Federal and Massachusetts Exemptions for Securities Crowdfunding
by John D. Hancock
Companies in Massachusetts have two new methods to conduct smaller securities offerings: crowdfunding under a federal regulation adopted in October 2015 and crowdfunding under a Massachusetts regulation adopted earlier in 2015. Both are designed to provide efficient and affordable means of raising capital through the sale of small amounts of securities to a large number of investors.
The SEC’s new Regulation Crowdfunding, which takes effect on May 16, 2016, significantly changes how companies can conduct securities offerings exempt from registration under the Securities Act of 1933. Traditionally, requirements for exempt offerings have imposed significant restrictions on the offering process, such as limits on solicitation and advertising, the number or type of offerees, or the offering’s geographic scope. Under Regulation Crowdfunding, companies may offer and sell up to $1 million of securities to the public anywhere in the United States without registering the offering. The regulation allows companies to reach potential investors who are ordinarily excluded from exempt offerings and may enable companies unable to raise funds through traditional offerings to grow and thrive.
Unfortunately, the regulation imposes some requirements, such as the obligation to provide ongoing public disclosure, that may limit its utility.
The Massachusetts Crowdfunding Exemption was adopted after Regulation Crowdfunding was proposed but before it was adopted. The exemption relies on Section 3(a)(11) of the Securities Act and federal Rule 147, which historically have had limited utility. The state exemption is more flexible than Regulation Crowdfunding, including a higher maximum offering amount, fewer affirmative disclosure requirements and no ongoing reporting requirements.
The new exemptions may be most attractive to newly organized startups with straightforward business plans whose capital needs can be satisfied entirely through crowdfunding. Companies considering crowdfunding should nonetheless anticipate the risks and costs associated with a large shareholder base.
Under Regulation Crowdfunding, an issuer may conduct one or more offerings to raise up to $1 million in any twelve-month period. The dollar limit applies to offerings under the regulation by the issuer of the securities, its predecessors, if any, and companies controlled by it or under common control with it. The securities are generally non-transferable for one year.
Each investor can purchase only a limited dollar amount of crowd-funded securities in any twelve-month period, regardless of the number of issuers involved. If a person’s annual income or net worth is below $100,000, he or she can invest up to $2,000 or, if greater, 5% of the lesser of his or her annual income or net worth. If both a person’s annual income and net worth equal or exceed $100,000, he or she can invest up to 10% of the lesser of his or her annual income or net worth, up to $100,000.
Significantly, offerings under the regulation are eligible for federal preemption of state securities laws under Section 18(b)(4)(C) of the Securities Act, which should reduce compliance costs.
Some companies are ineligible to conduct offerings under Regulation Crowdfunding. The regulation provides an exemption only for the initial issuance of securities and does not expressly extend to a later conversion or exercise of those securities, which could occur months or years after the conclusion of the offering. Accordingly, there may be practical limits on the types of securities that can be included in a crowdfunding offering without introducing excessive complexity or cost.
Intermediary; Online-Only Offerings. Under the regulation, an issuer must engage an intermediary and conduct its offering “exclusively” through that intermediary’s online platform. The intermediary must be either a broker registered under Section 15(b) of the Securities Exchange Act of 1934 or a “funding portal” registered under Regulation Crowdfunding.
Neither an intermediary nor its directors, officers or partners may have or receive an interest in the issuer’s securities, except that an intermediary may receive, as compensation for its services, securities on the same terms and conditions as investors in the offering.
Limited Advertising; Promoters. The regulation prohibits advertising in connection with the offering and prohibits payment of compensation for promoting the offering outside the intermediary’s platform. An issuer may, however, distribute notices that refer investors to the intermediary’s online platform if the notices contain only certain limited information. The issuer may communicate with potential investors through the online platform, but its founders, employees and promoters must disclose their relationship with the issuer and the receipt of any compensation from the issuer.
Offering Structure. Crowdfunding offerings must remain open for at least 21 days before the issuer may consummate any sale. The issuer must disclose the targeted offering amount, the deadline for reaching that amount and, if greater than the target, the maximum offering amount. Importantly, investors may cancel their offering commitments until 48 hours before the offering deadline.
If funding commitments fall short of the target at the offering deadline, investors’ funds must be returned to them. If the target is reached earlier than the offering deadline, the issuer may, in some circumstances, accelerate the closing.
Offering Statement. The most challenging aspect of an offering under the regulation is the requirement to prepare an offering statement. The SEC has estimated that, on average, preparation of the necessary disclosures will take approximately 100 hours, and experience suggests that the SEC’s estimates of paperwork burdens are often low. The regulation will likely be more attractive to very early-stage enterprises because the disclosure requirements will be less burdensome than for more mature companies.
The offering statement must disclose specific information, including, e.g., descriptions of the issuer’s business, business plan, financial condition (including material changes or trends since the most recent balance sheet), the terms of the offering, the anticipated use of proceeds and risk factors. The statement must also include information about directors, officers, beneficial owners and related parties. Issuers must provide financial statements prepared in accordance with U.S. generally accepted accounting principles for the two most recently completed fiscal years or, if shorter, the period since inception. For offerings up to $100,000, the issuer’s CEO must certify the financial statements. For offerings between $100,000 and $500,000, or for an issuer’s first offering under Regulation Crowdfunding, an independent accounting firm must “review” the financial statements. For subsequent offerings greater than $500,000, an independent accounting firm must audit the financial statements. These financial statement requirements may significantly increase the cost of a crowdfunding offering.
The offering statement is subject to the anti-fraud provisions of the Securities Act and must be updated to reflect material changes. Because the disclosure is directed at retail investors, SEC staff may expect a level of clarity closer to that found in a public offering prospectus than a private placement memorandum. Many issuers will benefit from the advice of experienced disclosure counsel in satisfying this requirement.
Progress Updates. An issuer must notify investors within five business days after investment commitments reach 50% and 100% of the targeted offering amount. If the issuer accepts funds above the targeted offering amount, the issuer must also notify investors of the total amount sold.
Filing Requirements. Offering statements, amendments and progress updates must be filed with the SEC, via EDGAR, on new Form C. This information will be publicly available.
Ongoing Reporting. One downside of a crowdfunding offering is that the issuer must file an annual report with the SEC within 120 days after each subsequent fiscal year. The annual report is substantially similar to the offering statement, excluding offering-related information. The financial statements in the annual report must be certified by the issuer’s CEO and need not be reviewed or audited; however, reviewed or audited financial statements must be included, if available.
The obligation to file annual reports terminates if (a) the issuer becomes a public reporting company, (b) after the completion of the offering, the issuer has filed an annual report and has fewer than 300 shareholders or the issuer has filed annual reports for the three most recent years and has assets of $10 million or less, (c) all of the securities issued under the crowdfunding exemption are repurchased or (d) the issuer liquidates.
Exemption from Exchange Act Registration. Ordinarily, companies with more than $10 million of assets and more than 500 shareholders of record that are not “accredited investors” must register under the Exchange Act. However, shares issued in a crowdfunding offering are excluded from this calculation if the issuer has filed all required annual reports, has assets of $25 million or less and has engaged the services of a registered transfer agent.
Investor Management. Given the potentially unlimited number of participants in a crowdfunding offering, issuers should consider how they will manage a company with hundreds or thousands of unfamiliar investors. Investors in early crowdfunding offerings will likely be inexperienced with investing in non-public companies and may not anticipate how little information or access to management they will receive. Issuers should consider how to respond to myriad requests for information and progress reports or to unfavorable or inaccurate public comments by investors. Issuers should anticipate that disappointed investors may assert claims or may file complaints with government regulators. Issuers should consider adding contractual provisions to their offering documents to reduce the costs of investor disputes, such as mandatory arbitration.
Lastly, issuers should consider the impact of a crowdfunding offering on potential exit opportunities. Acquisitions of non-public companies usually involve indemnification by the target’s securityholders, and a large number of unsophisticated securityholders may complicate the target’s ability to consummate a transaction that is attractive to both a buyer and the target’s own larger shareholders, who may be asked to bear a disproportionate share of potential liability. Similarly, a large number of unaccredited investors may limit the buyer’s ability to pay with securities, since the exemptions that buyers customarily rely upon for acquisitions of private companies will be unavailable.
In January 2015, Massachusetts adopted its own crowdfunding exemption from state registration requirements. Like Regulation Crowdfunding, the state exemption requires specific written disclosures to investors, imposes dollar limitations on investors’ purchases, is unavailable to disqualified issuers and certain types of issuers, and limits offerings to $1 million in any twelve-month period. Under the state exemption, however, issuers with audited financial statements can offer up to $2 million of securities. The exemption is limited to issuers organized under Massachusetts law with a principal place of business in Massachusetts, and securities may be offered and sold only to investors in Massachusetts. Moreover, the exemption requires issuers to comply with either Section 3(a)(11) or Rule 147.
Notably, the state exemption does not require that the offering be conducted exclusively online, nor does it require an intermediary. However, the exemption prohibits the issuer from remunerating anyone, other than registered broker-dealers, for soliciting prospective purchasers, which may limit the use of funding portals that are not registered broker-dealers.
The state exemption imposes certain requirements absent from the federal exemption. The minimum offering amount must be “sufficient” to implement the business plan described in the offering materials and must be at least 30% of the maximum offering amount. If the minimum offering amount is not met within one year, the issuer must return investors’ funds. The issuer must also file with the Secretary of the Commonwealth a notice of the offering, copies of offering materials and, after the offering, a sales report.
Although the express disclosure requirements of the state exemption are narrower than those of Regulation Crowdfunding, the state exemption requires disclosure of “any additional information material to the offering” and “full and fair disclosure to offerees and investors of all material facts relating to the issuer and the securities being offered, in accordance with Section 101” of the Massachusetts Uniform Securities Act, M.G.L. ch. 110A. Section 101 follows the traditional anti-fraud formulation of Rule 10b-5 under the Exchange Act that the issuer may not “make any untrue statement of a material fact or … omit to state a material fact necessary in order to make the statements made, in the light of the circumstances under which they are made, not misleading,” nor may the issuer otherwise commit fraud. The potentially open-ended nature of this disclosure requirement may discourage some issuers from using the state exemption.
Both the federal and Massachusetts crowdfunding exemptions offer novel but untested means to raise funds from a broad section of the public. As companies and investors gain experience with the exemptions, regulators should augment their usefulness by eliminating requirements that prove to be burdensome, costly or impractical.
John D. Hancock is a partner at Foley Hoag LLP. He practices in the areas of corporate finance, securities, and mergers and acquisitions. He can be reached at email@example.com. The views expressed in this article are his alone and do not necessarily express the views of Foley Hoag.
 These regulations apply when a crowdfunding campaign involves the offer or sale of securities; they do not apply to crowdfunding campaigns that offer participants, for example, early access to, or a discount on, a new product or service, such as an album, video game, or software.
 17 C.F.R. Part 227, adopted under Sections 4(a)(6) and 4A of the Securities Act of 1933.
 950 C.M.R. 14.402(B)(13)(o).
 Under Section 3(a)(11) and Rule 147, a safe harbor thereunder, an issuer may conduct a crowdfunding offering, but only to investors in the state in which it is organized and operating. When the SEC adopted Regulation Crowdfunding, it proposed to amend Rule 147 to permit offers by out-of-state issuers. However, the amended rule would require that the offering be registered under state law or conducted under a state exemption that limits the offering size to $5 million and imposes an investment limitation on each purchaser. See Securities Act Rel. No. 33-9973, Exemptions to Facilitate Intrastate and Regional Securities Offerings, 80 F.R. 69786 et seq.
 All offerings must comply with federal and applicable state securities laws. As explained below, Regulation Crowdfunding generally preempts state law. An offering under the new Massachusetts exemption must also comply with existing federal exemptions under Section 3(a)(11) and Rule 147.
 The SEC made clear that its “integration” doctrine – under which multiple offerings may be treated as a single, integrated offering based on factors such as the timing of the offerings, the purpose of the offerings and the types of securities offered – will generally not apply to offerings under the regulation, as long as each offering independently satisfies the requirements of the exemption applicable to it. Nonetheless, an issuer may face difficulty satisfying these requirements simultaneously. For example, advertising permitted under Regulation Crowdfunding may constitute unlawful solicitation under Rule 506(b) of Regulation D, and a general solicitation permitted under Rule 506(c) of Regulation D may constitute illegal advertising under Regulation Crowdfunding.
 For example, the regulation is generally unavailable to foreign issuers, public companies, investment companies, special purpose acquisition companies, companies without a specific business plan and issuers disqualified for prior illegal conduct.
 A “funding portal” is a limited-purpose broker that acts as an intermediary in a crowdfunding offering but that does not offer investment advice or recommendations, solicit purchases, sales or offers to buy the securities displayed on its platform, compensate employees or others for solicitations or sales on the platform, or handle investor funds or securities.
 Permitted information includes the issuer’s name, address, telephone number and website, the terms of the offering and a brief description of the issuer’s business.
 Liability is imposed on the issuer and its directors, key executives and others who “offer or sell” the securities, including intermediaries, and extends to any written or oral communication made to an investor in connection with the offering. These individuals should not overlook their exposure to personal liability, particularly for issuers that lack the resources to provide insurance coverage or meaningful indemnification.
 The issuer need not provide any progress reports, however, if the intermediary provides “frequent” progress updates to investors through its online platform.
 Under the federal exemption, the dollar limits on each investor apply across all issuers whose securities are purchased under the crowdfunding exemption; under the state exemption, the dollar limits apply on an issuer-by-issuer basis.
 Interestingly, the dollar limits do not apply to securities offered and sold to the issuer’s directors, officers, partners, trustees and 10% shareholders.
 Through incorporation of Section 3(a)(11) and Rule 147, the state exemption effectively prohibits out-of-state offers. In order to comply with this prohibition, an issuer would need to take steps to ensure that information about its offering is available only to investors in Massachusetts.