Crowdfunding: Understanding Title II and Title III of the JOBS Act

In recent years, crowdfunding has been a useful tool for small businesses to raise capital because it allows entrepreneurs to solicit from a wider range of investors. In theory, this would also help alleviate funding gaps and regulatory concerns associated with raising smaller capital amounts. Websites like Kickstarter and IndieGoGo have been helping to facilitate these types of investments for years.

This form of alternative financing is regulated by the JOBS (“Jumpstart Our Business Startups”) Act  first passed by Congress in 2012. The term “JOBS Act” is informally used to represent Title II, Title III, and Title IV of the legislation. Title II was officially passed in September of 2013 with the intent to make it easier for startups and small businesses to raise capital. However, unlike Title III (which took effect May 16, 2016), Title II places heavy restrictions on who can purchase the securities being offered. We focus on the key distinctions between Title II and Title III, and what this might mean for your fundraising efforts.

Title II

Companies looking to raise money through the sale of securities must either register the securities offering with the SEC or rely on an exemption from registration. Most exemptions from registration prohibit general solicitation (such as advertising in the newspaper, on the internet, etc). However, Title II allows a company to employ “general solicitation” to market securities offerings, provided they follow the rules and guidelines of Rule 506 of Regulation D. Under this new exemption, companies can use the Internet or other mediums to advertise their security offerings. This gives the company a chance to attract a large number of new investors in a short period of time, but restricts the type of investor who can purchase those securities.

Under the Title II exemption a company can only make an offering to “accredited” investors. The act defines an accredited investor as anyone who has either a net worth of $1,000,000 (your principal residence cannot be included in this calculation), or who made greater than $200,000/year for the three years leading up to their current securities purchase. Additionally, the company must take “reasonable steps” to verify they are in fact accredited. This does narrow a company’s investment pool slightly, but the potential to reach more investors in a short period of time greatly outweighs the negative. Additionally, there is no cap to the number of investors or to the amount of money that can be raised under this exemption. If you’re a company trying to raise capital for the first time, then you likely don’t have a list of willing investors to draw from, and the ability to use the Internet could change things dramatically.

Title III

Title III, adopted May 16, 2016, gained a lot of attention because it allows a company to make securities offerings to non-accredited investors. In theory, this would allow a company to solicit a virtually infinite number of investors from the general public to meet their fundraising goals. That may be music to the ears of hungry startups eager to disrupt traditional investing, but there is some fine print to consider. If a company is soliciting non-accredited investors, then they can only raise $1,000,000 in a 12-month period. If that amount meets your needs, then this exemption provides a very fast way of crowdfunding your capital. If not, it can still be useful when implemented in conjunction with more traditional fundraising strategies.

There are also some restrictions to consider regarding the purchasers of your offering under this exemption. Investors who make less than $100,000 a year can invest the greater of 5% of their annual income or $2,000. Investors who make greater than $100,000 a year can invest up to 10% of their annual income, but they cannot invest more than $100,000 in one year. Funds, such as venture capital firms, are prohibited from investing in a Title III raise.  Additionally, transactions must be conducted through an intermediary that either is registered as a broker-dealer, or is registered as a new type of entity called a “funding portal”. A funding portal must register with the SEC, and be subject to the SEC’s examination, enforcement and rulemaking authority. Furthermore, for companies that raise over $500,000, significant disclosures in the form of audited financials are required. This can create an annual cost of $10,000+ for years down the line if you use this type of crowdfunding.

Certain companies are ineligible to use Title III. Common disqualifications include non-US companies, companies who failed to comply with the annual reporting requirements during the two years immediately preceding the filing of the offer, and companies with no specific business plan or that have indicated their business plan is to engage in a merger or acquisition with an unidentified company.

Finally, for those issuers who are conducting an offering, in addition to the offering documents, issuers are required to disclose (1) information about the officers, directors and owners of 20% or more of the company, (2) description of the issuer’s business and use of the funds, (3) the price for each security, the target offering amount and if they will accept more than the target amount, (4) any related party transactions, (5) the issuer’s current financial health and (6) either reviewed or audited financials, depending on the offering.

Even with these caps, restrictions and requirements to qualify for the exemption, the Title III exemption still has the potential to be a very powerful crowdfunding tool. However, it’s very important to consider that venture capital firms will be excluded, and a large cap table could hinder downstream investment.

Crowdfunding: Conclusion

Crowdfunding has already disrupted traditional fundraising models for small businesses and it is now set to do the same for securities offerings. Even though there are some restrictions, both the Title II and Title III exemptions greatly widen the investor pool for companies interested in crowdfunding. While the exemptions do have the potential to make raising capital less difficult, venture capitalist and angel investors will still play a role in early stage investments. A comprehensive strategy, and a complete understanding of relevant exemptions, is needed to get the biggest benefit from the JOBS Act.

If you have any questions, or need assistance as you prepare for a round of fundraising please give us a call at (415) 633-6841 or send us an e-mail at info@bendlawoffice.com.

Disclaimer: This article discusses general legal issues and developments. Such materials are for informational purposes only and may not reflect the most current law in your jurisdiction. These informational materials are not intended, and should not be taken, as legal advice on any particular set of facts or circumstances. No reader should act or refrain from acting on the basis of any information presented herein without seeking the advice of counsel in the relevant jurisdiction.  Bend Law Group, PC expressly disclaims all liability in respect of any actions taken or not taken based on any contents of this article.