Use Caution when Evaluating Crowdfunding Deals
In May 2016, the Securities and Exchange Commission (SEC) began allowing private companies to raise as much as $1 million per year from everyday investors. How? The SEC approved the use of online “crowdfunding” platforms run by intermediaries to carry out the mandate under the Jumpstart Our Business Startups (JOBS) Act. Here’s a closer look at the mechanics of crowdfunding, the reporting requirements based on the size of the company and the market’s response to crowdfunding in its first year.
Historically, the SEC has allowed private companies to solicit capital only from “accredited” investors, which are people with net worth of at least $1 million (excluding the value of their primary residences) or annual income of more than $200,000 per individual (or $300,000 for married couples). Online solicitations to these wealthy individuals were required to come from SEC-registered intermediaries.
In October 2015, the SEC approved final crowdfunding rules that establish a registration exemption for companies raising up to $1 million a year through online funding portals. They also created a registration process for intermediaries and added a new incentive for them by allowing intermediaries to take ownership stakes in the issuers as compensation.
Investors don’t need to be accredited to participate in these offerings. The rules do, however, limit how much investors can purchase in an offering. Investors earning less than $100,000 annually can invest the higher amount of:
- $2,000 per year, or
- 5% of the lesser of their net worth or annual income.
Investors with both net worth and annual income above $100,000 can invest the lesser amount of:
- 10% of their annual income, or
- 10% of their net worth.
Additionally, no one is allowed to invest more than $100,000 in crowdfunding deals in any one year. The SEC also requires a one-year holding period before securities purchased through a crowdfunding deal can be resold.
Assurance and disclosure requirements
Companies that sell securities through an online crowdfunding portal must provide some basic information, such as a description of the business and the names of its officers, directors and primary owners. Issuers must also comply with three tiers of disclosure, based on the size of the offering:
- 1. Less than $100,000. The company must provide investors with federal income tax returns certified by the chief executive.
- 2.$100,000 up to $500,000. The company must have its financial statements reviewed by an independent public accountant.
- 3. Above $500,000. The company must provide audited financial statements, unless the offering is the first time the company is raising capital using the crowdfunding process. In that case, the company needs only to have the financials reviewed by an independent accountant.
In addition, all issuers must prepare their financial statements in accordance with U.S. Generally Accepted Accounting Principles (GAAP).
Year in review
So, how has the market responded to online crowdfunding? Young companies are increasingly participating in the nascent crowdfunding market to fund up-and-coming businesses like bakeries and craft breweries. Through the end of 2016, 156 companies made 163 offerings seeking a total of $18 million from investors. The average offering was only $110,000.
The SEC has been monitoring the crowdfunding market to ensure that issuers aren’t misleading investors. Although some issuers clearly understand and follow the assurance and disclosure rules, many companies haven’t fully adhered to them. Some omissions of disclosures or departures from GAAP are more egregious than others. So far, the SEC hasn’t found enough noncompliance to warrant pulling the plug on crowdfunding.
But the SEC cautions investors to review crowdfunding deals carefully. The process for an initial public offering (IPO) of common stock incorporates a relatively strong set of investor protections. Conversely, crowdfunding is classified as an exempt offering, and the SEC doesn’t supervise the offerings. Instead, the JOBS Act contemplated the market would use the wisdom of the crowd to act as protection against potential fraud.
Before considering raising capital through online crowdfunding portals, it’s important for companies to understand the reporting requirements, so they won’t inadvertently mislead investors by providing inconsistent, erroneous or incomplete financial data. At the same time, investors should perform in-depth due diligence to avoid investing in ventures that don’t follow GAAP or provide adequate disclosures. An accounting and auditing professional can help issuers and investors objectively evaluate a crowdfunding deal.
If you have questions regarding crowdfunding deals, please contact Dan Ward, Principal, Audit Services, at 314.983.1237 or firstname.lastname@example.org.