Navigating the Equity Crowdfunding Craze: What Illinois Entrepreneurs & Businesses Should Know

By: Rita W. Garry and Nichole M. Fundora

Illinois entrepreneurs and businesses had more than one reason to celebrate on January 1, 2016. Just in time to ring in the New Year, House Bill 3429, which amends the Illinois Security Law of 1953 (the “Act”), became law and created a new private placement exemption from registration; namely, 4T. Thereafter, the Illinois Secretary of State issued proposed regulations to use 4T (Section 130.493) which are expected to be finalized in late February or early March this year.

The new 4T exemption and Section 130.493 detail the hoops Illinois businesses must jump through before seeking capital through equity crowdfunding, including extensive disclosure, reporting and qualification requirements. The new law and regulations make it clear equity crowdfunding is not a capital-raising vehicle businesses can rush into without thoughtful planning and guidance. Unlike the donation models and peer-to-peer lending crowdfunding campaigns, equity crowdfunding involves the regulated offer and sale of a security. At the outset, an Illinois business must examine its need for equity crowdfunding, understand the requirements and limitations of the 4T exemption, and evaluate the risks and obligations of crowd equity stakeholders.

What is the 4T exemption?

Because equity crowdfunding involves the sale of securities, Federal and State security offering registration requirements are an initial concern. These registration processes are complex and expensive and, consequently, rarely used by startup companies. However, both State and Federal laws provide exemptions from registration to permit the sale of securities in private placements, such as the newly created Illinois 4T exemption. It is important to note that even though securities offerings can be conducted without formal registration filings, all offerings must comply with all anti-fraud laws and regulations or run the risk of civil and criminal liability and penalties.

Under the Illinois 4T exemption, an Illinois business, as the issuer, can sell its securities strictly to Illinois residents, whether or not the investors are accredited investors, to raise capital to begin and/or continue operating an Illinois-based business. As a result, members of an Illinois community can now invest in their local businesses and potentially share in their success. However, the exemption does have limitations:

-The offer or sale must comply with the Federal intrastate offering exemption.

-The Illinois issuing company cannot raise more than $1,000,000 of equity through intrastate equity crowdfunding in a 12-month period. However, this limit is raised to $4,000,000 if the business makes audited financial statements available to prospective investors and the Secretary of State. Important to note, money contributed by an accredited investor does not count towards the monetary limitations set out in 4T exemption.

-The Issuer does not sell more than $5,000 of securities to the same Illinois resident investor in a 12-month period.

How do you use the 4T exemption?

Prospective issuers must file the Crowdfunding Issuer Form (FormCF) with the Illinois Secretary of State, 15 days before they intend to engage in equity crowdfunding or post an offering on a registered internal portal. This registration is effective for 12 months and subject to annual renewal 30 days prior to the end of any 12-month period. Among other things, Form-CF will require the issuer to provide proof of corporate good standing, use of a qualified escrowee to hold subscribed funds until the offering is closed, use a registered internet portal to host the issuer’s offering, and agree not to pay any commissions or other remuneration to any person (including the registered internet portal) for soliciting sales of its securities unless they are Illinois registered dealers or securities salespersons. Although, in regard to private placements, Illinois is generally considered a disclosure state, the Illinois Securities Department may investigate an issuer’s management to ascertain the accuracy and completeness of its compliance with these pre-offering requirements.

Beyond filing requirements, the 4T exemption and corresponding regulations create an affirmative duty on the issuer to fully and fairly disclose all relevant organization, business, and offering details, including its ownership and capital structure, business plan and financial information. Issuers must provide investors with offering details, such as minimum target offering amounts, amount of shares to be issued and the offering deadline date to meet the minimum funding amount. The offering also must conspicuously notify investors of their cancellation rights, which allows an investor to cancel his or her investment up to 48 hours before such offering deadline. Moreover, if an issuer fails to earn the target offering amount by the deadline, it must fully refund the investors any amounts invested.

How do you prepare for equity crowdfunding?

Choosing the Right Entity. Generally, equity crowdfunding is only suitable for certain business entities. For example, an S-corporation is not likely to benefit from equity crowdfunding since S-corporations, by law, are restricted to fewer than 100 shareholders. Likewise, investors will not be attracted to a partnership since they will be exposed to personal liability in connection with the partnership’s debts and obligations. Corporations, limited partnerships and limited liability companies are the best entity structures for businesses seeking equity crowdfunding. However, entrepreneurs should consult with a business attorney and an accountant to help choose the right entity for his or her business, since each business entity results in different legal compliance and tax consequences.

Management Protection. Before exploring equity crowdfunding, a business needs to evaluate its own corporate governance. Without tailored foundational documents, such as customized articles of incorporation, bylaws, and founders’ agreements, a business with many owners will face serious management and ownership challenges as the business matures. Equity crowdfunding adds a new layer of complexity with the potential for a larger group of non-working owners whose expectations may not align with the founders’ visions or business realities. Of course, all businesses should work with skilled business attorneys, but businesses exploring equity crowdfunding to gain access to essential capital will require attorneys skilled in both corporate governance and securities laws compliance.

Preparing for Equity Crowdfunding. The 4T exemption requires issuers to comply with disclosure requirements summarized in the form a detailed business plan. Beyond compliance, a business plan needs to also attract potential investors. However, the attraction cannot be deceitful or misleading. As such, businesses must have realistic business goals and target amounts, proper business valuation, compliant escrow agreements and carefully selected brokers and internet portals.

To attract potential investors, a business needs to be familiar with an investor’s concerns:

1. Who I am getting involved with? Be transparent about its ownership, management, valuation and investment plan.

2. How do I become involved? Provide potential investors with a minimum investment amount, a target funding amount, amount of shares to be issued and the deadline for such target. Beyond offering details, ensure investors know the Issuer’s vision and goals. Discuss the investor’s role in the investment plan and the Issuer’s future.

3. How will I be protected? Disclose the offering deadlines, cancellation rights, refund and substantial change notices. Give investors detailed investment plans showing how their investments will be used, timelines and plan of actions. Be available to investors and communicate frankly about the offering’s risks.

4. What happens next? Once issued shares, the investor is a shareholder, entitled to any and all rights the original shareholders have. Integrate and educate new shareholders.

Financing Future. Every business contemplating equity crowdfunding should have an exit strategy. A business may determine equity crowdfunding is its one and only round of financing and lead a small lifestyle business. Other businesses may be short on capital after expansion and require subsequent rounds of financing. Either way, a business should be prepared and understand the business and legal consequences of the next stage of its business life, including managing owners, making major decisions, and corporate compliance.

Conclusion

In addition to Illinois’ 4T exemption, on October 30, 2015, the SEC adopted final rules that permit crowdfunding from non-accredited investors, subject to the monetary limitations, effective January 29, 2016. These new Federal rules provide additional democratization of investing for small startups and entrepreneurs. However, exemption 4T stands to deliver the greatest opportunities for Illinois startups and Illinois resident investors alike, while also keeping successful businesses and people in Illinois.

If you have questions about the information provided above or desire to set up your business for equity crowdfunding success, please contact Rita W. Garry at (312) 696-1366 or rwgarry@golanchristie.com or Nichole M. Fundora at (312) 696-1367 or nmfundora@golanchristie.com.

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Rita W. Garry is a partner at Golan & Christie LLP and has more than 30 years of experience in corporate, finance, and securities matters. Ms. Garry serves as a key legal advisor and strategic business partner to many privately-held business enterprises across an array of industries. Ms. Garry practice areas include entity formation and operations, debt and private equity financing, ecommerce and cybersecurity compliance matters, and private companies’ mergers, acquisitions, divestures and other commercial transactions.

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Nichole M. Fundora is an associate attorney at Golan & Christie LLP and focuses her practice on new business ventures, corporate governance, mergers, acquisitions and emerging issues of law and social media. Nichole received her J.D. from Chicago-Kent College of Law and her B.B.A. and marketing concentration from Saint Mary’s College in Notre Dame, Indiana.

© 2016 Golan & Christie
This article originally appeared in the WBAI Winter 2016 Newsletter.

 

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