Photo by JJ under a Creative Commons license from Flickr.
Good news for the sharing economy: The Securities and Exchange Commission (SEC) just released proposed regulations that would allow businesses to crowdfund by seeking investments or loans through online intermediaries. These proposed regulations, mandated by the 2012 Jumpstart Our Business Startups (JOBS) Act, remove important securities law barriers and take crowdfunding beyond the donation-based model of Kickstarter and Indiegogo. Soon, ordinary people will be able to actually invest in a wide variety of enterprises and receive a return. October 23rd commenced a ninety-day public comment period, during which individuals and organizations are invited to offer the SEC feedback on the rules. The rules will hopefully go into effect soon thereafter since the SEC, generally a sharply divided Commission, unanimously approved the proposed regulations.
What exactly does this mean for the sharing economy? Most importantly, it means that an infinitely diverse array of people will now be able to start and finance new enterprises. Starting a capital-intensive business will no longer be a privilege relegated to those with access to bank loans or venture capital. It also means that community members will be able to more easily share in the ownership of local businesses. The legalization of investment crowdfunding is one of the most important steps to date, toward a true sharing economy.
To illustrate just how powerful the impact of the proposed regulations could be, let’s say, for example, that you want to raise $500,000 to open an urban food market that sells only locally produced food. Because even typical grocery stores don’t tend to produce high profit margins, it may be difficult to finance your unique enterprise using traditional sources of capital.
The first place you would normally go to seek financing is a bank. However, prior to lending banks often require you to demonstrate that you are a low risk investment and show at least two years of operation with some profit. Obtaining sufficient—or any—capital from a bank for a startup enterprise can be very difficult.
Next you might try to tap wealthy private investors. However, because our securities laws were crafted to protect individuals from losing money by investing in questionable businesses, the laws only allow entrepreneurs to seek investments from high income and high net worth people who are deemed accredited investors. To be accredited, a person must have an individual net worth (or joint net worth with a spouse) that exceeds $1 million dollars—excluding the value of the primary residence. Alternatively, the investor must have an income of over $200,000 or a joint income with a spouse exceeding $300,000. The federal government estimates only 7.4% of U.S. households were accredited in 2010. Prior to the JOBS Act, publicly advertising to accredited investors was prohibited. Accessing these tightly-knit venture and angel investor circles required prized connections and endless face-to-face pitches. What’s more, in order to sell your investment opportunity and secure venture capital, you generally have to demonstrate a potential high return on investment and be prepared to give away some amount of ownership stakes and control of your business.
Most startups either cannot or are unwilling to meet these demanding requirements and instead rely on credit cards, friends, and family to bootstrap their business idea. Once the new crowdfunding regulations are enacted (hopefully by Summer 2014) you’ll have another option for financing your alternative grocery store: to advertise on the Internet and offer ordinary people the chance to invest smaller sums of money in a project they believe in.
It is not surprising that it took the SEC a year and half to draft the regulations. The SEC’s mission requires it to balance the competing aims of protecting investors from suspicious business ventures and to simultaneously facilitate efficient capital raising for businesses. These competing aims lead to many subtle, yet complicated nuances imbedded within the proposed regulations.
While you should always consult an attorney about your business ideas and financing options, let’s consider what the SEC’s proposal could mean for your socially and environmentally responsible grocery store.
Freedom to choose what you’re offering
Exercising and maintaining control over the terms of how you’re going to receive capital is just as important as the increased access to capital. Once the crowdfunding regulations take effect, you will not be confined by the terms set by a bank loan officer or a venture capitalist. Instead, you can decide what investment opportunity best suits your vision. Will it be a share of stock? A preferred share? A loan? A revenue-sharing agreement? Having more options means the ability to control the future of your business.
How much can you raise and how can you raise it?
The crowdfunding regulations allow you to raise up to $1 million in financing per year. However, you can’t advertise directly through your own website. Instead, you can only advertise through a certified funding portal that acts as the intermediary between your grocery store and
the public. These funding portals don’t exist yet, but will likely be similar to Kickstarter and Indiegogo. They will advertise your grocery store vision, provide details on the investment opportunity you’re offering (such as an equity, debt, or royalty agreement), allow potential investors to learn more about your company and enable communication between investors so they can peer review the different business opportunities. However, all of your communications with investors must be done through the intermediary. The funding portals must also provide educational materials but cannot offer investment advice to the investors.
What are some of the other compliance requirements?
The JOBS Act mandates also include provisions that some believe may make compliance difficult for smaller startups. If you hope to raise more than $500,000, for example, you are required to submit audited financial statements, an expensive undertaking particularly for a newly established enterprise. If you seek to raise more than $100,000, reviewed financials are required, less expensive but a burdensome requirement nonetheless. All businesses using the exemption are required to report financial information to the SEC annually, unless your business goes public, goes under, or gets acquired.
The SEC also imposes restrictions on individuals who invest through these portals, including a maximum aggregate investment amount per year. An investor with an annual income or net worth under $100,000 can invest the greater of either $2,000 or 5% of the annual income or net worth per year. An investor with annual income or net worth of over $100,000 may invest 10% of the annual income or net worth per year, not to exceed a maximum of $100,000. One silver lining is that it’s the funding portal’s responsibility to verify investor compliance with these requirements, not yours.
Other noteworthy JOBS Act provisions
The SEC has proposed that the crowdfunding exemption can be used at the same time as other offerings without triggering what is called integration. This allows you to finance your grocery store through crowdfunding while simultaneously pursuing another type of securities offering, such as a large investment from an accredited investor. By not triggering integration, businesses are provided with greater flexibility for meeting their financing needs.
Also worth mentioning is a provision of the JOBS Act that has already taken effect. The new Rule 506(c) opens up an exemption for small businesses to advertise investment opportunities and solicit accredited investors directly. Previously, Rule 506 prohibited general advertising and required a preexisting relationship in order to discuss your investment proposal. With the new Rule 506(c), you can publicly advertise through the Internet, newspapers, magazines, and broadcast media to connect to with accredited investors.
The new Rule 506(c) does, however, shift the burden to the business to verify that your investors are in fact accredited, what can be an onerous and risky task. You must research the private financial information of your investors by reviewing W-2s, F-1099s, bank statements, securities holding statements, tax assessments, and credit reports until you are reasonably certain they meet the accredited investor thresholds. Utilizing the Rule 506(c) exemption is a multi-step process. You should consult an attorney on the details related to your business idea before starting down that path.
Historically, securities regulations have made it very difficult for social enterprises to access startup financing. With these new JOBS Act mandates—both the proposed crowdfunding exemption and Rule 506(c)—we begin to see new avenues for financing the sharing economy, allowing mission driven companies to create and retain control of their vision.
The movement for community ownership of enterprise
An early impetus for the eventual adoption of crowdfunding came from a 2010 project initiated by Jenny Kassan of the Sustainable Economies Law Center (SELC). SELC petitioned the SEC for a crowdfunding exemption that would allow enterprises to raise a maximum of $100,000 by seeking up to $100 per investor. The letter received significant public enthusiasm and sparked numerous public comment letters in favor of such the exemption. The JOBS Act ultimately allows for larger investments per person, but with more hurdles for the enterprise seeking capital.
SELC continues to explore a variety of projects and proposals aimed at lowering barriers to community ownership and cooperative ownership of enterprises. To stay in the loop, you can subscribe to SELC’s newsletter or visit SELC’s resource library, CommunityEnterpriseLaw.org, for more information on crowdfunding, Rule 506(c), and other options for raising capital for your community-based enterprise.