SEC crowdfunding and general solicitation are at odds

The new Title III rules are still unclear and companies may shoot themselves in the foot

While the prospect of raising money from an unlimited number of unsophisticated investors becomes more of a reality, the perils of the process may leave many overly-anxious companies shooting themselves in the foot, if they don't read the fine print about solicitation.

The Securities and Exchange Commission just came out with new crowdfunding rules for Title III of the JOBS Act earlier this week. This is the section that will eventually open up the floodgates to allow more unsophisticated (aka un-accredited investors) to invest in private companies, up from 35 today.

I'm very excited about individual investors putting their money into something that can potentially deliver a great return and create jobs. There's also a sense of pride and community building by helping others get started.  

Yet we're not there yet. There is that small matter of how to tell the public you're offering shares in your company.

The SEC is still taking comments on this matter.

For now, the irony of the new Title III proposals is that companies that go this route - raising as much as  $1 million in a 12-month period - won't really be able to tell the world they're investing. 

At least the way it stands now, if a company decides to use this exemption, technically called Section 4(a)(6) of the Securities Act of 1933, (which it still can't because the SEC is still taking public comment. Go here if you want to share your views with them), then it cannot make general solicitations.   

It can't make a general solicitation, like the one below where this person sent out an unsolicited announcement to his LinkedIn network. By doing this, he just limited himself to accredited investors. 

That's because this form of general solicitation [sending out a Tweet, posting a Facebook update, or sending out a LinkedIn message, for example] falls under another rule, called 506c, which allows companies to tell the world that it's raising money - but limits the investors to "only" accredited investors.

"There are two completely different and unrelated offerings [4a6 and 506c] but because of integration rules you have to pick one and if you try to do both you likely will blow both exemptions," said Roger Royse, of Royse Law Firm. 

Moreover, with this kind of general solicitation under 506c, the company would have had to file a Form D before making this announcement. If it didn't, then it would be out of compliance, as would the funding portal that it's using to facilitate the transaction," said Kate Mitchel, partner at Scale Venture Partners.

Now the SEC is still not clear on general solicitation and crowdfunding. In fact, in its document it asks for comment on this:

Should we prohibit an issuer from offering securities in reliance of Section 4(a)(6) within a specified period of time after or concurrently with a Rule 506c offering under Reg D involving general solicitation?

Should we prohibit an issuer from using general solicitation or general advertising under Rule 506c in a manner that is intended, or could reasonably be expected, to condition the market for a Section 4a6 offering or generate referrals to a crowdfunding intermediary?

Should issuers that began an offering under Section 4a6 be permitted to convert the offering to a Rule 506c offering? 

"This is all hypothetical since there is no Title II fundraising yet and with 295 requests for comment I still am skeptical that there ever will be, at least in a way that anyone can use," added Royse.

So this is still murky water. And as it stands, the SEC's rules on crowdfunding for un-accredited investors remain at odds with the new general solicitation rules.

As for other proposed crowdfunding rules under Title III. Here's the good and the bad, in my opinion.

1) In its attempt to curtail the risk of shell companies looking to cheat unsuspecting investors, the SEC has proposed a number of safeguards. For instance, the new SEC rules limits how much each individual can invest: an investor will be limited to either $2,000, or 5% of their income or net worth, if they are worth less than $100,000. This is a good rule, though interestingly enough it's a lower percentage than the 9% of income low-income people spend on lottery tickets. 

2) This isn't so good: If an individual makes more than $100,000, he or she would only be able to invest 10% if his/her income and ultimately no more than $100,000 of securities through crowdfunding. What this means is that any investor who wanted to write a $150,000 check couldn't. And for many startups, there are investors willing to make that investment. 

3) This is probably good, but onerous and possibly expensive, depending on who's footing the bill: Companies must also disclose to the SEC, certain information, such as audited financial statements and who their officers and directors are and anyone who owns 20%-plus of the the company. The company also has to give annual financial statements to the SEC, sometimes audited by a third-party accountant, and make them available to prospective investors. 

4) This is better for investors, and great for potential crowdfunding portals that "register" with the SEC:
The SEC proposes that these transaction only take place on a site that is a registered broker dealer, or a site that is registered as a funding portal. So no chance of putting up a virtual sign on your website saying you're raising funds, click here! 

5) This is great for issuers and investors:
The SEC won't put any burden on companies to make sure an individual investor's fnancial situation is what they say it is. The SEC would require investors to self-verify. So if an investor writes out a $5,000 check, and they only make $50,000 (but lies about it on paper in order to qualify), then so be it.     

Getting there

Now, it's probably fair to say that navigating these waters isn't easy. And kudos to the SEC for trying to find a process, while trying to protect unsuspecting investors from fraudulent companies and brokers.  

Moreover, investing in startups is highly risky and the odds of recouping your money, let alone making a return are pretty low.

This is Vator's position on startup investing:

If we think of investing in mature, publicly-traded, companies like backing a shipment of cargo on an airplane, with a relatively clear manifest, route, and largely predictable arrival time, then investing in a startup should be thought of as backing an explorer about to set sail on an expedition to undiscovered lands, across dangerous seas. All the explorer can tell you is the general direction they plan to head, and the rumors they’ve heard of the gold at the other end. Most of these explorers won’t find any gold. Worse, many will die trying.

At the same time, lottery tickets are also a moonshot. The odds to win, at least Powerball, is 1 in 175,223,510. Yet one man spent $967,000 in lottery tickets, and on average "poor" people spend 9% of their income on lottery tickets. In fact, in the United States, people spend $62 billion in lottery tickets a year.

We live in a world of increasing transparency, where learning is becoming accessible to all. And unsophisticated investors can get up to speed fairly quickly. There's only so much protection the government can provide. At some point, they need to move aside and allow consumers and gamblers become investors. 

If some of that money that goes into lottery tickets can be funnelled into startups, then there's at least the chance for job creation and the blossoming of a culture that aspires to create, build and innovate. 

(Image source: ronedmonson.com)