Intrastate crowdfunding offerings may not exceed 500 investors — unless you want to be an SEC reporting company

In recent months, individual states have been jumping on board the crowdfunding bandwagon by revising their securities laws to make it simpler for companies in their states to raise capital from individual investors over the internet.  These are laudable efforts and will help small companies legally raise funds from outside investors.

As other commentators and analysts have described, these intrastate crowdfunding exemptions have limited filing requirements with state governments and utilize the Section 3(a)(11) exemption from federal registration of the offerings under the Securities Act.  From the standpoint of the companies issuing securities, this seems like a great deal.  They only have to deal with their own state government and can freely sell investment interests within their local communities to an unlimited number of investors.  They are not limited to selling to accredited investors, and can sell to anyone for as little as they are willing to accept and as much as the particular state requirements permit.

Now here is where federalism becomes an issue for intrastate sales of securities.  While specific intrastate offerings of securities are exempt from registration under the Securities Act, if the company receives equity investments from 500 or more holders of record who are not accredited investors, that company may be required to become an SEC reporting company under Section 12(g) of the Exchange Act (the reporting threshold also requires that the company have $10 million in gross assets — that threshold may well be met by a company that is achieving success following a significant capital raise).  Even if the company originally sold to fewer than 500 investors, but those investors sold part of their investments to other people after the required holding periods, the company may find itself with more than 500 holders of record.

This means full registration with the SEC.  Annual and quarterly filings, current reports, financial statements produced under US GAAP, disclosure of management compensation, detailed “management’s discussion and analysis”.  This is not something a company wants to commit itself to by mistake.

Originally the reporting requirements for the Exchange Act only applied to companies whose securities were listed on national securities exchanges.  In 1964, the Exchange Act was amended to expand the statutory registration requirement to include issuers of securities traded-over-the-counter.  This category includes all securities sold during an intrastate offering (even if there are statutory or contractual limitations on the transfer of the securities).

The federal crowdfunding exemption from registration under Section 4(a)(6) of the Securities Act includes a provision that exempts those securities from the holder-of-record count for reporting under the Exchange Act.  CrowdCheck confirmed with the Division of Corporate Finance at the SEC that there is no such exemption from the holder-of-record count for securities issued pursuant to the Section 3(a)(11) exemption.

Notice that I am saying “holders of record” rather than “investors”.  This is an important distinction when it comes to triggering the reporting requirements of the Exchange Act.  When a company sells its equity securities directly to individual investors, which the investors hold themselves, those investors are the holders of record on the company books.  As an alternative, those equity securities may be held by brokers, dealers, or banks for the benefit of the investor.  In such cases, the holder-of-record count does not consider the separate investor accounts in which securities are held, but only the entity which actually holds the equity security, as reflected on the company’s books.

Companies issuing securities under the intrastate crowdfunding exemptions can be proactive and not rely solely on the actions of their investors to maintain a holder-of-record count under 500.  For instance, an issuer may require that securities sold pursuant to an intrastate crowdfunding exemption be held by a registered broker, such as Folio.  Such a requirement will also make life much easier for the company as it tries to keep track of who holds its securities and who is entitled to receive periodic communications as required by state law.  However, this type of solution will add costs to the offering for the company issuing securities.

All this is to say that even when securities are sold exclusively through an intrastate transaction, companies issuing securities must be aware that federal securities laws could still require the company to register its securities and start engaging in regular reporting with the SEC, and that there are solutions to these concerns that companies should plan for.

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