Suppose you are representing a startup business client with what seems to be a useful new product or service. The client’s business plan is stellar, and the initial ownership group is comprised of experienced individuals with the know-how to execute the plan.

There’s only one problem: The client has limited access to investment capital to launch this great new concept.

Obtaining equity capital can be a complicated and costly legal issue for small businesses, particularly new and emerging companies. Since the 1930s, businesses in the U.S. have had to comply with strict requirements in both federal and state securities laws, particularly with respect to smaller investors.

These difficulties ultimately led to the passage of so-called equity crowdfunding laws. Crowdfunding refers to raising capital for a business by accepting investments of small dollar amounts from a larger number of people, typically via the internet. In other words, a “crowd” of investors helps to fund the business.

The 2012 Jumpstart Our Business Startups Act¹ (the JOBS Act) allowed new, emerging businesses to tap large and small investors alike with the promise of ownership in the business and loosened the solicitation rules for larger investors to allow businesses to cast a wider net for funds with the goal of simplifying the fundraising process. Three years later, the Securities and Exchange Commission (SEC) enacted Regulation CF.²

In the meantime, states such as Wisconsin passed their own crowdfunding laws. These state-based crowdfunding laws, although important to fill gaps while the SEC considered its final regulations, were limited in their usefulness because a business could only raise funds from investors inside the borders of that state.

The SEC initially promulgated Regulation CF in 2016. In March 2021, the SEC finalized amendments to Regulation CF³ to increase the amount(s) that can be raised via the exemption. Following these amendments, most issuers have elected to conduct their crowdfunding offerings under Regulation CF because of the higher maximum offering amount permitted and the flexibility of soliciting investors from multiple states.

Definition of “Security”

A key issue in raising money is whether what is being sold is a “security.” Legally speaking, a “‘security’ means any note, stock … evidence of indebtedness, certificate of interest, or participation in any profit-sharing agreement.”⁴ In other words, an individual or an entity does not have to be selling shares of stock to be engaged in the sales of a security under the law.

Registration versus Exemption

Securities selling became heavily regulated when, in the aftermath of the 1929 stock market crash and during the Great Depression, Congress enacted the Securities Act of 1933.⁵ The Act created the SEC as the federal regulatory agency having jurisdiction over and oversight of the raising of investment capital. Under the Act, a company seeking to raise funds, referred to in the Act as the “issuer,” must either register its offering with the SEC (that is, a “public offering”) or qualify for one of several exemptions if the transaction is “not involving a public offering.” Most small private-company offerings are made under exemptions set forth in Regulation D and particularly rules 504 and 506(b) and 506(c).⁶

In 1953, the U.S. Supreme Court held in Securities & Exchange Commission v. Ralston Purina Co. that a transaction “not involving a public offering” is an offer made to those who are able to “fend for themselves.”⁷ The Ralston Purina decision made it difficult for issuers to conduct an exempt offering to anyone other than “accredited investors.”⁸

JOBS Act of 2012

In response to the success of rewards-based crowdfunding⁹ and demand from the startup community to streamline businesses’ ability to raise capital, Congress passed the JOBS Act in 2012.

The centerpiece of the JOBS Act was creation of an exemption to permit securities-based or equities-based crowdfunding without registering the offerings with the SEC. Until the JOBS Act and the promulgation of Regulation CF, crowdfunding was not a legal means of raising equity capital.

Wisconsin Crowdfunding Act

Despite passage of the JOBS Act, the SEC did not issue final equity crowdfunding rules until May 16, 2016. As a result, several states – including Wisconsin – enacted their own crowdfunding laws because of interest from small businesses in using this process to raise capital.

Under Wisconsin’s crowdfunding law,¹⁰ which took effect on June 1, 2014, a Wisconsin business may raise up to $1 million from state investors through crowdfunding portals, referred to in Wis. Stat. ch. 551 as “internet site operators.” The amount that can be raised increases to $2 million if the issuer has had an audit in its most recent fiscal year and has provided the audit to prospective investors and the Wisconsin Department of Financial Institutions (DFI).

Any one purchaser may invest a maximum of $10,000 in a single crowdfunding offering unless the purchaser is an accredited investor or a certified investor. Certified investor is defined as a person who has an individual net worth (or joint net worth with the individual’s spouse) of at least $750,000 or had an individual income larger than $100,000 in each of the two most recent years (joint income with spouse in excess of $150,000).

Effective April 5, 2018, 2017 Wis. Act 213 updated certain provisions of the crowdfunding exemption:

• The issuer must have a principal place of business and be doing business in Wisconsin but no longer needs to be organized under Wisconsin law.

• The exemption incorporates Rule 147A¹¹ (adopted under the Securities Act of 1933 in place of Rule 147).

• The escrow agent must be authorized to do business in the state but no longer needs to be chartered under Wisconsin law.

• Internet site operators can receive commissions.

• Issuers no longer need to file their quarterly reports to investors with the DFI’s Division of Securities but must provide them if requested by the division.

Provisions Regarding Solicitations of Interest. A solicitation-of-interest exemption was added as Wis. Stat. section 551.202(26m). To qualify for the exemption under Wis. Stat. section 551.202(26), issuers must do the following:

• File a notice with the Division of Securities at least 10 days before commencing an offering. The notice must include a disclosure document, an escrow agreement with a Wisconsin-chartered financial institution, a financial audit (if applicable – upload with the disclosure document), and a $50 filing fee.

• Comply with the “intrastate” exemption under federal law, meaning that all sales must be to Wisconsin investors.

• Make the offer available through one or more internet sites that are registered with the DFI.

• Provide a copy of the disclosure document to each prospective investor, hold all payments in escrow, and not access any escrowed funds until the target offering amount has been raised.

• Provide quarterly reports to investors.

Issuers that are subject to the “bad actor” disqualification under federal securities law are not eligible for the solicitation-of-interest exemption.

Before offering securities for sale under the crowdfunding exemption, a solicitation of interest or “testing the waters” can be conducted in compliance with Wis. Stat. section 551.202(26m).

Before the initial solicitation of interest, the offeror must file with the division a completed solicitation-of-interest form and related materials. No sales of securities can be made until 20 calendar days after the last delivery of a solicitation-of-interest document, scripted media broadcast, internet post, or other media publication.

Wisconsin Law Applies Only to State Residents. The fundamental limitation, however, in Wisconsin’s crowdfunding law is the “intrastate” requirement. This restriction, while needed to remove the state crowdfunding law from the purview of federal jurisdiction under the Commerce Clause of the U.S. Constitution, limits the pool of potential investors solely to Wisconsin residents. In other words, a Wisconsin business engaged in a crowdfunding campaign under the Wisconsin law must turn away interested investors from outside Wisconsin. This restriction is a downside for businesses with a strong need for capital.

Regulation CF

The SEC finalized its crowdfunding rules as Regulation CF on May 16, 2016. A company issuing securities in reliance on Regulation CF can raise a maximum aggregate amount of $5 million in a 12-month period.¹² During any 12-month period, investors are permitted to invest up to $2,500, or 5% of their annual income or net worth, whichever is greater, if both their annual incomes and net worth are less than $124,000. Investors may invest up to 10% of their annual income or net worth, whichever is greater, if either is equal to or more than $124,000.¹³

Securities that are purchased in a Regulation CF offering cannot be resold for a year, and holders of the securities do not count toward the threshold that requires a company to register with the SEC under Exchange Act Section 12(g).

Companies that conduct Regulation CF offerings must file certain information with the SEC via Form C and make it available to investors and to the intermediary that is used to facilitate the offering. The offering document must include information about officers, directors, and holders of more than 20% of the issuer’s securities. The disclosure requires a business description, the offering terms, a description of the use of the proceeds from the offering, and the price of the securities being offered.¹⁴

The Form C disclosure includes certain related-party transactions, a description of the financial condition of the company, and its financial statements. Companies are required to update the offering document to include material changes and to provide updates about the progress in reaching the targeted offering amount. Crowdfunding issuers also must file annual reports with the SEC and provide annual reports to investors.¹⁵

Financial Disclosure Requirements. Regulation CF’s financial disclosure requirements differ based on the amount of the offering:

• For offerings of $124,000 or less,¹⁶ the issuer must provide financial statements and certain information from the issuer’s federal income tax returns, all certified by the principal executive officer. If, however, financial statements of the issuer are available that have either been reviewed or audited by a public accountant that is independent of the issuer, the issuer must provide those financial statements instead and will not need to include the information reported on the federal income tax returns or the certification of the principal executive officer.

• For offerings from $124,000 to $618,000, financial statements must be reviewed by a public accountant that is independent of the issuer. If, however, financial statements of the issuer are available that have been audited by a public accountant that is independent of the issuer, the issuer must provide those financial statements instead and will not need to include the reviewed financial statements.

• For offerings of more than $618,000, financial statements must be audited by a public accountant that is independent of the issuer.¹⁷

Intermediaries. Regulation CF transactions must be conducted through an SEC-registered intermediary, which will be either a broker-dealer or a funding portal. The intermediaries will conduct the offerings through online platforms. Intermediaries must provide investors with educational materials that outline the risks of investing. They also must take measures to reduce the risk of fraud.¹⁸

Funding portals cannot offer investment advice or make recommendations. They cannot solicit purchases, sales, or offers to buy securities offered or displayed on their websites. The rules impose restrictions on compensating people for solicitations and prohibit the funding portals from holding, possessing, or handling investor funds or securities. The rules provide for a safe harbor under which funding portals can engage in certain activities consistent with these restrictions.¹⁹

Equity Crowdfunding’s Limitations

Equity crowdfunding is not a panacea. For businesses that might need to consider multiple rounds of financing over a period of several years, using an offering that might yield numerous small, unsophisticated investors could be problematic when seeking more “sophisticated” capital (for example, from a venture capital firm) in a subsequent financing round. Further, certain types of businesses are restricted or barred from undertaking an equity crowdfunding campaign to raise capital to launch a business. For example, a law firm could not sell equity in the firm to nonlawyers in a crowdfunding campaign. Similarly, the three-tier system laws related to alcohol distribution in Wisconsin would bar certain individuals who hold licenses in other alcohol-related businesses from investing in the crowdfunding campaign of a brewery, distillery, or winery.

Conclusion

Regulation CF, as amended in 2021, is a useful arrow in the quiver for new and emerging companies seeking to raise investment capital. However, careful planning and forecasting as to later financing needs and other business matters should be considered before embarking upon such a campaign. Also, in some instances, the Wisconsin Crowdfunding Law remains a viable option for Wisconsin businesses looking to raise capital solely from Wisconsin residents.

Endnotes

1 Jumpstart Our Business Startups Act, Pub. L. No. 112-106, 126 Stat. 306 (2012).

2 17 C.F.R. pt. 227—Regulation Crowdfunding, General Rules and Regulations [hereinafter Regulation CF].

3 See generally Facilitating Capital Formation and Expanding Investment Opportunities by Improving Access to Capital in Private Markets, 86 Fed. Reg. 3496 (Jan. 14, 2021).

4 15 U.S.C. § 77b(a)(1).

5 Pub. L. No. 73-22, 48 Stat. 74.

6 Revision of Certain Exemptions from Registration for Transactions Involving Limited Offers and Sales, 47 Fed. Reg. 11,251 (Mar. 16, 1982) [hereinafter Regulation D]; 17 C.F.R. § 230.504; 27 C.F.R. § 230.506(b), (c).

7 SeeSecurities & Exchange Comm’n v. Ralston Purina Co., 346 U.S. 119 (1953).

8 “Accredited investors” for individual investors means persons having $1 million net worth not including their primary residence; or income exceeding $200,000 in each of the two most recent years; or joint income with a spouse exceeding $300,000 for those years and a reasonable expectation of the same income level in the current year. 17 C.F.R. 230.501(a).

9 “Rewards-based crowdfunding” typically refers to websites such as Kickstarter, where businesses offer rewards in exchange for a contribution with the clear understanding that the contribution does not entitle the person to any profits in the enterprise.

10 Wisconsin’s crowdfunding provisions were created by 2013 Wis. Act 52 and are codified at scattered sections of Wis. Stat. ch. 551.

11 17 C.F.R. § 230.147A.

12 Regulation CF originally specified a maximum raise of $1,070,000. This amount was increased to $5 million under the March 2021 amendments.

13 17 C.F.R. § 227.100.

14 17 C.F.R. § 227.303(a); 17 C.F.R. § 227.201 (disclosure requirements).

15 17 C.F.R. §§ 227.201-.202.

16 Under temporary rules promulgated by the SEC on May 4, 2020, in response to the COVID-19 pandemic, an issuer could raise up to $250,000 with self-certified financials, and reviewed financials were acceptable for offerings of up to $1,070,000. These temporary rules expired as of Aug. 29, 2022.

17 17 C.F.R. § 227.201(t).

18 See 17 C.F.R. §§ 227.300-.305.

19 See 17 C.F.R. §§ 227.400-.404.

» Cite this article: 96 Wis. Law. 24-28 (April 2023).