Jumpstarting a Business via Crowdfunding
Friday, July 10th, 2015
By: D. Page Kelley, III
We’re all familiar with the concept of crowdfunding, which provides the means for individuals or companies to seek funding from a large number of investors, via the internet, for a wide range of projects. For example, in the case of a crowdfunded album, contributors who agree to provide funds toward the costs of recording, manufacturing and marketing that recording may be rewarded with special benefits, like an advance copy of the recording, “swag” like T-shirts or signed photos, or less tangible benefits like being listed as a contributor in the recording credits.
However, crowdfunding benefits have typically not included ownership interests in the company or music venture that will own recordings or other music assets. Why haven’t ownership interests in music companies also been offered via crowdfunding? From a non-legal perspective, founders of a company may simply want to retain full ownership and control. However, from a legal perspective, public offerings of profit participations or ownership interests in businesses are generally viewed as offers of securities in the United States, and as such are subject to the application of both federal and state securities laws, which have historically greatly restricted and severely limited the scope of such public offerings.
In an effort to provide small companies with greater access to investment, The Jumpstart Our Businesses Act, or JOBS Act, was enacted into law in April 2012. Since that time, start-up companies have been able to engage in public advertising of equity securities offerings under Regulation A of the JOBS Act, but those offerings have remained subject to a number of constraints. Among the most important: (1) Regulation A “capped” the amount that a company could raise in a 12-month period at $5 million; (2) although public advertising (including online advertising) was permitted, only qualified investors (individuals earning more than $200,000 per year or having a net worth of over $1,000,000) could ultimately invest; and (3) in addition to complying with the federal JOBS Act regulations, a company offering securities had to comply with the separate securities laws of each of the 50 states in order to offer securities nationwide, a costly and burdensome process.
However, on March 25th of this year, the Securities and Exchange Commission (“SEC”) adopted final rules under the JOBS Act, known as Regulation A+. When those rules become effective in June of this year, they will provide start-up companies with the ability to raise far more capital from a far larger pool of potential investors through crowdfunding, and compliance with state securities law in connection with such offerings will become much less burdensome.
Regulation A+ creates two (2) new tiers of offerings, Tier 1 for offerings of up to $20 million, and Tier 2 for offerings in excess of that amount up to $50 million. Anyone may invest in Tier 1 offerings; there are no financial requirements for potential investors. For larger, Tier 2 offerings, purchases by an individual investor may not exceed 10% of the greater of that individual’s annual income or net worth. Tier 1 offerings must continue to comply with all state securities laws, but a newly-implemented coordinated review process among state administrators is expected to greatly streamline the process. Larger Tier 2 offerings are generally exempt from the requirements of state securities laws.
Although Regulation A+ is designed to give companies the ability to raise more money through a larger pool of investors, the SEC has also retained for Regulation A+ offerings substantial disclosure requirements for the protection of those investors. For example, before actually making sales of securities, both Tier 1 and Tier 2 offerors must file with the SEC a very detailed Form 1-A offering statement concerning the company’s business, its management, the offered securities, the material risks of investment and the planned uses of the investment proceeds. The Form 1-A must also include detailed financial statements. In the case of Tier 2 offerings, the financial statements must be audited. The submitted Form 1-A must be reviewed and approved by the SEC before sales can commence. And information contained in the Form 1-A, with some exceptions, must be made available to investors. In addition, both Tier 1 and Tier 2 offerors must comply with any applicable continuing reporting requirements to the SEC and to investors.
However, it is important to note that Regulation A+ permits offerors to “test the waters”, by posting basic information concerning a potential securities offering online in order to determine potential investor interest, before incurring the costs of preparing and filing the detailed Form 1-A and any required financial statements. Thus, substantial costs need not be incurred unless and until demonstrated interest justifies that undertaking.
Commentators and business analysts are virtually unanimous in their opinion that many new businesses will avail themselves of Regulation A+ funding. Presumably, new music entities will be among them. If a new music business venture is prepared to meet the filing and disclosure requirements necessary for the protection of investors, Regulation A+ offers the potential to gather enthusiastic investors of any and all financial means, and to benefit from their publicly-shared enthusiasm. However, there are also disadvantages to a company’s founders in sharing ownership of a new venture with, effectively, a large group of strangers. For example, maintaining creative control is likely to be crucially important to individuals starting a new music venture. That process may become more difficult if the company’s founders are being publicly “second guessed” by a potentially large and vocal group of investors. In addition, to the extent that the company’s offering materials have described specific uses of funds or specific business activities, the company’s founders may find that their decision-making flexibility is restricted by their prior disclosures to investors
Historically, for new entertainment ventures, financial risk has been quite high in comparison to anticipated returns. Especially given today’s rapidly changing and unpredictable music marketplace, new funding sources are not likely to alter that reality. However, Regulation A+ offerings could provide the ability for a company’s founders to spread that risk over many investors, each of whom will be risking a relatively small amount, rather than having to seek funding from a small number of “deep pockets”, as has more often been the case in the past. If that happens, the “Jumpstart Our Businesses Act” might really have a shot at achieving its goal.
Published in MusicRow Magazine (www.musicrow.com), June/July Awards Issue