This is educational material and does not constitute legal advice nor is any attorney/client relationship created with this article, hence you should contact and engage an attorney if you have any legal questions.

Regulation Crowdfunding (“Reg CF”) has revolutionized how startups and small businesses raise equity capital, enabling them to secure up to $5 million in a 12-month period from a large number of non-accredited investors.

Overview of Regulation Crowdfunding

The Jumpstart Our Business Startups (JOBS) Act, signed into law on April 5, 2012, included Title III, known as the "Capital Raising Online While Deterring Fraud and Unethical Non-Disclosure Act of 2012" or the "CROWDFUND Act." Title III created a new exemption under Section 4(a)(6) of the Securities Act of 1933, codified as 15 U.S.C. § 77d(a)(6), allowing eligible companies to raise funds through crowdfunding without registering the offering with the SEC, provided certain conditions are met.

To implement this exemption and establish the regulatory framework, the Securities and Exchange Commission (SEC) adopted Regulation Crowdfunding (17 CFR Part 227) on October 30, 2015, with the regulations becoming effective on May 16, 2016. Reg CF allows eligible companies to offer and sell securities to a broad investor base, including non-accredited investors, through online crowdfunding platforms, subject to specific regulatory requirements and limitations.

If “crowdfunding” sounds familiar, that’s because you’ve likely heard of platforms such as Kickstarter or Indiegogo, among others. While these platforms enable non-accredited investors to contribute money, the contributions are more akin to pre-purchases or gifts; they money put into these companies are not investments.

In contrast, Reg CF platforms like WeFunder, StartEngine, Dealmaker Securities, and others, enable non-accredited investors to actually invest in startups, with all the associated risks and rewards, thereby democratizing the investment landscape by letting new startups’ biggest fans support the things they care most about.

This comprehensive guide provides a detailed overview of Reg CF, its key requirements, limitations, and best practices for issuers and intermediaries.

The Spectrum of Fundraising Regulations

Startups and small businesses often follow a progression of fundraising stages, each with its own set of regulations and requirements. Understanding this spectrum can help companies strategically plan their capital-raising efforts while considering the cost, time, and pros and cons of each option.

(Read more about fundraising and startups here.)

• Bootstrapping involves using personal savings and reinvested revenue to fund the business. This method offers full control and no dilution of ownership, but it limits the amount of available capital and increases personal financial risk. It is a quick method to start with low external costs.

• Friends and Family funding involves raising initial funds from personal networks. It offers easier access to capital with flexible terms, though it can strain personal relationships and is limited in scale. This method is relatively quick and low-cost, though often informal.

• Angel Investors provide capital in exchange for equity. They offer larger capital amounts and can provide mentorship and networking opportunities. However, this approach dilutes ownership and often requires giving up significant equity. Securing angel investment takes moderate time and incurs costs associated with legal and due diligence processes.

• Reg CF (Regulation Crowdfunding) allows raising up to $5 million from a wide range of investors, including non-accredited investors, through online crowdfunding platforms. This method democratizes access to capital and offers marketing benefits but requires compliance with regulatory standards, disclosure requirements, and ongoing reporting. The preparation and compliance can take a moderate to long duration, and costs include fees to access the crowdfunding platform, or portal, and compliance-related expenses, too.

• Venture Capital (Reg D 506(b)) involves attracting larger investments from venture capital firms through private placements, overwhelmingly under SEC Rule 506(b). Reg D 506(b) rounds are private offerings exempt from SEC registration, requiring minimal disclosures, and allowing companies to raise substantial capital without going public. This approach provides strategic support from experienced investors but results in significant dilution of ownership and high expectations for growth. The process is long and competitive, with significant legal and compliance costs.

Key Definitions

To better understand Regulation Crowdfunding, it's essential to familiarize yourself with some key terms:

• Issuer: A company offering and selling securities through Regulation Crowdfunding.

• Intermediary: A crowdfunding platform, either a registered broker-dealer or a funding portal, that facilitates Reg CF transactions.

• Investor: An individual or entity that purchases securities offered through a Reg CF offering.

• Accredited Investor: An individual with an annual income exceeding $200,000 ($300,000 with spouse) or a net worth over $1 million, excluding the primary residence.

• Crowdfunding: The practice of raising small amounts of money from a large number of people, typically via the internet.

Eligibility Requirements and Offering Limits

Startup (“issuer”) Eligibility

To be eligible for a Reg CF offering, an issuer must:

• Be U.S.-based: The entity must have its headquarters and principal place of business in the United States. This does not entirely preclude foreign entities from utilizing Reg CF, but they must establish a U.S.-based headquarters and do actual business in the U.S., and not merely funnel revenue to a foreign office.

• Not be an investment or shell company: The issuer must not be an investment company, blank check company, or shell company as defined under the Securities Exchange Act of 1934. This means that the company must have a well-defined, operational business plan and cannot exist solely to acquire or merge with other companies.

• Not be disqualified: The issuer must not be disqualified under Reg CF's "bad actor" provisions, which include disqualifications due to certain criminal convictions, regulatory or court orders, and other legal sanctions.

Offering Limits

Reg CF allows issuers to raise up to $5 million in a 12-month period. The offering limit is determined by aggregating all Reg CF offerings conducted by the issuer and its affiliates within the preceding 12 months including the current raise. This means that if an issuer is attempting to raise $3M today, but they already raised $3M less than 12 months ago, then they will be limited to raising just $2M for the current raise.

Investment Limits for Non-Accredited Investors

Non-accredited investors are subject to investment limits based on their annual income and net worth:

• If either annual income or net worth is less than $124,000, the investor may invest the greater of (a) $2,500 or (b) 5% of the greater of their annual income or net worth.

• If both annual income and net worth are equal to or more than $124,000, the investor may invest up to the greater of: (a) 10% of their annual income, or (b) 10% of their net worth, not to exceed $124,000.

Insider Transactions and Bad Actor Disqualification

Insider Transactions

Insiders, such as officers, directors, and significant shareholders, are required to disclose their participation in a Reg CF offering. Transactions involving insiders are subject to additional scrutiny to prevent conflicts of interest and self-dealing.

Bad Actor Disqualification

Issuers are disqualified from conducting a Reg CF offering if they or certain related parties (e.g., officers, directors, significant shareholders) have been involved in specified bad acts, such as securities fraud or other regulatory violations.

Disclosure Requirements and Offering Process

Disclosure Requirements

Issuers must provide comprehensive disclosures to potential investors, including:

• Information about the issuer, its officers, directors, and significant shareholders.

• Description of the business and its financial condition, including financial statements.

• Intended use of proceeds and target offering amount.

• Offering price and valuation of securities.

• Ownership and capital structure.

• Risk factors associated with the investment.

Financial Disclosure Tiers

The extent of financial disclosures required depends on the amount being raised plus whatever has been raised in a Reg CF round in the past 12 months.

• Tier 1 (offerings up to $124,000): Certified income tax returns and financial statements certified by the principal executive officer. The financial statements must cover the most recently completed fiscal year.

• Tier 2 (offerings between $124,000 and $618,000): Financial statements reviewed by an independent public accountant. The financial statements must cover the most recently completed fiscal year.

• Tier 3 (offerings more than $618,000 but not more than $1.235 million): Financial statements reviewed by an independent public accountant. If audited financial statements are available, they must be provided instead. The financial statements must cover the two most recently completed fiscal years or the period since inception, if shorter.

• Tier 4 (offerings more than $1.235 million, up to $5 million): Financial statements audited by an independent public accountant. The financial statements must cover the two most recently completed fiscal years or the period since inception, if shorter.

The specific disclosure requirements change somewhat depending on whether the startup was incorporated less than 120 days ago; more than 120 days ago but within the same year; or more than one year ago. The following matrix should help clarify the subtleties:

Note that GAAP financials require a cover page; balance sheet; income statement; cash flow statement; stockholder equity statement; and footnotes which spell out details about taxes, equity, debt, accounting methodologies, or anything else of substantive or material importance; the idea here is transparency.

Filing Requirements and Offering Process

Issuers must file Form C with the SEC and provide it to the intermediary before commencing the offering. The offering must be conducted exclusively through a single intermediary platform. The offering must be open for at least 21 days before any securities can be sold. Investors can cancel their commitments for any reason up to 48 hours before the offering deadline.

Intermediary Requirements and Funding Portals

Intermediary Obligations

Intermediaries facilitating Reg CF offerings must:

• Register with the SEC and FINRA as either a broker-dealer or funding portal.

• Conduct due diligence on issuers and screen for potential fraud.

• Provide investor education materials and ensure investor acknowledgment of risks.

• Facilitate the offering and closing process, including the transfer of funds.

Funding Portal Regulations

Funding portals are subject to specific regulations, including:

• Prohibition on offering investment advice or recommendations.

• Restrictions on soliciting investments and handling investor funds.

• Requirements for recordkeeping and compliance with SEC and FINRA (Financial Industry Regulatory Authority) rules.

Ongoing Reporting and Compliance

Annual Reporting Requirements

Issuers must file an annual report, known as Form C-AR, with the SEC and provide it to investors within 120 days of the end of the fiscal year. The annual report must include updated financial statements and information about the issuer's business operations and financial condition. This ongoing reporting ensures transparency and accountability to investors.

Terminating Reporting Obligations

Issuers may terminate their ongoing reporting obligations under Reg CF if:

• They become a reporting company under the Securities Exchange Act of 1934.

• They have filed at least one annual report and have fewer than 300 holders of record.

• They have filed at least three annual reports and have total assets not exceeding $10 million.

• They have repurchased all the securities issued in the Reg CF offering.

Advertising and Promoter Compensation

Advertising Restrictions

Issuers are prohibited from advertising the terms of a Reg CF offering except for certain limited notices that direct investors to the intermediary's platform. Advertisements may include basic factual information about the issuer and the offering, but no specific terms of the offering may be included.

“Specific terms” include the amount, price, nature or type of securities being offered; the date the round is set to close; any progress made towards the fundraising goal; and how the startup intends to use the funds.

Additionally, certain disclosures must be attached to all public statements including emails, tweets, social media posts, YouTube videos, or anywhere else intended for public dissemination.

Promoter Compensation

Individuals promoting a Reg CF offering through an intermediary's communication channels must disclose the compensation they receive for their promotional activities. Issuers are prohibited from compensating promoters unless the compensation is disclosed in accordance with Reg CF requirements.

There is, however, a provision for a "testing the waters" (TTW) phase under §227.206 of Reg CF. During this phase, issuers can gauge investor interest through pre-offering communications so long as there is no “acceptance” of any money or consideration of any kind; and importantly, any indication of interest obtained during this TTW phase is entirely non-binding.

Best Practices for Issuers and Intermediaries

Issuers:

• Prepare comprehensive and accurate financial statements that meet the required level of review or audit based on the amount raised.

• Provide detailed and transparent disclosures to build investor trust and meet regulatory requirements.

• Engage with reputable intermediary platforms that comply with SEC and FINRA regulations.

• Maintain ongoing communication with investors through regular updates and annual reports.

Intermediaries:

• Conduct rigorous due diligence on issuers, including background checks and information verification, to prevent fraud.

• Provide clear and comprehensive educational materials to investors about the risks and processes involved in crowdfunding.

• Ensure compliance with all regulatory requirements, maintain up-to-date records, and facilitate transparent communication between issuers and investors.

Conclusion

Regulation Crowdfunding has opened up new opportunities for startups and small businesses to raise capital from a diverse range of investors, and in so-doing, has indeed effectively democratized the investment landscape by enabling non-accredited investors to support the businesses they love.

By understanding the key requirements, limitations, and best practices outlined in this guide, issuers and intermediaries can successfully navigate the Reg CF landscape, ensuring compliance and investor protection.

For more detailed information or assistance with your crowdfunding efforts, consult with a qualified securities attorney specializing in Regulation Crowdfunding and corporate law for startups and small businesses.