How to Follow Rule 506 When Crowdfunding Your Small Business

How a change in government regulation affects crowdfunding

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When President Obama signed the JOBS Act almost a year ago it introduced a new era of startup financing. But until the SEC makes the required rules, the fundraising bonanza known as crowdfunding that will allow companies to solicit investors via all manners of advertising is not yet with us.

As a recap, a large part of what Congress did with the JOBS Act was introduce two entirely new provisions that will change the way issuers offer unregistered securities. First, the statute called on the SEC to issue rules that will allow general solicitation in all accredited investor offerings, a drastic shift from preexisting securities law. Second, crowdfunding will allow issuers to solicit funding from sources that previously were limited, or altogether barred, from participating in the offering of unregistered securities. Crowdfunding, once fully legal, will allow business owners to issue unregistered securities to a large number of non-accredited investors in a manner that was not possible before. Assuming the SEC promulgates the required rules regulating the use of crowdfunding, many entrepreneurs and small businesses will rush to use this mechanism for seed and series A financing.

In spite of the warranted optimism surrounding crowdfunding it is unclear if it will be a more desirable way to raise money than a Rule 506 offering under the safe harbor provided by Regulation D of the Securities Act of 1933, as amended. Currently, Rule 506 is the most commonly used exemption when issuing unregistered securities. To understand how Rule 506 differs from crowdfunding let us look at some key areas where the two diverge.

Limitations on the size of an offering

Under Rule 506, there is no limitation on the size of an offering that qualifies for the exemption. Naturally, this is the exemption you want to use when raising large sums of money. However, if an issuer chooses to use the crowdfunding exemption it will be limited to a cap of $1 million during any 12-month period. The 12-month cap includes any funds that were raised in other equity offerings during the same period. Issuers should keep this in mind as the ease of fundraising using the crowdfunding platform is tempered somewhat by the relatively low cap on the amount of funds a company can raise.

In addition, there is a cap on how much an individual investor may invest in a crowdfunding offering; an investor may only invest the greater of $2,000 or 5% of his annual income or net worth, if either is below $100,000, or the lesser of $100,000 or 10% of his annual income or net worth, if either is above $100,000.

Limitations on the number of investors

Rule 506 has no limit on the number of investors permitted so long as all investors in a given offering are accredited investors (typically, individuals with a net worth of more than $1 million, or whose income exceeded $200,000 in the past two years). A Rule 506 offering can have a maximum of 35 non-accredited investors (who alone or together with their purchaser representatives must be sophisticated investors). Strictly speaking, crowdfunding also allows an unlimited number of investors but given that the $1 million cap, there is at least an implied limit on how many investors you can expect to have in any given offering. Part of the attraction to crowdfunding is that you can solicit small amounts of money from a large group of people to eventually hit your fundraising target. Keep in mind, however, that smaller checks mean more investors to keep track of.

As a small company you may be dealing with the immense administrative burden of keeping track of scores of investors and their separate demands. A Fortune 500 company may have the internal infrastructure and systems in place to track and manage hundreds of investors — but as a small operation — you are unlikely to have the required bandwidth to take advantage of a crowdfunding platform, unless you are receiving sizable checks from each investor. In addition, companies may be required to register with the SEC once they have either 2,000 shareholders of record or over 500 shareholders who are not accredited investors.

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