April 20, 2015

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Crowdfunding Gets Local: What Entrepreneurs and Start-Ups Need to Know to Capitalize on Exemptions for Intrastate Crowdfunding in Arizona and Colorado

Authors:

Jessica A. Benford
jbenford@rcalaw.com
(602) 440-4866

Blake P. Callaway

Many entrepreneurs and start-up companies are looking for innovative ways to raise money without the red tape of the securities laws.  Crowdfunding is often touted as the solution to this dilemma.  In its simplest terms, "crowdfunding" is the process of raising money through the internet, typically from a broad target of individuals.  Notably, however, crowdfunding transactions can be divided into two subsets that have distinctly different characterizations under existing laws.

The first category of crowdfunding involves online solicitations for donations or pre-purchases of goods or services.  Websites such as kickstarter.com and indiegogo.com are good examples of platforms that facilitate this form of crowdfunding.  As this first category draws upon individuals' altruism or materialism, this type of crowdfunding is not subject to legal regulation beyond basic concepts of fraud and theft.  This form of crowdfunding has obvious limitations and thus is not useful to most companies that are hoping to take advantage of crowdfunding.

The second category of crowdfunding, by contrast, solicits investments online from individuals for an equitable stake in a company or business going forward.1   This security-based type of crowdfunding involves the offer and sale of traditional securities.  This type of transaction must comply with federal and state securities laws, which require the securities being sold to be registered unless there is a lawful exemption.  At present, there are no crowdfunding exemptions in effect under federal securities laws or the state securities laws of Arizona and Colorado, which means that small start-up businesses in Arizona and Colorado have not been able to take advantage of security-based crowdfunding as an equity financing alternative.

Recognizing a strong demand for security-based crowdfunding, Congress and the legislatures of Arizona and Colorado have responded by passing legislation that is intended to provide transactional exemptions for securities-based crowdfunding transactions.  Arizona and Colorado join many other states that have adopted or proposed state crowdfunding laws. Thus, the remainder of this article summarizes the status of federal, Arizona, and Colorado crowdfunding legislation and regulation and discusses the practical effects of these regulatory measures once they become effective.

Federal Exemption

Under Title III of the Jumpstart Our Business Startups Act (the "JOBS Act"), which was enacted on April 5, 2012, Congress created the regulatory framework for a federal securities law exemption for crowdfunding transactions.  In particular, Title III of the JOBS Act added new Section 4(a)(6) of the Securities Act of 1933 (the "Securities Act"), which creates a registration exemption for securities offered and sold in crowdfunding transactions.  In addition, Title III of the JOBS Act added an exemption to the broker-dealer registration requirements under new Section 3(h) of the Securities Exchange Act of 1934 (the "Exchange Act") for persons operating internet-based platforms (i.e., funding portals) that facilitate crowdfunding transactions.

While Title III of the JOBS Act created the basic parameters for a crowdfunding exemption, Congress importantly delegated authority to the Securities Exchange Commission (the "SEC") to issue rules designed to implement the mandate of Title III of the JOBS Act.  As a consequence, the effectiveness of the crowdfunding exemptions created by the JOBS Act has been conditioned on the SEC adopting new rules and forms to implement the crowdfunding exemption.  The SEC proposed crowdfunding rules on October 23, 2013, but to date the rules have not been adopted.  However, some commentators expect final rules in 2015.

Until final rules are adopted, issuers and intermediaries will not be permitted to rely on the crowdfunding exemptions created by Title III of the JOBS Act.  Many commentators speculate that the increase in state legislation to exempt crowdfunding transactions is a response to the SEC delayed rulemaking and the complexity of the SEC proposed rules.

Arizona Exemption

In February 2015, Arizona Representative Jeff Weninger and Senator David Farnsworth introduced House Bill 2591 and Senate Bill 1450 to allow equity fundraising in Arizona.  The Arizona legislation applies to an issuer that is a business entity organized under the laws of Arizona.  The offering transaction must meet the requirements of the federal exemption for intrastate offerings.  Under SEC Rule 147(c), the issuer must meet the following requirements for doing business in Arizona: at least 80% of the issuer's gross revenues come from business within Arizona; at least 80% of the issuer's assets must be located in Arizona; at least 80% of the money raised must be used in Arizona; and the issuer's principal office must be located in Arizona.

Under the legislation, companies could raise up to $2.5 million over a 12-month period with audited financial statements or $1 million over a 12-month period without audited financial statements.  Each investor can invest up to $10,000 each or an unlimited amount if the investor is an accredited investor.  An "accredited investor" is defined in the SEC Regulation D and generally covers high net-worth individuals and sophisticated businesses.

Each issuer must complete a notice filing with the Arizona Corporation Commission not less than 10 days prior to commencing the offering.  The proposed notice filing would include a copy of the disclosure document to be provided to prospective purchasers, a copy of the Escrow Agreement for the required escrow account and any other documents or information required by the Arizona Corporation Commission.

The issuer must establish an escrow account for the offering proceeds with a bank, credit union or other depository financial institution that is authorized to do business in Arizona and maintains deposit insurance.  The issuer must specify a target offering amount and an offering deadline.  The offering deadline must be not less than 21 days and not more than one year from the date the offer is made.  The company must raise 80% of the target offering amount by the offering deadline to receive the investor funds.  Investors have the ability to cancel their commitment to invest up to 48 hours before the offering deadline or 72 hours before the early closing.  If the offering will be closed before the offering deadline, then the issuer must notify each purchaser and post the early closing date on the internet website where the offer was posted.

The issuer must deliver to prospective purchasers a disclosure document with certain required information regarding the company, the shareholders, the executive officers and directors, and the terms and conditions of the securities being offered.

The exemption requires that sales be made through one or more internet websites operated by a registered dealer, or a person who does not receive a commission or remuneration for the offer or sale of the securities and completes a notice filing with the Arizona Corporation Commission.  The website must limit access to the offer or sale of securities to residents of Arizona.  The Arizona Corporation Commission must have access to the website.  The issuer may distribute a limited notice regarding the offering with a link to the website of the website operator so long as the notice includes a disclaimer that the offering is limited to residents of Arizona.

On March 30, 2015, the Arizona house bill was passed and transmitted to the Governor.  The Governor signed the house bill on April 1, 2015, and the bill becomes effective on July 3, 2015.

Colorado Exemption

Colorado Representatives Pete Lee and Dan Pabon introduced House Bill 15-1246 on February 25, 2015, which proposed new legislation that would provide an intrastate crowdfunding exemption under the Colorado Securities Act.  Like the case of its Arizona counterpart, the Colorado intrastate crowdfunding exemption relies on the federal intrastate exemption under Section 3(a)(11) of the Securities Act and SEC Rule 147, and thus is independent of any federal crowdfunding exemption.

Through crowdfunding transactions, Colorado entities will be permitted to raise up to $2 million in a year if the issuer provides audited financials to the Colorado Securities Commission, or $1 million in a year if it does not submit audited financials.  To qualify for the exemption, the transaction must be a mini-max offering that establishes a maximum offering amount and a minimum offering amount that is at least half of the stated maximum offering amount.  Furthermore, the exemption will be limited to issuers that are entities organized under Colorado law who are not otherwise: (i) SEC reporting companies; (ii) investment companies or companies excluded from the definition of an investment company pursuant to Section 3(c) of the Investment Company Act of 1940; or (iii) issuers that directly or indirectly through affiliated persons are subject to disqualification by Commissioner rule or the standards set forth in Rule 506(d) adopted under the Securities Act.

Investors who do not qualify as accredited investors will be permitted to invest only $5,000 in a 12-month period, whereas accredited investors may invest any amount up to the maximum offering limits described above. Money received from investors must be deposited into escrow with a bank or other trusted institution and may only be released after the issuer has achieved the minimum offering amount and satisfied the other applicable conditions.

Issuers will also be subject to various reporting and disclosure obligations under the proposed bill.  For example, prior to commencing the offering, the issuer will be required to make a notice filing with the Colorado Securities Commissioner that will include appropriate fees and copies of the investor disclosure document and escrow agreement applicable to investor funds.  In addition, copies of the disclosure document must be given to prospective purchasers at the time of the offering.  Issuers will also be required to distribute to investors and file with the Colorado Securities Commission quarterly reports that discuss, among other things, executive and director compensation as well as the issuer's business operations and financial condition.

Crowdfunding transactions will need to be completed exclusively through a Colorado registered broker-dealer, a Colorado licensed sales representative, or an "online intermediary," which will be a new class of regulated person under the Colorado Securities Act.  Among other restrictions applicable to online intermediaries, online intermediaries will be prohibited from offering investment advice to investors, handling investor funds, or holding any direct or indirect financial interest in the issuer claiming the exemption.  Furthermore, online intermediaries will be required to maintain systematic records of crowdfunding transactions and may not be compensated based on the amount of securities sold by it.

The Colorado intrastate crowdfunding bill has been approved without amendment by Colorado's House of Representatives and Senate, and was sent to Colorado's Governor for approval on April 7, 2015.  The crowdfunding legislation was signed into law on April 13, 2015, but will not be effective until the Colorado Securities Commissioner adopts implementing rules, for which there is no current timeline.

Potential Disadvantages of Equity Crowdfunding Transactions

Crowdfunding is intended to provide start-up companies with a convenient and cost-effective means of raising seed capital.  However, there may be some disadvantages that issuers interested in taking advantage of the crowdfunding exemptions (when and if available) should consider.

  • It may not be desirable to have many small shareholders for purposes of voting, notices, and related shareholder governance matters.
  • An issuer with many unsophisticated investors may have limited options related to future financing and related capital structure considerations.
  • The quarterly reporting required in Arizona and Colorado may be more extensive and costly than the investor reporting contemplated by many start-up companies.
  • The disclosure document required in Arizona and Colorado is likely to be more involved than the disclosures regarding investment opportunities posted on websites, like kickstarter.com.
  • The funding portals/website operators may require compensation (where permitted by applicable law).
  • The Maximum Offering Amount under the Arizona and Colorado exemptions is likely only compatible with small-scale projects.
  • Meeting all exemption requirements may be more costly than some start-up companies can afford, particularly in view of the Maximum Offering Amounts under the Arizona and Colorado exemptions.
  • The issuer may face litigation risk from dissatisfied investors.
  • The issuer may face pressure to register the shares issued in a crowdfunding transaction or otherwise redeem those shares to compensate for a lack of a liquid market.
  • Because so much business is interstate, the requirements under SEC Rule 147 may limit the proposed business plan.

Important Considerations for Aspiring Crowdfunders

While the intrastate crowdfunding exemptions in Arizona and Colorado (if and when they become effective) may offer start-up companies a new alternative for raising money, issuers will need to carefully evaluate their business goals in view of some or all of the considerations described above.  Although limited to accredited investors and not more than 35 non-accredited investors, the private offering exemption under SEC Rule 506 may offer more flexibility and less uncertainty than crowdfunding.

Whether you are a new or established company contemplating crowdfunding as an option to raise capital, you should consider consulting with an attorney.  Our firm's lawyers have experience navigating federal and state securities law exemptions and are available to assist you with evaluating the available federal and state law exemptions to determine which exemptions are best suited to your needs.

For further information on the issues discussed in this article or assistance with other securities law issues, please contact Jessica Benford at jbenford@rcalaw.com or (602) 440-4866.

Crowdfunding Exemption Comparison Chart

The below chart provides more details on the differences between the Federal, Arizona and Colorado crowdfunding exemptions. Click here to download the PDF version.

Federal Exemption
(Enacted Law; Proposed Rules)

Arizona Exemption
(Effective July 3, 2015)

Colorado Exemption
(Enacted Law; Awaiting Implementing Rules)

Exemption 
Pre-Requisites

- Must find available state law exemption

- Must qualify for federal intrastate offering exemption (Section 3(a)(11); Rule 147)

- Must qualify for federal intrastate offering exemption (Section 3(a)(11); Rule 147)

Maximum Offering Amount
(12-months)

- $500,000 to $1 million with audited financial statements
- $100,000 to $500,000 with independently reviewed financial statements
-
$0 to $100,000 with certified tax returns for previous year and internally prepared financial statements

- $2.5 million with audited financial statements
-
$1 million without audited financial statements

- $2 million with audited financial statements
-
$1 million without audited financial statements

Minimum Offering Amount

- The stated target offering amount

- Funds in escrow must equal 80% of the target offering Amount on the expiration of the offering deadline or the early closing of the offering

- Not less than ½ of stated maximum offering amount

Maximum Investment Amount
(12-months)

- $2,000 or 5% of annual income or net worth if annual income and net worth are less than $100,000
-
10% of annual income or net worth if either annual income or net worth is greater than $100,000

- Unlimited if investor is an accredited investor
-
$10,000 if investor is not an accredited investor

- Unlimited if investor is an accredited investor
- $5,000 if investor is not an accredited investor

Issuer Requirements

- May NOT be foreign entity
- May NOT be a reporting entity under the Exchange Act
-
May NOT be an investment company (or investment company excluded under Section 3(b) or 3(c) of the Investment Company Act of 1940)
- May NOT be directly or indirectly through an affiliated person be subject to federal bad-boy disqualifiers
- May NOT be an issuer who has failed to file annual reports required by crowdfunding exemption rules in previous two years
- May NOT be a blank check company

- Must be a business entity organized under Arizona law
- Must be authorized to do business in Arizona
- Must be doing business in Arizona pursuant to SEC Rule 147(c)
- May NOT be a reporting entity under the Exchange Act
- May NOT be an investment company (or an entity that would be an investment company but for the exclusions provided in the Investment Company Act of 1940)
- May NOT be directly or indirectly through an affiliated person subject to state and federal bad-boy disqualifiers
- May NOT be a company that has not yet defined its business operations, that does not have a business plan or a stated investment goal for the funds being raised or that plans to engage in a merger or acquisition with an unspecified business entity

- Must be a business entity organized under Colorado law
- Must be authorized to do business in Colorado
- Must be doing business in Colorado pursuant to the SEC Rule 147
- May NOT be a reporting entity under the Exchange Act
- May NOT be an investment company (or investment company excluded under Section 3(c) of the Investment Company Act of 1940)
- May NOT be directly or indirectly through an affiliated person be subject to state and federal bad-boy disqualifiers

Investor Requirements

- n/a

- The purchasers must certify in writing or electronically that they are investing in a high-risk speculative business venture, may lose all of their investment, and can afford the loss
- Arizona resident (affirmative representation and proof that the individual is a resident – driver license, current voter registration or general property tax records)

- The purchasers must certify in writing or electronically that they are investing in a high-risk speculative business venture, may lose all of their investment, and can afford the loss
- Colorado resident or business entity organized under Colorado law

Pre-Offering Regulatory Filings

- Offering Statement on Form C that includes, without limitation, information concerning the issuer, directors and officers, employees, capitalization, business plan, risk factors, target offering amount, price and terms of securities, intermediary compensation, indebtedness, past offerings, and financial condition
- Progress reports regarding status of capital raising efforts upon achieving 50%, 100%, and greater than 100% of the target offering amount

- Notice filing
- Investor Disclosure Document
- Bank Escrow Agreement

- Notice filing
- Offering Fee
- Investor Disclosure Document
- Bank Escrow Agreement

Investor & Regulatory Disclosures / Reports

- Make Offering Statement available to investor
- Make investor-education materials available to investors
- Annual report on business operations that includes, among other things, updated financial statements  / tax return (based on size of offering), director and officer information, updated business plan, risk factors, summary of capital structure, summary of indebtedness, summary of exempt offerings, and summary of related party transactions

- Inform all prospective purchasers that the securities have not been registered under federal or state securities law and are subject to limitations on resale
- Deliver disclosure document to each prospective purchaser with certain required information
-
Quarterly reports with compensation disclosure and analysis by management of the business operations and financial condition of the issuer

- Inform all prospective purchasers that the securities have not been registered under federal or state securities law and are subject to limitations on resale
- Deliver disclosure document to investor at the time the offer of securities is made
- Quarterly reports, with compensation disclosures and analysis of business operations and financial condition

Sales Limitations

- Sales must be effected through an online intermediary that is a registered broker or registered funding portal who is a member of FINRA or similar association
- Issuers may not advertise terms of the offering except by a notice that directs investors to the intermediary's website
- May compensate individuals for promoting offerings through funding portal channels provided the compensation arrangement is disclosed
- Investors are permitted to cancel investment commitment until 48 hours prior to offering deadline

- Sales must be through one or more internet websites operated by a (i) registered broker, or (ii) a person who receives no compensation and makes a notice filing with the Arizona Corporation Commission
- The issuer may distribute a limited notice stating that it is conducting an offering under the exemption, the name of the website operator though which the offering is being conducted, and a link directing prospective purchasers to the website of the website operator

- Sales must be effected through an intermediary that is: (i) Colorado registered broker-dealer located in Colorado; (ii) Colorado registered sales representative; or (iii) "online-intermediary"
- Issuer may give notice within Colorado that it is conducting an offering that directs potential purchasers to the issuer's designated sales intermediary

Funding Portal Restrictions / Requirements

- Must register with the SEC and become a member of FINRA or similar institution
- Must maintain a fidelity bond of not less than $100,000
- Must maintain records of crowdfunding transactions for a period of 5 years
- Must make the issuer's disclosure documents publicly available online for 21 days before any securities are sold online
- May NOT offer investment advice
- May NOT handle investor funds
- May NOT solicit offers or purchase of securities displayed on its website
- May NOT hold a financial interest in an issuer selling securities through the intermediary

- Must maintain records of crowdfunding transactions for three years
- The website operator must limit website access to Arizona residents
- The Arizona Corporation Commission must have access to the internet website on which the offering is being made

- Must maintain records of crowdfunding transactions
- May NOT handle investor funds
- May NOT offer investment advice
- May NOT solicit offers or purchase of securities displayed on its website
- May NOT hold a financial interest in, or own securities of, an issuer selling securities through the intermediary
- May NOT receive or pay commission based compensation for amount of securities sold



END NOTES:

1 Some publications have characterized an offering with general solicitation under Rule 506(c) as "crowdfunding" because issuers are permitted to advertise the offering on the internet or otherwise so long as all purchasers are accredited investors. This article does not address general solicitation allowed under Title II of the JOBS Act.

This article is intended to provide general information regarding legal developments.  This information is not intended to be, and does not constitute legal advice.  Legal advice can be given, and an attorney-client relationship can be formed, only on the basis of specific facts discussed between client and attorney pursuant to an engagement to perform legal services.

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