How to Follow Rule 506 When Crowdfunding Your Small Business

How a change in government regulation affects crowdfunding

Disclosure requirements for Crowdfunding and Rule 506

Rule 506 requires no disclosures for an unregistered offering with the exception of required compliance with anti-fraud rules. On the other hand, crowdfunding will come with very specific reporting requirements. Companies will have to provide basic information about the offering, the company, and its officers, directors and major stockholders. Issuers using crowdfunding will also have to provide financial information, depending on the target offering size. For rounds up to $100,000, the company will only need to provide tax returns, if any, and financial statements certified by the chief executive officer. For rounds between $100,000 and $500,000, the financials must be reviewed by a certified public accountant. Above $500,000, the financials must be audited. Further, the crowdfunding exemption will not be available to foreign private companies, public companies, or investment companies. Finally, securities acquired in a crowdfunding offering will have limitations on the buyer’s ability to transfer those securities. Securities acquired in a crowdfunding transaction may not be resold for one year, except to the issuing company, an accredited investor or in a registered offering.

While these restrictions may not prove burdensome for some companies, they are still more than would be required under a traditional Regulation D offering to accredited investors.

Crowdfunding will require the use of third parties in fundraising

Rule 506 does not have a third party requirement and issuers can solicit investments directly from accredited investors. Under crowdfunding, an issuer is required to use a registered broker dealer or a “funding portal.” The JOBS Act defines a “funding portal” as any person acting as an intermediary in a transaction involving the offer or sale of securities; for the account of others solely pursuant to the new crowdfunding exemption from the registration requirements of Section 5 of the Securities Act; added by the JOBS Act.

Funding portals, like broker-dealers, must become members of a national securities association (i.e., FINRA). While there is an exemption from the broker dealer registration (outlined in a recently published SEC FAQ), it currently has little to no utility as the exempt platform would not be permitted to conduct a general solicitation. Whether exempt or not the funding portal requirement will certainly increase transaction costs associated with crowdfunding and limit some of its intended benefits.

Conclusion

At its core, crowdfunding allows entrepreneurs who do not have access to wealthy investors to still engage in unregistered securities offerings to get their businesses off the ground. The spirit of the law is in the right place and Congress should be applauded for this initial step. The worry is that the attendant reporting requirements and fundraising limitations that come with crowdfunding may not offer entrepreneurs and small businesses the kind of relief they expect. In addition, many unanswered questions remain.

It is unclear what disclosures will be required on crowdfunding websites or how companies will enforce transfer restrictions or protect unsophisticated shareholders who may participate in these offerings from being diluted. While many will look to crowdfunding as a game changer in fundraising (and it will be once the kinks are worked out), those who have access to accredited investors may find it more useful to go the more traditional route utilizing the Rule 506 exemption under Regulation D, as this continues to be an efficient and sound way for issuers to offer unregulated securities.

For more information on any of the topics covered in this article please contact one of our attorneys at contact@rbernardllp.com or visit our website at www.rbernardllp.com to learn more about our practice. Follow us on Twitter.

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