Startups, the SEC and what it means for crowdfunding

Contributing author Jonathan Frutkin is Principal with The Frutkin Law Firm and CEO of Cricca Funding

For most startup entrepreneurs, they go into the game knowing they will eventually need to raise money. They also know that more often than not, investors, in the form of family, friends or angel investors, will invest in exchange for shares of the company. Regardless of who actually belies up to the bar with capital, the entrepreneur needs to remember that selling of shares is tightly regulated by the Securities and Exchange Commission (SEC).

Back in the era of the Great Depression, the SEC was created to regulate the sale and purchase of securities. These laws were designed to protect unsuspecting people from losing all their money to cheats and swindles. The result is that the SEC created a regulatory scheme that made it very expensive and difficult to raise money, even from smart and rich people who knew what they were doing.

This all changed in 2012 when The JOBS Act became law. There are two major provisions that impact the way the companies are going to be raising money from private investors.

The first has to do with the legalization of general solicitation. In order to protect investors from stock promoters stealing money, the SEC prohibited people from raising money through advertisements. The problem is that for most companies, it really isn’t that they want to advertise in the newspaper or on TV that they are raising money. Instead the general solicitation ban prevented companies from communicating the fact that they were raising money at all. In short, the pre-JOBS Act law basically prohibited the company from telling anyone it was raising money except those that had a pre-existing business relationship. This shrunk the market a great deal. This “old” rule is contained in Rule 506(b).
The old Rule 506(b) also meant that most people raising money were unknowingly breaking the law. Things like pitch-days (where companies present their business plan to a room full of angel investors), sending along a private placement memorandum to a friend of a friend … all those actions were actually prohibited. The problem of course is that no one even knew it.
So Congress knew that this outdated and constantly ignored ban needed to be revised. Remember that the SEC only allows high net worth people to invest in most private deals. Only people with more than $200,000 in annual income or net worth (excluding their house) of more than $1,000,000 can participate. These people are called accredited investors. What this means is that most people are completely shut out from investing. However, when someone indicated an interest in investing, they simply could tell the company that they qualified as an accredited investor – they never had to prove it.
As part of the change, Congress set up a new deal where a company can generally solicit – meaning a company can advertise that they are taking investors. But in exchange for the new ability to advertise, if someone says they are accredited investor, the investor has to prove it. Of course, this has created another set of issues and problems, all of which are being worked through (including how exactly investors are verified and how advertising material gets into a company’s “permanent file” with the SEC). This new paradigm – where a company can advertise their stock offering but in exchange must verify the accredited status of the new investor – is all contained in new Rule 506(c).
In short, the change has been very significant. For startup entrepreneurs who now have the ability to communicate freely about money, the sky is the limit. Websites, television ads and social media campaigns are about to become totally commonplace to raise money.
But the next step is still coming in 2014. Then, anyone, rich or not, will be able to make investments into companies using the “crowdfunding” provision of The JOBS Act. The SEC just put out proposed rules which allow for input from the investing community about how exactly equity crowdfunding is going to work.
There are very few laws that are as complicated as securities laws. However, the good news is that things are finally changing – catching up to the real world of social media and instant communication, and a fulfilling future awaits more startups and wise investors.
Book_FrutkincrowdfuningJonathan Frutkin is Principal with The Frutkin Law Firm, PLC in Scottsdale. He also is CEO of Cricca Funding, He’s also the author of a book called “Equity Crowdfunding: Transforming Customers into Loyal Owners.”