By Amy W. Riedel
As many of you may know, Washington State’s governor, Jay Inslee, signed the Washington State Jobs Act on March 28, 2014. Our very own Peter J. Smith blogged about this development last spring. By enabling crowdfunding on the state level, Washington State is providing a more immediate solution for entrepreneurs and investors who are still waiting for the SEC to finalize the JOBS Act regulations. As Peter mentioned in his post, one of the major advantages of crowdfunding is that it allows startup companies to accept investment capital in the form of smaller investments from a larger group of people. To date, the most widely used exemption from registration has been Rule 506 under Regulation D, which allows companies to accept investment capital from “accredited” or “sophisticated” investors who meet certain thresholds regarding net worth, annual earnings, and/or business sophistication. This 506 exemption, while convenient, narrowed the field of who could invest in a company. Under crowdfunding, many more individuals will have the opportunity to support the companies that matter to them most.
Upon Governor Inslee’s signing, the Washington Department of Financial Institutions “DFI” got quickly to work drafting related rulemaking, issuing the final rules on October 1, 2014, which will become effective on November 1, 2014. The full text of the rules can be found here. The rules present an exciting new option for companies considering equity financing, but one that also requires the issuer follow very specific requirements regarding timing, the offering, investor disclosures, ongoing reporting, and SEC compliance.
Rules for Survival – The Requirements
- Timing Requirements. The first rule is timing – DFI must provide prior approval of the offering. Unlike the 506 exemption, which requires notice within 15 days of the first sale, the issuer must provide detailed notice of the potential offering to DFI on this form. Once DFI has reviewed the form and supporting documents, it will then issue approval to proceed with the offering. This is particularly important for enthusiastic entrepreneurs to remember as they develop their business plan, timeline, and momentum – they must first comply with these regulatory provisions before actually seeking investors.
- Issuer Offering Requirements. Next, the offering will need to meet basic issuer requirements:
- The issuer is an entity organized and doing business in Washington State;
- The issuer will not raise more than $1,000,000 in a twelve month period
- The issuer must also specify a minimum target offering: the minimum amount of money it will raise within a specified deadline that is sufficient to implement the issuer’s business plan; and
- The issuer must have an escrow agent and an escrow agreement that with that agent which includes terms specified in the DFI rules.
- Investor Qualification Requirements. Issuers are also required to obtain certain verifications from investors regarding annual income and state of residence. Specifically, investors must:
- Be residents of Washington State;
- Only invest the following maximums in 12 month period amongst all potential issuers:
- If investor’s net worth or annual income is less than $100,000, the maximum is the greater of $2,000 or 5% of the annual income or net worth of the investor; or
- If net worth or annual is above $100,000, the maximum is 10% of the investor’s annual income or net worth, but no more $100,000.
- Acknowledge by signature the following statement: “I acknowledge that I am investing in a high-risk, speculative business venture, that I may lose all of my investment, and that I can afford the loss of my investment,” and
- Confirm to the issuer that the equities are being purchased for investment, and not for resale.
- Reporting Requirements. As long as there are outstanding securities that were issued pursuant to the Washington State Jobs Act, the issuer must provide quarterly reports to the shareholders. These reports should be publically available and free of charge on the issuer’s website within 45 days of the end of the fiscal quarter. The reports must include the following:
- Executive officer and director compensation, including cash, bonuses, stock options, or other equity securities;
- The names of any of the issuer’s shareholders who hold 20% or more of the issuer’s outstanding securities;
- The names of the issuer’s officers, directors, managing members, or other people of similar responsibilities; and
- A brief analysis of the business operations and financial conditions of the issuer by the issuer’s management.
This reporting requirement is a concern for some issuers, particularly those who don’t want to share their financial statements with the public at large each quarter. On the other hand, these financial disclosures can create a positive open dialogue with current shareholders, as well as future investors and potential employees. A company should evaluate this obligation not only in the present as they consider immediate capital, but also their future responsibilities to these investors as the business may grow.
- Federal Compliance Requirements. It is also important to keep in mind that this state exemption relies on an overriding federal exemption for intrastate offerings, Rule 147 under Section 3(a)(11) of the Securities Act of 1933. Since the federal crowdfunding act has not been completed, issuers are instead relying on this existing exemption when following the Washington State Jobs Act. This federal compliance obligation creates two potential problems:
- Advertising. As states began circumventing the long delays in enacting the JOBS Act by relying on Rule 147, the SEC jumped in to point out an additional hurdle companies will face through advertising. The SEC issued Compliance and Disclosure Interpretations last April and again more recently on October 2 regarding the issue of online advertising. The result of this guidance is that issuers may advertise offerings online via their own website or on third party websites (e.g. social media), but only if they can use technological means to limit the access to in-state residents, for example, by limiting access to those with an I.P. address located in-state, or by requiring that users verify primary state of residence before accessing materials. It is unclear how realistic this actually is for companies. As a result, online advertising should be approached with caution and serious analysis of the potential limitations of technological means. The SEC indicated that issuers should also provide clear disclaimers and restrictive legends indicating that the offering is only available to in-state residents. This is true not of not only online advertising, but also the offering documents.
- Shareholder Maximums. Beyond rule 147, the issuer must also comply with Section 12(g) of the Securities Exchange Act of 1934. This requires that issuers must register with the SEC if they have (A) more than $10 million in assets and (B) a class of securities that is held by 2,000 people or 500 people who are not accredited investors. The registration required by Section 12(g) is a costly and burdensome obligation that is not appealing to most startups – in fact it is the reason that issuers are seeking this crowdfunding exemption in the first place.
Issuers will need to carefully guard the total number of their shareholders, keep detailed and accurate shareholder records (a potentially burdensome task as the number of shareholders increases), and include strong stock transfer limitations in agreements with shareholders.
The Result: Proceed Enthusiastically, but With Caution
Washington is enacting an exciting new law that will open investment opportunities to more of the public and allow startups more options to raise capital. This exciting new law is also one that may not be right for all companies considering equity fundraising, and one that should be carefully analyzed by the company and counsel. In their analysis, companies should consider the advantages and disadvantages of ongoing quarterly reporting, the logistics of managing potentially large numbers of shareholders, the potential limitations on advertising, and the timeline required by DFI, not to mention the host of unforeseen issues under this new regulatory scheme.
The good news is that there are many capable and competent professionals eager to help business navigate these new rules. If you would like to discuss the possibility of crowdfunding or other equity fundraising, be sure to reach out to competent counsel (including Apex Law!) for guidance.
The article provided above is for general information purposes only and should not be relied on as specific legal advice. This article does not form an attorney-client relationship. If you have any questions about this article, please feel free to contact Amy W. Riedel at firstname.lastname@example.org.