligibility to purchase the securities.
The income and net worth tests are calculated in the same manner as in the accredited investor context.10
The Regulatory Burden – Filing Requirements, Costs, and Complexity
As mentioned above, the biggest question mark surrounding the adoption of Regulation Crowdfunding was whether the amount of money to be raised justified the regulatory burden imposed. Given the limited number crowdfunding offerings conducted to date, the preliminary answer appears to be "no" for most businesses.
Coming in at a mere 685 pages, Regulation Crowdfunding contains no shortage of complexity. While a complete overview of the mechanics and operation of Regulation Crowdfunding is beyond the scope of this update, Regulation Crowdfunding does impose several initial and ongoing disclosure requirements on prospective issuers that warrant mentioning.
The heart and soul of a Regulation Crowdfunding filing is found on Form C.
The cover page of the Form C is completed in XML format, is made publicly available on the SEC's website, is populated online, and is, perhaps, the only portion of Regulation Crowdfunding that is genuinely straightforward. The Form C's cover page only requires basic information concerning: (i) the issuer (name, jurisdiction of origination, address, etc.), (ii) the crowdfunding intermediary used, (iii) the offering (type of securities, number of securities, price, target offering amount, etc.), and (iv) basic financial data.
Filed as an exhibit (and also made publicly available on the SEC's website), the Form C offering statement contains the bulk of the disclosures required by Regulation Crowdfunding. While most Form C offering statements filed to date have roughly followed a suggested "question and answer" format, the structure and sophistication of the filings diverge greatly.
Among several others, the Form C offering statement requires11 disclosure of: (i) the issuer's officers or directors (including a three year history of business experience); (ii) the issuer's equityholders holding 20% or more of the issuer's securities; (iii) the issuer's business plan and business description; (iv) the intended use of proceeds (including information about target offerings, oversubscription, maximum offerings, the offering price, etc.); (v) the crowdfunding intermediary to be used; (vi) securities legends; (vii) risk factors; (viii) the date and location of annual reports; (ix) the issuer's capital structure; and (x) depending on the size of the offering, certified or audited financial statements. Importantly, traditional securities anti-fraud protections also apply.12
Progress updates are required to be filed with the SEC when an offering hits certain milestones (at 50% of the target offering and again at 100% of the target offering). Annual updates are likewise required to be filed with the SEC on Form C-AR. The annual update is substantially similar to the Form C offering statement.
There are three main cost drivers in a crowdfunding offering: (i) the crowdfunding portal's commission; (ii) accountants' fees for financial statement certification or audit; and (iii) time and expenses incurred with the filing requirements (the initial offering statement, progress updates, annual statements, and termination statements).
The SEC estimates intermediary fees (i.e., the crowdfunding portal) as a percentage of offering proceeds of (i) 5% to 15% for offerings of $100,000 or less, (ii) 5% to 10% for offerings between $100,000 and $500,000, and (iii) 5% to 7.5% for offerings above $500,000.13
Financial statement requirements vary depending on the size of the offering. For offerings under $100,000, financial statements are required to be certified by the issuer's principal executive officer. For offerings between $100,000 and $500,000, financial statements must be reviewed by an independent public accountant. For offerings over $500,000, the financial statements must be audited or certified by independent public accountants, depending on the number of issuances the issuer has undertaken. The SEC estimates vary widely depending on the type of review needed (between $1,500 and $18,000 for an accounting review and between $2,500 and $30,000 for a full audit).
Finally, with respect to preparing and filing the various required forms, the SEC estimates the Form C (the initial offering statement) will take a mere 100 hours of preparation time. The Form C-AR (the annual report) is estimated at an additional 50 hours of preparation time. Depending on the amount of time spent internally by the issuer and the amount outsourced to attorneys, the fee estimates are all over the map.14 It is also worth noting that if an offering does not meet its target threshold (i.e., if the offering fails), the costs incurred preparing the offering statement and status updates would be incurred without the distribution of offering proceeds to offset such fees.15
All in all, the lowest estimate provided by the SEC for a small crowdfunding offering is $6,667 in fees and expenses. For offerings exceeding $500,000, the SEC's high-end estimates come in at just under $120,000.
III. The NC PACES Act (i.e., the Intrastate Exemption)
The statutory framework of the NC PACES Act is refreshing in its relative simplicity to its federal counterpart (while the additional complexity added by the rules remains to be seen, we are hopeful it will pale in comparison). For North Carolina companies looking to raise money solely from North Carolina investors, the NC PACES Act has the makings of an appealing alternative to Regulation Crowdfunding.
The Nuts and Bolts of the NC PACES Act
Issuer. The issuer must be a business entity formed under the laws of North Carolina and/or registered with the North Carolina Secretary of State. There are no restrictions on the type of business entity that may issue securities under the NC PACES Act. Moreover, the issuer will be disqualified if it is deemed an Investment Company under the Investment Company Act of 194016 or if the issuer or certain affiliates of the issuer have been subject to specified "bad boy" disqualifications.
Capital Formation Limits (Issuer). For issuers without audited or reviewed financial statements, the total capital raise is limited to $1 million in the 12 month period preceding the current offer or sale. If the issuer provides audited or reviewed financial statements to each prospective investor and the North Carolina Secretary of State, this limit is increased to $2 million in the same 12 month period. Offers and sales to controlling persons do not count toward these limitations.17
This $2 million threshold is considerably more favorable than Regulation Crowdfunding, which is capped at $1 million and requires reviewed or audited financial statements for issuances over $100,000.
Capital Formation Limits (Investors). For unaccredited investors, the limit per investor is $5,000 in any 12-month period. There is no limit on the amount accredited investors may contribute to an issuer. Controlling persons are not subject to the investor income limitation.
These investor limitations have several advantages over Regulation Crowdfunding. The ceiling for investors under Regulation Crowdfunding, even for accredited investors, is $100,000. Accredited investors and controlling persons are not subject to any contribution limitation. Moreover, the NC PACES Act does not contain the convoluted income/net worth tests to determine maximum investments. Finally, the Regulation Crowdfunding limitations are not-issuer specific. In the Regulation Crowdfunding regime, once an investor hits his or her threshold across all offerings, that investor is prohibited from further investment. Under the NC PACES Act, contributions do not appear to be issuer-specific, meaning an unaccredited investor could contribute up to the maximum ($5,000) to multiple issuers.
Disclosure and Ongoing Reporting Obligations. We expect the time and expense to be incurred in preparing the disclosure statement and other required filings under the NC PACES Act to be considerably less than the estimated 100 hours to prepare the Form C under Regulation Crowdfunding.
Under the NC PACES Act, not less than 10 days prior to the commencement of the offering (which includes the posting of offering materials on a publicly available website), the issuer must file with the North Carolina Secretary of State (i) a notice together with a $150 filing fee and (ii) an escrow account agreement between the issuer and the financial institution that will hold investors' funds in escrow until the minimum target offering is met.
Also within this 10 day window, the issuer must file a disclosure statement—the document that will be distributed or made available to all prospective investors—setting forth: (i) general information about the business, the business plan, and its officers and their compensation; (ii) the identity of any beneficial owner owning more than 10% of any class of the issuer's securities; (iii) the identity of officers, directors, and members, including prior experience; (iv) information about the offering, including the terms of the securities being offered and any existing securities, the minimum and maximum amount of securities being offered, and the percentage ownership represented by the offered securities (or the implied valuation of the company based on the price); (v) the identity of any person retained to assist the issuer in conducting the offering (including any online intermediary but excluding lawyers and certain other professionals); (vi) a description of any pending litigation; and (vii) the names and addresses (including a URL) of any website that will be used in connection with the offering.18
The complete disclosure document must be made available to each prospective investor at the time the offer of securities is made.
With respect to ongoing filing requirements, the NC PACES Act requires a quarterly report be distributed to investors (or posted on the website used to conduct the offering) and filed with the North Carolina Secretary of State. The report must contain the (1) specific compensation received by each director and executive officer earned since the previous report and on an annual basis (including bonuses, warrants, etc.) and (2) an analysis by management of the issuer of the issuer's business operations and financial condition.
Websites. Unlike Regulation Crowdfunding, which is required to be conducted through a registered online portal (which charges a nontrivial fee), the use of an online medium for the NC PACES Act is optional.
If an issuer decides to use an online platform, the issuer must obtain from each purchaser evidence of North Carolina residency (and evidence of that investor's status as an accredited investor, if applicable). Moreover, the website must file a statement with the North Carolina Secretary of State that is organized under the laws of North Carolina or authorized to do business in the State. Both the issuer and the website must keep and maintain records of offers and sales of securities effected through the website.19
Interaction with Federal Law
As mentioned in the introduction, the Securities Act requires offers and sales of securities to be registered with the SEC, unless an exemption is available. Typically referred to as the "intrastate offering exemption," Section 3(a)(11) of the Securities Act provides an exemption for "any security which is a part of an issue offered and sold only to persons who reside in a single State or Territory, where the issuer of such security is a person resident and doing business within or, if a corporation, incorporated by and doing business within, such State or Territory."
The importance of federal law in the intrastate offering context is twofold—first, an issuer wishing to take advantage of the NC PACES Act would independently have to qualify under the federal intrastate offering exemption (or otherwise risk violating federal securities laws). Second, the NC PACES Act expressly requires compliance with Section 3(a)(11) and/or Rule 147.
Issuer Residency and Doing Business. Rule 147 is the regulatory safe harbor promulgated by the SEC under Section 3(a)(11). As an initial matter, Rule 147 requires an issuer be deemed a "resident" and "doing business" in the state where securities are offered and sold. In the typical corporate or limited liability company context, residency is the state where the issuer is incorporated or organized. Thus, limited liability companies and corporations wishing to utilize the intrastate offering exemption must be incorporated or organized under North Carolina law.
An issuer is deemed doing business in the state when (i) its principal office is located in such state, (ii) 80% of its gross revenues (together with any subsidiaries) are located in such state;20 (iii) 80% of its assets are located in such state; and (iv) 80% of the proceeds from the issuance will be used in such state.
Investor Residency. Offers to sell are limited to residents within the issuer's state. To verify residency, the issuer must obtain a written representation from each purchaser as to his or her residence. For issuers wishing to take advantage of the NC PACES Act, this means every offer to sell must be only be made to individuals with their principal residence in North Carolina or a business entity with its principal office in North Carolina.
Limiting offers to in-state residents only presents considerable challenges that must be carefully traversed by issuers wishing to rely on an issuer-owned websites, third party internet portals, or the issuer's social media presence to conduct or promote the offering.21
Resales by Investors. During the nine months after the conclusion of the offering, investors may only resell to other North Carolina investors. The issuer must take certain steps to prohibit intrastate offers and sales, including placing a legend on the securities, issuing stop transfer restrictions, and disclosing, in writing, to prospective investors these limitations on resale.
IV. Practical Considerations
Where does this regulatory maze leave entrepreneurs and small businesses wishing to take advantage of the dynamic capital formation potential offered by crowdfunding?
As a preliminary matter, existing businesses and prospective entrepreneurs will first have to decide whether to utilize the federal exemption provided by Regulation Crowdfunding or, once the rules become effective, the intrastate exemption provided by the NC PACES Act. For businesses needing to tap a national investor pool (and not able to sell only to accredited investors), Regulation Crowdfunding, together with its added layers of costs and complexity, will be the only viable option.
However, for those businesses with an adequate network of potential North Carolina investors, the NC PACES Act presents businesses with the ability to raise capital on more favorable terms, with less complexity, and ultimately (we suspect), at a much lower cost than its federal counterpart. While we anxiously await the rules implementing the NC PACES Act, it is never too early for businesses to begin planning.
Crowdfunding's mandates must be considered from the entity formation stage, through the offering, and, ultimately, until the last security sold no longer remains outstanding. Technical compliance can mean the difference between a smooth offering and a regulatory headache. Raising capital is often the single biggest challenge facing entrepreneurs and existing small businesses. Once the rulemaking dust settles, we hope the NC PACES Act will present businesses in this State with an opportunity to cost-effectively clear both practical and regulatory capital formation hurdles.
1 SML Perspectives, Avoiding the Danger of Raising Private Capital (Nov. 22, 2011), http://www.smithmoorelaw.com/Avoiding-the-Dangers-of-Raising-Private-Capital-11-22-2011.
2 The SEC estimates it costs $2.5 million, on average, to achieve initial regulatory compliance for an IPO, with an ongoing compliance cost of $1.5 million per year.
3 Both the cost to service the debt (especially for start-ups with uncertain cash flows) and, often times, the requirement that the business owner sign a personal guarantee make loans less appealing than raising money through the sale of equity securities.
4 Section 4(a)(6) of the Securities Act.
5 Regulation Crowdfunding, 80 Fed. Reg. 71,387 (Nov. 16, 2015).
6 One commentator had the tally at 35states with active intrastate crowdfunding legislation. See Anthony Zeoli, State of the States (last updated October 2016), https://crowdfundinglegalhub.com/2015/01/16/state-of-the-states-list-of-current-active-and-proposed-intrastate-exemptions/.
7 NC Senate Bill 481 (to be codified at N.C. Gen. Stat. § 78A-17.1, et seq.)
8 Investors have 48 hours prior to the funding deadline to cancel their commitments.
9 For those not inclined to decipher this legalese, the SEC has provided a table showing practical examples of how these annual income/net worth limits work. See https://www.sec.gov/oiea/investor-alerts-bulletins/ib_crowdfunding-.html. Business entities are also permitted to invest under the regulations.
10 The SEC has published a helpful investor bulletin explaining the nuances of the accredited investor calculation. See https://www.investor.gov/additional-resources/news-alerts/alerts-bulletins/investor-bulletin-accredited-investors.
11 Some of these "requirements" are not directly mandated by statute, but included in the suggested Form C and may be misleading to exclude.
12 An issuer is required to disclose any material information necessary in order to make the statements made, in light of the circumstances under which they were made, not misleading.
13 We would note these estimates are probably on the high end. At least one funding portal has fees as low as 3%.
14 The SEC estimates that 75% of the Form C work will be done by the issuer and 25% by outside professionals.
15 The entire SEC cost and time estimate analysis, including assumptions relied on, can be found at the following link, beginning on page 349: https://www.sec.gov/rules/final/2015/33-9974.pdf.
16 The SEC has published a quick reference guide on Investment Companies, available here: https://www.sec.gov/answers/mfinvco.htm. The SEC characterizes investment companies as any "company (corporation, business trust, partnership, or limited liability company) that issues securities and is primarily engaged in the business of investing in securities."
17 "Controlling person" is defined as "an officer, director, partner, trustee, or individual occupying similar status or performing similar functions with respect to the issuer or to a person owning 10% or more of the outstanding shares of any class or classes of securities of the issuer." Although not entirely clear, it appears this 10% ownership test is determined pre-offering and should not be applied retroactively (i.e., after an investor has purchased the securities) to determine the issuer and investor limitations. For example, it does not appear an unaccredited investor with no present interest in the issuer could purchase $20,000 (thus exceeding the $5,000 investor contribution limitation) in securities, even if, after such investment, he or she became a 15% owner of the issuer (and thus would retroactively meet the definition of controlling person).
18 The NC PACES Act contains several other technical requirements, such as an express legend that must be included on the disclosure statement and a requirement that each investor make certain representations in a written certification prior to purchasing securities.
19 Provided that certain conditions are met, the website and officers of the issuer will be exempted from registering under North Carolina's broker/dealer laws.
20 There are exemptions from this requirement for issuers with under $5,000 of sales in the most recent 12-month fiscal period.
21 SEC guidance on use of the internet in the Rule 147 context is available at the following link: https://www.sec.gov/divisions/corpfin/guidance/securitiesactrules-interps.htm. Proposed amendments to Rule 147 have been published that would help alleviate a number of these burdens and anachronisms. See https://www.sec.gov/rules/proposed/2015/33-9973.pdf.