Why Intrastate Equity Crowdfunding

In the last article, I introduced the concept of intrastate equity crowdfunding as a fundraising mechanism for for-profit businesses in their early stage. This article continues the series by discussing why an entrepreneur or company might choose intrastate equity crowdfunding versus the other available options. To start, we'll look at what fund-raising options exist within the law. Then we'll look at some pros and cons of intrastate equity crowdfunding as against those other options. I think you'll see, by the end of the article, that intrastate equity crowdfunding is not for every situation or every business, but that it has a unique position among the options for certain kinds of fundraising situations. But first, we need to motivate the entire discussion - why is this a legal matter at all, and why can't an entrepreneur simply raise funds from any source available?

Wait, there's a limit to how I can get funded?

As a starting point, we need to take a look at the development of the law in this area. Quick history review: on "Black Tuesday," October 29, 1929, the stock market completed the biggest self-off in its history (until about 40 years later, but let's stick to the point). It deflated in value from "Black Thursday" until Black Tuesday by a total of around 30%. Over the next few months, it continued to fall signaling the start of the worldwide Great Depression, which dominated life for more than a decade and probably led to World War II. Conventional wisdom at the time, and in some quarters since, blamed the Depression on the stock market crash that was in turn blamed on rampant speculation: people were buying stocks not based on their projections of the performance of the companies, but instead based on their speculation as to what other stock buyers would do.¹ In this climate, the U.S. Congress adopted the Securities Act of 1933 (often called "the '33 Act"). It was followed by the Securities Exchange Act of 1934 (the "'34 Act"), and a host of other laws since. The '33 Act regulated the sale of ownership interests in companies, and basically required a fairly rigid transparency for companies that would be publicly traded on stock exchanges. The '34 Act regulated the exchanges themselves, and the trading of shares. Between them, the Federal securities laws regulate almost every aspect equity transactions across state lines.

The basic principle of the new securities regulation is that companies that sell "securities" must be transparent, which means they must file and deliver initial and annual public reports that detail their financial condition, prospects, risks, and the specific risks of investing; must avoid making any false or misleading statements; and must not trade in a manner that is unfair. The idea is that investors and potential investors will be able to make informed decisions, will be protected against fraud, and will invest primarily in (albeit risky, but appropriately-priced) entrepreneurial ventures while companies and their officers and principals will avoid illegal or unsavory conduct that would have to be reported, and aggressively work for their shareholders' and the public's benefit. In other words, companies are either very closely held (family businesses,) or else they are large, publicly-traded (or at least publicly-reporting) enterprises. But such a division is obviously unworkable, and the Federal securities regulations make room for that by exempting some companies and some transactions from the requirements.

One significant exemption from the Federal regulation is that any transaction that takes place entirely within a single state is completely exempt from the Federal law. That means that there are a whole class of securities transactions that are subject only to state law in the state in which they occur. For that reason, every state has adopted so-called "Blue Sky" laws to regulate intrastate transactions. For the most part, these laws (including Alaska's) mimic the essential principles of Federal securities regulation, but there are differences and the differences can be significant.

Because it will help you read other resources around the web on this topic, some quick vocabulary. A "security" is, generally speaking, any interest in the profits or debt of an entity. So loans can be securities, bonds can be, but ownership interests in a company almost always are. An "issuer" is an entity that issues a security. Typically, that is the company. So, for example, Coca-Cola Corporation is an issuer. The stock in that issuer is a security. Buying and selling that security is a regulated securities transaction. One way to understand the basic rule of securities regulation is: if the issuer meets the requirements, it must be registered with a regulator (usually the Federal SEC); securities must be registered with a regulator (either SEC or, in Alaska, the Department of Commerce, Community, and Economic Development Division of Banking and Securities ("DBS")) unless exempt; and transactions in unregistered securities must be registered unless exempt. So three levels: issuer, security, or transaction and any one of them can trigger a filing obligation or more.

Final thought before we get to the meat and bones: while compliance can be very expensive, non-compliance is almost always worse. This is not the place to get too deeply into the costs of non-compliance, but they can be considerable (particularly if the issuer goes for a later round after screwing up an early round of financing). That said, the costs of generating and providing the materials that are required for a fully compliant non-exempt transaction are also outrageous. Spending $30k-$100k to get the funding prospectus right can really moot the benefits of a company's $50k initial funding raise! For an early or growth stage venture, it is almost certainly worth spending some time and effort to complete a properly managed funding round.

What Are The Exemptions?

As noted above, issuers are generally exempt from SEC requirements unless they are not - unless a company meets the requirements of a filing company, it does not have to file. Put differently, the default is that issuers are exempt. In particular, early stage companies are exempt unless they have done something very wrong. And for our purposes, we will regard restricted securities (that is, securities that clearly state that they cannot be resold except under very special circumstances)² as being exempt.³ That means that if a particular event is going to be subject to a filing requirement, it will be because the transaction is non-exempt. The chart and discussion that follows discusses transactional exemptions.

The Chart

How To Read The Chart

Holy cow. Looks complicated - don't worry, it is. But it will help if you understand what the columns are intended mean and the possible entries:

• Exemption: This is the name and section of the exemption in whatever law or regulatory regime it fits.
• State/Fed: There are 3 possible entries, here. Fed Only means that if this exemption is utilized, only Federal securities regulations apply (in other words, if this exemption works for the raise then the issuer does not need any other exemption). Fed/State means that this regulation provides an exemption to Federal securities regulation but an additional State exemption is necessary, or else the transaction will have to be filed at a State level. Alaska means that a transaction making use of the exemption will be exempt from State regulation in Alaska, but it may still be subject to Federal regulation. That just means that the transaction must meet the requirements of Section 3(a)(11), Rule 147 or 147A, or occasionally Rule 504, Reg A Tier 1, or Section 4(a)(2). In practice, this is very often Section 3(a)(11) at the moment.
• Max raise: Most exemptions have a 12-month lookback. If there is a limit in this column, the issuer must not raise more than the limit within the prior 12 months. Note that there is a ton of subtlety that I am glossing over, here. For instance, are we looking back to all raises? Or just those that have utilized this particular exemption? Are we looking at a single round, or all rounds? Do we include the amount of the current raise? Do we include 12 months prior to the start of the current raise, its end, or a particular transaction within it? How rigid are these technical rules? The answers to all of these subtle questions is beyond our scope. Look for a future article.
• Advertising: This is an overview of what kind of communication the issuer is permitted to engage in and still qualify for the exemption. In general, if no advertising is permitted than only "insiders" and folks with an existing relationship with the issuer or one of its principals are permitted to invest. That very tightly limits who can invest in an issuer in a particular funding round. The smaller the circle of potential investors, the less total investment is available and the less competition investors have with one another (meaning the issuer may have to give more in order to get the same level of investment).
• Issuer limits: These are any limits that are placed on the issuer. For instance, many exemptions are not available to issuers that are disqualified because someone involved in the issuer is a "bad actor" under the securities regulations. This includes people convicted of a felony or certain misdemeanors, subject to certain civil orders or securities enforcement orders, etc. A good overview can be found at the SEC's Disqualification Compliance Guide. "Bad Actor Disqualification+" in this column means there are some additional restrictions on what issuers can participate, mostly cutting out investment companies and some others.
• Investor limits: Many exemptions are limited to investors who are presumed to be able to protect themselves or else can absorb the level of loss represented by a failed investment within the boundaries of the exemption without significantly affecting their ability to continue their lifestyle. "Accredited investors" meet certain wealth or income guidelines whereby they can stomach a complete loss. "Sophisticated investors" have special training, experience, or information that allows them to fully evaluate an investment opportunity and protect themselves from loss.
• Filings: In order to take advantage of the exemption, the issuer may have to file some paper. Form D is a document filed with the SEC through its EDGAR filing system that lays out information about the issuer and its principals. It also describes the issuance (the security and the terms of the offer to transact) and financial information about the issuer.

So How Do I Pick An Exemption?

There are a lot of questions that go into choosing an exemption. One that didn't fit into the chart was whether one exemption is mutually exclusive. For instance, if a particular raise is subject to Regulation D (say Rule 506(b)), does that mean it is not exempt under Section 4(a)(2) (assuming it meets the requirements of that exemption as well)?⁴ But assuming you can only choose one (combination of) exemption(s) for a particular raise, a good rubric for choosing might look like this:

1. Look at the issuer restrictions. Eliminate any exemption for which you cannot qualify.
2. Estimate how much you need to raise. Eliminate any exemption that does not permit you to raise enough to meet your needs for the projected round.
3. Determine whether you already know your investors. If you can reach out through one or two levels of contacts and likely complete your raise, you probably do not need to advertise. If you will have to solicit outside of your inner circle, eliminate any exemption that does not permit solicitation.
4. Look at your non-fundraising goals for this round of financing. Aside from getting money in to take your next step, what else would you like this round to accomplish? For instance, if you want a community to feel invested in your business a good way to generate that kind of goodwill is to allow them to invest in your business. That likely requires crowdfunding. If your business would benefit more from getting some sophisticated individuals closely involved in the decision-making, you may benefit more from an accredited-investor-only raise. If you restrict solicitations and investments to accredited investors it opens the doors in many ways, so that may be a good option. Eliminate the exemptions that don't fit your desired and probable investor mix.
5. From what is left, choose the exemption that best fits your needs. This is likely to be the one that is easiest to use: ie - it has the lightest filing requirements, the easiest proof requirements, and requires the least in terms of investor disclosures.

And Why Equity Crowdfunding?

If this or something like it is the test, when would an intrastate equity crowdfunding exemption be the best choice? When the total raise for the round is $1M or less, the issuer meets the requirements, and it is looking to build goodwill and common purpose within Alaska. Note, I don't mean to say that Alaskans need to be the primary market, just that Alaskans need to have an interest in it. For instance, I could see intrastate crowdfunding as a great option for a company that markets products to tourists to a particular region and wants everyone in the region to be invested in selling their "home grown" products or services. Or for a startup tech company that, if successful, will create jobs and opportunity for rural young people with an interest in high tech.

This is worth emphasizing. The primary reason to choose crowdfunding as an exemption is not the number of investors (there are other exemptions with no limit on the number of investors,) or the type of investors (there are other exemptions with no limit on the type of investors,) or on the max raise ($1M is the LOWEST limit of any exemption). Instead, there are two reasons to choose an intrastate crowdfund: (1) the unique combination of all of these qualities, and (2) intrastate equity crowdfunding may be the best way for an early stage company to build invested goodwill within its home community.

Because it is very new (it only became legal in Alaska in 2017) it has not been well-tested, and companies have not yet figured out how to take advantage of this benefit. In fact, as of this writing only one issuer in the state has attempted an intrastate equity crowdfund, and they faced a lot of the struggles that a first mover will encounter. The next article will discuss some limitations that have also interfered with issuers really fully benefitting from this new exemption. But intrastate equity crowdfunding does represent an innovative opportunity for companies to get a lot of "locals" on their side in a meaningful way, which may help drive other benefits.

Conclusion

There are excellent reasons to choose equity crowd-funding over other varieties of legal fundraising methodologies. This is a place to take some care: getting it wrong in the first round can make the second more expensive, and so on. But if your business would benefit from invested goodwill within Alaska, and if the amount of the raise is small, equity crowdfunding may be an excellent option.

^{1. In case you are curious, I think both the cause of the crash and the cause of the Depression itself are much more complicated than this. I blame the Depression on a whole host of factors, chief among them a price deflation that had started somewhat earlier and some misguided monetary policy. Speculation did not help the stock market stay afloat, but I think the crash was actually a signal of what had already started and not a cause of things to come. That said, the world has changed: if 2008 taught us anything, it is that so much wealth is tied to the equity market today that a significant correction can devastate the underlying economy and yes, actually cause a downturn.}↩
^{2. Securities may be represented by a piece of paper, the bearer of which is considered the owner of the security. If so, the piece of paper is called a "certificate" and the security is said to be "certificated". Not all of them are: some interests are represented just by an agreement, or by an entry in a stock ledger. Those are "non-certificated securities". The statement discussed in text clearly setting out the transfer restrictions must appear on the certificate of a certificated security, where it is called a "legend" and the security is said to be "legended".}↩
^{3. It is not this simple, but our assumption winds up being a very good approximation.}↩
^{4. The answer to this particular example is "no" - Reg D is not exclusive. See 17 CFR 230.500(c). But not all of them are so simple.}↩