How HR2930, The Entrepreneurial Access To Capital Bill Will Work.

Exemption Framework

The following framework is the foundation of HR2930, the Entrepreneur Access to Capital Act that passed the US House of Representatives 407-17 on November 3, 2011.  It is also the foundation for S1791, the Democratization of Capital Act submitted in the Senate soon after.  President Obama also made reference to this framework in the American Jobs Act.

This framework is the suggested rule under which the law should be made.  At the bottom are the shared components each Crowdfunding site must have in order to register to offer crowdfunded securities to the public.

Any entrepreneur/business that does not meet the criteria outlined below or “graduates” from the framework would have to comply with existing SEC rules.  As with all security-related instruments, US anti-fraud provisions prevail.

Definitions and Qualifiers:

Amount & Class of Shares: A “funding window of up to $1M” for entrepreneurs and small businesses. “Small Business” is defined as one with average annual gross revenue of less than $5M during each of the last three years or since incorporation if the business has existed for less than three years.  This definition is consistent with definitions utilized by the Small Business Administration. Straight common shares along with their standard rights as well as Revenue Based Financing (RBF) could be used.  Common stock is on par with similarly used shares in early stage rounds of family and friends financing and RBF is a new form of financing where investors own a percent of future revenue for a certain period of time.

Instead of a typical bank loan which requires a business to pay a fixed interest payment, a revenue-based loan receives a percentage of revenues over a specified amount of time, allowing “interest” payments to fluctuate when a growing company has inconsistent cash-flows or lumpy or seasonal revenues. In a world where business costs such as software and infrastructure are increasingly becoming “as-a-service” and adjust with the ebbs and flows of a business needs, RBF payments automatically ramp up and down along with a business. It’s the inherent variability of RBF that makes the structure so appealing.  Imagine if your business loan payment reduced to zero if your business revenue dropped to zero for an unanticipated quarter, and then automatically kicked backed on when your revenue returned. Another way of saying this is RBF turns loan repayment from a fixed expense to a variable expense.
Limit: Investments from unaccredited investors will be capped at $10,000 or 10% of their prior years Adjusted Gross Income (AGI).  The $10,000 limit is in line with other established financial disclosure limits like those on banking transfer reporting requirements.  Accredited investors will not be subject to any limits. (Note: The vast majority of individuals who choose to make Crowdfund Investments will most likely invest below $500.  The current average is approximately $80 on existing crowd funding platforms).
Risk Disclosure: Given that 60% of Americans now own stocks or mutual funds, there is a certain level of investor sophistication that is greater today than ever before (in the 1930s, only 5% of the population invested their money).  In addition, unlike investing in the public markets where individuals rely upon the experience/advice of advisors, people choosing to invest via crowdfunding will often be investing in their social networks with people they know and trust.  Hence, accreditation should be attached to investors understanding of the risks inherent in this type of investment.  Prior to using these platforms, investors will have to agree to use standard verification technology and to verify that they understand there is no guarantee of return, and that they could lose their entire investment. In addition, they must agree to have an understanding that their liquidity/return is limited to any dividends, sale, public offering or a merger of the company.
500-Investor Rule: Eliminate the 500-investor limit for Crowdfund Investing. A SEC stipulation requiring a company that exceeds 500 individual investors with more than $10 million in assets to file its financials with the Securities & Exchange Commission. According to SEC rules, such a company has 120 days following the end of their fiscal year’s end to file.
The 500 investor rule is a key threshold for private businesses which do not wish to disclose financial information for public consumption. Many believe that the 500 Investor Rule was one of the reasons that Google filed for its IPO when it did, as the company was going to have to start disclosing to the SEC anyway.State Law: Exempt these offerings from state law registration requirements based on the limited size of the amount that can be raised, but leave intact a simplified and modified state law notice filing requirements, similar to the way SEC Rule 506 currently works but less cumbersome. Rule 506 of Regulation D is considered a “safe harbor” for the private offering exemption of Section 4(2) of the Securities Act. Companies using the Rule 506 exemption can raise an unlimited amount of money. A company can be assured it is within the Section 4(2) exemption by satisfying the following standards:

    • The company cannot use general solicitation or advertising to market the securities;
    • The company may sell its securities to an unlimited number of “accredited investors” and up to 35 other purchases. Unlike Rule 505, all non-accredited investors, either alone or with a purchaser representative, must be sophisticated—that is, they must have sufficient knowledge and experience in financial and business matters to make them capable of evaluating the merits and risks of the prospective investment;
    • Companies must decide what information to give to accredited investors, so long as it does not violate the antifraud prohibitions of the federal securities laws. But companies must give non-accredited investors disclosure documents that are generally the same as those used in registered offerings. If a company provides information to accredited investors, it must make this information available to non-accredited investors as well;
    • The company must be available to answer questions by prospective purchasers;
    • Financial statement requirements are the same as for Rule 505; and Purchasers receive “restricted” securities, meaning that the securities cannot be sold for at least a year without registering them.

While companies using the Rule 506 exemption do not have to register their securities and usually do not have to file reports with the SEC, they must file what is known as a “Form D” after they first sell their securities. Form D is a brief notice that includes the names and addresses of the company’s owners and stock promoters, but contains little other information about the company.

General Solicitation: Allow for general solicitation on registered platforms where individuals, companies and investors can meet virtually, ideas can be vetted by the community as a sort of peer review and individuals can make informed decisions regarding whether or not to invest their money. Makes sense, right?

Filing & Reporting: Standardized forms (generic term sheets & subscription agreements) based on industry best practices will be used to maintain transparency and reduce time and expense for all parties.  They will be electronically maintained using standardized procedures. Post funding standardized and automated reporting for use of proceeds will be required on a quarterly basis by entrepreneurs.  Platforms will provide the SEC monthly offering reports that include information on: deals funded, entrepreneurs’ names, social security numbers, addresses, dates of birth, amount of capital raised, list of investors and individual dollar amount contributed.

Platform broker/dealer exemption: Due to the small nature of the dollar amount, and the high volume of automated activity, it will allow facilitation of funding for securities without need for a (FINRA) broker/dealer license by the facilitator, where deals facilitated fall within the constraints of this framework. Without this exception, even a lemonade stand backed by a set of parents would technically have to become a broker/dealer in order to facilitate funding.

Availability: This exemption shall not be available to foreign issuers, investment companies, and public companies.

So, there it is. If you are as excited about this opportunity as we are, please … please … please … contact your Senators and let them feel your passion. When this passes, we will witness a historic moment in job creation and entrepreneurial opportunity never before witnessed in this country. This is a HUGE deal. This will make the Internet froth of the late 1990’s and early 2000’s seem like a minor footnote in economic history. And, this is all GOOD!

Following are the issues and controls inherent in this bill and why they reduce the potential for fraud and the individuals they are intended to protect:

Registration for an entrepreneur will include these fields: SS#, Date of Birth & Address, Phone, email and facebook contact. No foreign residents will be able to post funding proposals to US citizens.  Entrepreneurs need to know that their name, city, state, email and facebook contact information will be PUBLIC information.  Using internet technology, both email addresses and cell phone numbers will have to be confirmed valid. Entrepreneurs will have to agree to a background/address verification (xAVS)/credit check.  If an entrepreneur has committed fraud they will not be able to post a funding proposal.  A large percentage of fraud originates outside the USA , and foreign entrepreneurs will not be allowed to participate.  By providing a way for investors to directly connect to entrepreneurs it reduces fraud. This obviously protects Investors.

Credit Card. Every entrepreneur must pay a minimum fee to list their project.  The fee will cover the cost of background checks and the address on the card must match the address on background report   AVS checks to ensure the address entered on the form matches the address to which the cardholder’s billing statements are mailed. People ordering products and/or services using a stolen card number will never know the real cardholder’s billing address, so this is the mechanism that will stop fraud before it occurs. AVS only works with orders conducted in the US.  Protection for Investors.

Facebook Login. Entrepreneurs and Investors must log in with a Facebook Login. A way to track and verify identity. This requirement may be open to multiple social network platforms. It is one of the debates now being conducted by the Senate Finance Committee.

Post warning messages. Every Crowdfunding site will be required to warn those who may attempt to make a fraudulent offer. The warning will include the notification that IP addresses are being logged. IP addresses can come in handy (though far from bulletproof) when locating people about fraudulent behavior. This will greatly deter the number of instances of fraud. More protection for Investors.

Finally, all Crowdfunding sites will be required to register an Investor Quiz, completed and signed by their investor members. Questions like the following will have to be answered in the affirmative:

1)   Do you understand that most startups fail?

2)   Do you understand that you might never see a return on your money?

3)   Do you understand that these are “restricted shares” and any return will be limited to dividends, stock buy-back, sale, merger or IPO?

4)   Do you understand that Crowdfunding is a high risk investment class, and like most investments, the way to reduce exposure is to diversify (eg: invest in stocks that are not as risk)?

5)   Do you understand that the reason Crowdfunding will work is because it is presumed that you have a 1st or 2nd degree relationship with the entrepreneur?  Do you know him or know people who know him, and do you understand his idea and business model?

6)   Do you understand that it is your responsibility to understand the business idea and how it makes money to decide if it is worthy of your investment?

7)   Do you understand the that investment offering is an arbitrary amount determined by the entrepreneur and if you do not deem it worthy for the risk, that you shouldn’t invest?

So, hopefully all of these details will be sorted out in committee and that they will stay as close to the original exemption framework as possible. And, that the final version sails through the Senate so we can GET BUSY!

If you have questions or comments, please feel free to drop them in below, and we will be happy to try and respond. Thanks.


About Steve King

iPeopleFINANCE™ Chief Operating Officer. Former CEO of Endymion Systems, Inc. a $36m Information Systems Services company. Co-founder of the Cambridge Systems Group, the creator of ACF2, the leading IBM Mainframe Data Center Security product; acquired by Computer Associates. IBM, seeCommerce, marchFIRST, Connectandsell alumni. UC Berkeley alumni. View all posts by Steve King

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