Capital Fundraising, Crowd Sourcing and Securities Law
“With regulators considering easing fund-raising rules for start-ups …” a recent Wall Street Journal story began, “social-networking sites that link entrepreneurs to large pools of donors are gearing up for a boom.”
First, the background. Federal and state securities laws govern the sales – including the solicitation of sales – of securities, affecting all efforts to raise capital for startups. This includes any public efforts to raise money, and includes raising small or large amounts of money. Generally, sales and solicitations of sales of stock require compliance with SEC and various state securities law, and more particularly the registration requirements of those laws.
The applicable federal laws are SEC regulations governing how capital can be solicited and from whom capital can be raised.
Advertising and Solicitation Rule. SEC Rule 502(c) prohibits “any form of general solicitation or general advertising” for the sale of securities, except as permitted by other rules. These rules traditionally prohibited general fundraising through radio, television and newspaper advertisements, but for the same reasons would bar the same conduct through Twitter, Facebook and other social media.
Accredited Investor Rules. SEC Rules 504, 505 and 506 permit sales of securities to “accredited investors” without compliance with the securities registration requirements. Accredited investors” is defined in SEC Rule 501, individuals with net worth exceeding $1 million or with annual income exceeding $200,000.
Now, the current context. Social media is not new nor are calls to relax the capital raising rules, but noise for changes has come from increased start-up activity and, in particular, increased popularity of public fundraising sites seeking to “crowdsource” capital for ownership purposes beyond donations. The Wall Street Journal reported in April that the SEC is considering revising its advertising and solicitation Rule, if not necessarily to permit unfettered general solicitations, then at least to allow increased recognition of some use of social media for startup companies and small businesses seeking to raise relatively small amounts of capital. SEC chairman Mary Schapiro sent a letter in April to Darrel Issa, Chairman of the House Committee on Oversight and Government Reform, stating that the Commission was considering new Rules or relaxing existing Rules. Schapiro noted that she had received a widely-supported petition to ease rules for crowd-funding capital raises of up to $100,000.
The Journal noted, however, that in the early 1990s the SEC relaxed registration requirements for capital raises of up to $1 million, as well as accredited investor rules for wealthy individuals. The story also noted that those relaxed requirements had been abandoned at the end of that decade out of revived concerns about investor fraud – perhaps not coincidentally, around the same time as the dot-com crash.
Current advocates for relaxing the rules – see for example, Joe Wallin’s Startup LawBlog – suggest that the SEC’s rules “don’t make sense”, although without offering much support other than that Depression-era legislation and accompanying Rules never contemplated social media. That narrow point in and of itself is almost certainly correct.
Presumably, though, rules designed to prevent fraud still accomplish exactly that in light of the proliferation of ways for fundraisers to reach a broader investing public. The advocates of changing the rules seem to be principally the same people who have always loathed the SEC, namely people trying to raise money from the public. A better argument against the SEC’s existing rules might be simply that investors do not need these protections anymore, not that the existing rules aren’t adaptable to the medium. That may or may not be true, but that does seem to be Wallin’s real argument when he writes, “If folks are willing to acknowledge that they are willing to lose their money on a highly speculative venture, let’s let them.”
Interestingly, the National Venture Capital Association has already publicly opposed any such broad regulatory relaxation. From the NVCA’s perspective, securities law changes that incentivize small capital raises will discourage ultimate interest in companies seeking to tap into the broader public capital markets through traditional initial public offerings (IPOs). Since IPOs are the most common form of payday for venture capital, this of course diminishes the attractiveness of venture capital, for investors and for entrepreneurs.