Two unusual and potentially highly important (yet surprisingly brief) bills are now pending before the US Congress. This blog entry will describe one of them and explain why I consider it to be a potential enormous game-changer in the capital raising world for small businesses.
The “Entrepreneur Access to Capital Act” (H.R. 2930) would create an entirely new exemption -- a 21st Century social media category exemption -- to the registration requirements under federal securities law. It is called the “Crowdfunding Exemption” and, yes, “crowdfunding” here has basically the same meaning it does in the internet world.
The necessary background if you aren’t familiar with the federal law governing registration of securities for sale (the Securities Act of 1933, as amended): every time a security is offered for sale or sold in or by means of interstate commerce (which means almost every time a security is sold), the transaction must be registered under the Act unless it is made under an express exemption from the Act.
What the vast majority of people don’t realize is that, since 1933, offerings and sales of every security in or by means of interstate commerce must either be registered (like the current Facebook offering) or sold under an express exemption (like, for example, a private offering to a dozen friends, family members and employees). In fact, small businessmen every day violate this law when they offer and sell stock to their friends, family, neighbors, customers, employees, and business friends with total disregard/ ignorance as to whether or not they satisfy an express exemption from registration.
The number of offerings and sales of securities made in registered transactions under the Act in the US is large, but the number is dwarfed by the number of transactions made (or which should be made) through exempt transactions.
For small and medium-sized businesses, a registered offering under the Act is something to be read about in the newspaper or listened to on CNBC. It is not a realistic choice for capital raising: too large, far too costly, too disruptive (the owners of the business become nameless and numerous), and too much of a burden after the sale has closed and the money has been collected (a company which sells securities under the Act automatically becomes subject to the Securities Exchange Act of 1934, which regulates the company -- not its offering or sale of stock -- on a periodic basis).
There are several ways to raise capital through registration-exempt transactions, but not all are suitable for every business. And despite what your fellow businessmen may have suggested, selecting and using an exemption in a manner that complies with all of its conditions does require the guidance of an attorney skilled in the area of securities laws, may require financial statements audited by a CPA, and ultimately may involve retaining a local broker or placement agent as an intermediary to sell your securities. All of this costs significant time and money. The alternative is to break the law and risk the consequences, which may be visited upon you by the SEC, your state securities commissioner, or in civil court by disappointed investors. And if you are found to have violated the registration exemptions, the slightest remedy you will confront is rescission: you must return the investors (all of the investors) all of their money with interest. In addition, you may be barred from using the same or similar registration exemptions in the future.
That is where HR 2930 may change things drastically.
What the Bill Says
The “Entrepreneur Access to Capital Act” would create an entirely new and different kind of registration exemption, which the bill calls the “Crowdfunding Exemption.”
Over a 12 month period, an issuer could raise up to a maximum of $1 million ($2 million if potential investors are furnished audited financial statements) if no single investor invests more than $10 thousand (assuming his annual income is $100 thousand or more; if an investor has a lower annual income, then his maximum investment would be capped at !0% of his income). The issuer would have to meet about a dozen mostly straightforward additional conditions. For example, the issuer would have to warn investors about the speculative nature of investing in small issuers and startups and that the securities purchased cannot be transferred for one year except to an “accredited investor” or the issuer; to obtain from investors answers to questions that demonstrate their understanding of the level of risk generally applicable to startups and small issuers, the risk of illiquidity of the securities they purchase, and “such other areas as the Commission may determine appropriate by rule or regulation”; and give the SEC a short list of information about the issuer, such as its address and names of principal, and about the offering, such as the amount of the issuer’s fundraising target and the intended use of those funds. Of course, the SEC may adopt regulations that make compliance more difficult, but the tone and intent of the bill indicates the agency should take a light hand in rulemaking under this exemption.
The wildcard in this list of conditions is the one which requires the issuer to take “reasonable measures to reduce the risk of fraud with respect to such transaction.” Exemption from registration NEVER exempts the issuer and its controlling persons from the antifraud provisions of the Act (and state securities laws), but exactly what “reasonable measures to reduce the risk of fraud” means here will be something to be studied more if this bill becomes law.
Additionally welcome is that the bill adopts a substantially similar lists of conditions where an issuer raises money through an “intermediary” or third party and provides that the intermediary will NOT be required to register as a broker under the 1934 Act solely because he participated in a crowdfunding transaction.
Finally, this “Crowdfunding Exemption” is added to the list of federal exemptions which automatically preempt state securities laws on registrations and exemptions from registration. An issuer complying with this new federal exemption need not fear that his state or another state will effectively undo the new exemption by imposing its own, more onerous requirements.
Part 2 will discuss what the bill may mean to a typical small to medium size business, and where the bill stands now.