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• In early November, the SEC outlined updates to several regulations in the JOBS Act, particularly Regulation A, Regulation D, and Regulation Crowdfunding (Regulation CF), which essentially created the equity crowdfunding market we have today. The updates to Regulation CF will increase the maximum allowable fundraising amount per 12 months to $5.0 million from $1.07 million and includes provisions to allow issuers to engage with prospective investors before a planned raise.
• While there is a material difference between the type of business that engages crowdfunding versus that which raises VC, the increased limit could induce a number of small businesses to raise through a crowdfunding platform instead of pursuing VC. Through Q3 2020, more than 2,300 venture rounds between $1.0 million and $5.0 million were raised, suggesting that the new crowdfunding limit could reach a large pool of companies.
Signed into law in April 2012, the Jumpstart Our Business Startups (JOBS) Act brought many changes to US law that have impacted the private markets since. Several of the laws set out to help US-based companies raise capital from investors who didn’t historically have access to private markets, while also helping to cut costs of traditional financing routes. Although many companies have made use of the laws created through the act to access equity funding, adoption by both investors and issuers has been slower than hoped. To further enhance the JOBS Act, on November 2, 2020, the SEC adopted amendments to several of the rules that had been instituted or adjusted by the JOBS Act, including those pertaining to the following: Regulation Crowdfunding, which had created the framework for equity crowdfunding; Regulation A, which is designed to enable modified IPOs; and Regulation D, which governs certain small private securities offerings.
The updates include increasing the limit that companies can raise through each type of offering, as well as tinkering with the investor allowances and enabling companies to market their offerings to non-accredited investors beyond mentioning that an offering was taking place (i.e., no details). The changes present intriguing opportunities for companies looking to move forward with these financings to raise equity, especially through the use of Regulation Crowdfunding, of which updates included raising the equity crowdfunding limit to $5.0 million per year, erasing the limit on investments into crowdfunding by accredited investors, and adding the ability for companies to “test the waters” and interact with prospective investors to gauge interest in the offering.
Regulation Crowdfunding law and adoption
Regulation CF was written as a piece of the JOBS Act and formally enacted in 2016, and it enabled companies to raise capital through specialized platforms by receiving investments from a broad number of small investors, including non-accredited investors. Crowdfunding for capital was not new. Platforms such as Kickstarter and Indiegogo already existed and had helped many companies raise funds to build out new products. However, backers of campaigns on those sites were only provided early access to products or other non-equity items, rather than an equity stake in the company and participation in the company’s financial upside, and that upside could be huge. Oculus Rift raised more than $2 million in 2012 on Kickstarter, only to be purchased by Facebook just two years later for $2.3 billion. While the company had raised multiple VC rounds in between, the Kickstarter backers were left out of the massive windfall they would have received if their investment represented equity instead of a presale product.
As first written, Regulation CF stipulated that transactions must be made through an SEC-registered intermediary (platform) and capped the amount that could be raised through crowdfunding by any company at just $1.07 million every 12 months. One of the other important provisions was allowing non-accredited investors to take part in the deals. While equity crowdfunding wasn’t billed as the next get-rich-quick scheme, the regulation’s opening of investment to non-accredited investors was an important step toward making private investment available to the masses.
A primary motivation of the JOBS Act was to open up the private markets to help small businesses in need of new avenues raise capital. Arranging financing for the many startups, businesses, and business ideas isn’t easy. Without assets or patented intellectual property, many aren’t able to procure traditional bank financing or SBA loans, despite founder conviction. Venture firms look for specific types of growth trajectories to fund, and many businesses simply can’t meet those criteria. For these companies, crowdfunding presents a unique opportunity: the ability to raise capital, without a loan-like payback schedule, from investors that want to own a piece of the business.
The limits placed on equity crowdfunding did cause problems. For one, companies were still unable to actively market their funding rounds to nonaccredited investors, which was intended to be a protection against fraud. In addition, the $1.07 million limit was a barrier that could make equity crowdfunding a burden for companies looking for more capital. While further financing could be raised through non-crowdfunding sources, having to do that in addition to the time and resources needed to run a crowdfunding campaign likely put off some companies considering the idea.
Since Regulation CF was formally enacted in 2015, equity crowdfunding has shown tepid adoption, with less than $500 million raised through Regulation CF to date. Recently figures show that crowdfunding has begun to pick up, however, as knowledge and understanding of crowdfunding begins to take hold. Even before the new updates rolled out, Q3 saw the highest total of any quarter to date for financings through Regulation CF, with more than $70 million closed during the period.1 The expanded rules could help further grow the market, which would be a boost to small companies and crowdfunding investors alike, but also could have effects on the lower end of the US venture ecosystem.
How the changes may impact equity crowdfunding
The new SEC updates expand the upper limit of the amount each company can raise through crowdfunding every 12 months to $5.0 million. From a capital need perspective, this could entice companies previously opposed to crowdfunding to put together a campaign. Rather than splitting a round between another private offering and a crowdfunding campaign, companies can raise all of the capital through a single platform. However, it should be noted again that there is a distinct difference between many VCbacked companies and the businesses that use crowdfunding; through Q3 2020 more than 2,300 venture deals were closed at between $1.0 million and $5.0 million, suggesting there is potential for the pool of companies using equity crowdfunding to grow significantly.
There is evidence that raising the limit may not necessarily lead to higher adoption of crowdfunding. Raising even $1.0 million through crowdfunding has been difficult. Limits on the amount non-accredited investors can invest each year makes it necessary to receive commitments from a huge number of backers to reach a goal of that size. At the time of this writing, the largest running campaign on Wefunder had raised roughly $794,000 from nearly 1,100 backers. At an average investment of $720, a company would need nearly 7,000 investors to accomplish a $5.0 million raise.
There had been limits on the amount that accredited investors—those already able to invest in private securities—were able to invest in crowdfunding campaigns, further adding upward pressure on the total number of backers needed. The recent updates eliminated these limits, which will also help to offset the need for such an enormous number of backers by allowing accredited investors to invest as much as they would like into campaigns.
The other major adopted rule change brings the ability for companies to “test the waters” and engage with prospective investors to see if there is an appetite for an offering. Because many investors in crowdfunding campaigns are non-accredited, the SEC has been willful in protecting them from bad actors and fraud through the newly created market. It should be noted there have been no cases of fraudulent offerings through SECregistered platforms to date.
Demo days, which have become common and newsworthy events from top accelerators, will now also be available to crowdfunders, as demo days are no longer covered by the general solicitation and advertising laws that have hindered crowdfunders in the past. By allowing engagement with prospective investors, regardless of accredited status, potential crowdfunding companies can gauge support and promote their products before launching a campaign. Companies can use the feedback from these outreaches and events to tailor their offerings to build further support, or to decide to abandon their crowdfunding plans. Companies that decide against launching a campaign because of low support could spur a consolidation of investments into higher quality deals, which would benefit strong companies and investors alike.
Through October 2020, more than $150 million has been raised through equity crowdfunding, which is double the amount raised in 2018, and already more than $30 million higher than the amount raised in 2019.3 These numbers have also come during the COVID-19 pandemic, and may promise further growth as the economy rebounds.
The impact that the updated equity crowdfunding rules will have on the market may not be seen for some time, but we would expect them to boost support for the offering type and make crowdfunding through Regulation CF more mainstream. And one day we might point to an Oculus-like example for the growth of the equity crowdfunding market.
The SEC announcements in early November weren’t solely focused on Regulation Crowdfunding, as mentioned above, and the tweaks to Regulation A, Regulation D, and other private offering exemptions were made with transparency and growth of the private markets in mind. Many around the industry see these tweaks and updates as an overall positive for the market, and we should expect further changes in the future.
Excerpts from “Updates Announced to Regulation Crowdfunding by the SEC on November 2, 2020”
For Regulation Crowdfunding, the amendments:
1. raise the offering limit in Regulation Crowdfunding from $1.07 million to $5 million;
2. amend the investment limits for investors in Regulation Crowdfunding offerings by:
• removing investment limits for accredited investors; and
• using the greater of their annual income or net worth when calculating the investment limits for non-accredited investors; and
3. extend for 18 months the existing temporary relief providing an exemption from certain Regulation Crowdfunding financial statement review requirements for issuers offering $250,000 or less of securities in reliance on the exemption within a 12-month period
“Test-the-Waters” and “Demo Day” Communications. The Commission is amending offering communications rules, by:
1. permitting Regulation Crowdfunding issuers to “test-the-waters” prior to filing an offering document with the Commission in a manner similar to current Regulation A; and
2. providing that certain “demo day” communications will not be deemed general solicitation or general advertising.
The amendments establish rules that permit the use of certain special purpose vehicles that function as a conduit for investors to facilitate investing in Regulation Crowdfunding issuers.
Other Improvements to Specific Exemptions
1. harmonize the bad actor disqualification provisions in Regulation D, Regulation A, and Regulation Crowdfunding.
Taken from “What’s Next for Equity Crowdfunding? SEC updates Regulation Crowdfunding to further boost market “https://files.pitchbook.com/website/files/pdf/Q4_2020_PitchBook_Analyst_Note_What_s_Next_for_Equity_Crowdfunding.pdf