July 2014 By Paul Foley, Will Joyner, Jeffrey Skinner, and Kate McCurry

North Carolina JOBS Act Pioneering Investment Crowdfunding Legislation July 2014 By Paul Foley, Will Joyner, Jeffrey Skinner, and Kate McCurry

North Carolina JOBS Act Pioneering Investment Crowdfunding Legislation Small businesses and startup companies play a critical role in the American economy, accounting for nearly 99.7% of all employers and creating more than 60% of the new, private sector jobs each year. In North Carolina alone, there are over 800,000 small businesses with an annual total payroll in excess of $50 billion. 1 In a push to facilitate growth and investment in small businesses and startups, Congress passed the Jumpstart Our Business Startups Act (the JOBS Act ) in 2012. One of the primary focuses of the JOBS Act was to legalize Investment Crowdfunding, where for-profit operating companies raise money for their business by offering and selling equity or debt securities from the company to the general public. We believe that Investment Crowdfunding could be a key facilitator of economic growth that this country and the state of North Carolina has been seeking since the Great Recession. I. Early Evidence of Investment Crowdfunding Success Unfortunately, implementation of Investment Crowdfunding throughout the country under the JOBS Act has been delayed as the SEC tries to finalize its rules. However, a number of states unwilling to wait on the SEC, have already implemented their own Investment Crowdfunding laws. In doing so, these early adopter states are seeking to build upon successful Investment Crowdfunding efforts in non-u.s. jurisdictions, such as Australia, the United Kingdom, France and the Netherlands. A recent study of the impact that Investment Crowdfunding has had in some of these jurisdictions highlights some tremendously positive aspects of Investment Crowdfunding. 2 Some of the key findings of this study were: Companies increased their revenue by 351% after successful Investment Crowdfunding offerings. 39% of companies hired an average of 2.2 new employees per company after successful Investment Crowdfunding initiatives. 1 State of Small Business and Entrepreneurship, www.sbtdc.org/pdf/ssb.pdf. 2 How Does Crowdfunding Impact Job Creation, Company Revenue and Professional Investor Interest?, Crowdfund Capital Advisors. 2

In addition to the companies that made new hires, another 48% of companies said they intended to use Investment Crowdfunding proceeds to hire new staff. In total, 87% of firms either had hired or intended to hire new employees as a direct result of financing achieved through Investment Crowdfunding. The average successful Investment Crowdfunding campaign raised an average of $178,790. Within three months of an Investment Crowdfunding campaign, 28% of the companies had closed an angel investor or venture capital round of funding and an additional 43% were in discussions with institutional investors. II. Overview of Securities Law and Investment Crowdfunding Investment Crowdfunding is a type of crowdfunding whereby for-profit companies generate funding by offering and selling to investors equity securities (i.e., an ownership interest in the company) or debt securities (e.g., bonds) in return for investors financial contributions to the company. Because Investment Crowdfunding involves the offer and sale of securities, it is subject to the requirements of U.S. securities laws, including the Securities Act of 1933, as amended ( Securities Act ) and applicable state Blue Sky laws. If a company wants to offer equity or debt securities to raise money, the company either must register the securities being offered or qualify for an exemption. Registration of small offerings (e.g., under $10 million) is prohibitively expensive, so small offerings rely on private offering exemptions from these legal requirements. In the past, the private requirement of these exemptions has limited small offerings to wealthy investors who are contacted without public advertising or marketing. As a result, small businesses have often relied on the business owner s personal The advantage of Investment Crowdfunding is that it allows companies to conduct securities offerings that rely on available registration exemptions in a more cost-efficient manner. finances or on institutional capital (i.e., bank loans, angel investors, etc.) for funding. 3

The advantage of Investment Crowdfunding is that it allows companies to conduct securities offerings that rely on available registration exemptions in a more cost-efficient manner and it gives entrepreneurs the opportunity to advertise the investment opportunity to large groups of people (through the internet or otherwise) and solicit investment from those individuals without regard to potential investors income or net worth. Among other advantages, this enables small business owners to solicit their friends, families and communities those who are most likely to believe in the company and benefit from its success for investment in their companies. III. Current State of Federal Legislation and Regulation One of Congress main goals in implementing the JOBS Act was to lift the restrictions prohibiting Investment Crowdfunding under the Securities Act. Under the JOBS Act, Investment Crowdfunding offerings would be able to be made subject to the following requirements (among others): 3 $1 million limitation on the amount of money a single entity can solicit using Investment Crowdfunding; Individuals who are not accredited investors (generally individuals with an annual income of $200,000 or greater or a net worth in excess of $1,000,000) may not invest more than $2,000 or 5% of their annual income in a single Investment Crowdfunding offering; and Accredited investors may invest up to 10% of their annual income in a single Investment Crowdfunding offering, but may not invest more than $100,000 in any single Investment Crowdfunding offering. The JOBS Act requires the SEC to finalize rules for Investment Crowdfunding. However, until the rules are final, Investment Crowdfunding across state lines is not legal unless the offering is registered. The SEC was originally supposed to adopt final rules to regulate Investment Crowdfunding within a year of the passage of the JOBS Act; in reality, it was more than 15 months before the SEC even presented proposed rules. To date, final rules have not been adopted by the SEC and the SEC has not provided a timetable for when the rules will be ready. Accordingly, the Investment Crowdfunding portion of the JOBS Act still is not implemented and there is no clear indication of when it will be. IV. State Responses As mentioned above, until the SEC finalizes final rules, Investment Crowdfunding across state lines is effectively prohibited. However, eleven states have 3 H.R. 3606, Jumpstart Our Business Startups Act, Title III, January 3, 2012. 4

recognized the potential economic benefits of Investment Crowdfunding and seized upon the opportunity presented by the exemption from the Securities Act for intrastate offerings by enacting legislation that allows for intrastate Investment Crowdfunding offerings. As of today, each of the following states has legalized Investment Crowdfunding offerings as long as they are limited to companies and investors located in their state: Washington, Idaho, Kansas, Wisconsin, Michigan, Indiana, Tennessee, Alabama, Georgia, Maryland, and Maine. The following states have similar bills pending: Florida, Utah, Alaska, Missouri, Virginia, Maryland, New Jersey, and North Carolina. V. North Carolina Response In 2013, the North Carolina House of Representatives responded to the stalled national efforts to implement meaningful Investment Crowdfunding by drafting and passing the North Carolina Jumpstart Our Business Startups Act (the NC JOBS Act ). 4 The NC JOBS Act is currently awaiting passage in the North Carolina Senate. The intent of the NC JOBS Act is to utilize the intrastate exemption from federal registration of securities offerings to create an efficient statutory scheme that will allow North Carolina s small businesses and startups to conduct Investment Crowdfunding offerings on an intrastate basis. Currently, the NC JOBS Act is considered one of the most innovative Investment Crowdfunding proposals, and has been championed by industry observers. 5 A few of the key highlights that make the NC JOBS Act so innovative are the following: 6 A flat $2,000 investment limit for non-accredited investors, per issuer. This is a key, simplifying difference from the JOBS Act, which has a confusing regulatory framework with various different investment limitations. This flat dollar amount limitation will make a significant practical difference for companies seeking to raise money because it removes the need to inquire about a non-accredited investor s net worth, income, etc. This will enable issuers (and portal websites) to avoid having to request or collect sensitive 4 House Bill 680, An Act to Enact the Jump-Start Our Business Start-Ups Act, April 11, 2013 ( House Bill 680 ). 5 See. One State is Leading in Investment Crowdfunding: Guess Which One. Forbes, May 2, 2013 available at http://www.forbes.com/sites/groupthink/2013/05/02/one-state-is-leading-in-investmentcrowdfunding-guess-which-one/. 6 House Bill 680. 5

personal information about all of their potential investors. Audited financial statements are not required to be presented for companies seeking to raise $1 million or less. Issuers that do present audited financial statements will be permitted to raise up to $2 million. This alleviates the costly requirement contained in the SEC s proposed rules for the JOBS Act that would require all companies to present audited financial statements. This distinction will be particularly important for entrepreneurs seeking to raise less than $1 million, since for them obtaining audited financials likely would make using Investment Crowdfunding cost-prohibitive. The NC JOBS Act includes built-in protection that is designed to shield entrepreneurs using Investment Crowdfunding from lawsuits (except in the case of fraud). This protection is likely to encourage entrepreneurs to come to the market and seek funding without having to worry about the risks of costly litigation. While regulators will be given the authority to draft rules that interpret the NC JOBS Act, there are no enacting rules that have to be passed by regulators before the NC JOBS Act becomes effective. This means that the law would go into effect immediately if passed by the North Carolina Senate and signed into law by the Governor. There is typically no required filing before an offering can take place. Instead, notice is required to be given only once a 25 th investor commits capital or before general solicitation occurs, whichever comes first. In contrast to the onerous and complex regulations contained in the JOBS Act and the SEC s proposed rules thereunder, the NC JOBS Act provides a workable framework under which Investment Crowdfunding could be utilized by North Carolina startups and small businesses to raise capital and create jobs. VI. The Future of Investment Crowdfunding in North Carolina If the NC JOBS Act is passed, the next question is whether Investment Crowdfunding will gain traction with investors in North Carolina. With all of the investment opportunities that are currently available to the general public, what will make Investment Crowdfunding compelling to investors? We believe that the answer is likely to be innovation. Since most startups and small businesses do not have the established track record of more well-known investments, the proliferation of Investment Crowdfunding will force entrepreneurs to think outside of the box to convince the public that their products are worthy of investment. One example of the success that can come from creative thinking took place recently in the United Kingdom, 6

where a Mexican restaurant named Chilango combined the concepts of Investment and Rewards-Based Crowdfunding ( Reward Crowdfunding ) to produce the first ever burrito bond. 7 Chilango sold pieces of debt for 10,000 (about $17,000) each, but also promised that any purchaser of this debt would be entitled to one free burrito with extra guacamole every week. This kind of headline-grabbing marketing innovation, even in forms less extreme than the burrito bond, may encourage North Carolinians to divert some of their funds from more traditional investments toward Investment Crowdfunding opportunities. If the NC JOBS Act is enacted, Investment Crowdfunding could also help to attract and sustain a population of innovative, technical and well-trained individuals in North Carolina. First, it could help North Carolina keep some of its youngest and brightest minds within the state, since entrepreneurs would no longer need to look elsewhere to help establish and fund their ideas. Further, the NC JOBS Act could also help to entice entrepreneurs outside of the state to come to North Carolina to seek investment. Based on the available statistics, it is estimated that if 1,000 new startups were successfully funded through Investment Crowdfunding in Regardless of the risks, Investment Crowdfunding still provides a better alternative to the most popular forms of crowdfunding today. North Carolina, approximately 800 new jobs would be created and an estimated $178,790,000 in new capital would be injected into the North Carolina economy. Not only would this create a larger corporate tax base for the state, but it also would generate increased tax revenue as the growth potential of the new companies is realized. There are, of course, risks associated with the proliferation of Investment Crowdfunding. Among them are the risks resulting from the speculative nature of small businesses and startups, as well as the risk of fraud. However, these risks may have been overstated. With respect to the speculative nature of small business, Investment Crowdfunding may actually help to alleviate many of the problems that make small businesses and startups so speculative by exposing them to a market with few barriers to entry. For example, an unsuccessful Investment Crowdfunding campaign could be an early warning sign to a small business or startup that their business lacks potential. With respect to the risk of fraud, no law or regulation will eliminate this risk entirely. However, recent 7 See A Taste of Things to Come: Burrito Bond has Crowdfunding s Flavours All Wrapped Up, http://www.theage.com.au/business/markets/a-taste-of-things-to-come-burrito-bond-has-crowdfundingsflavours-all-wrapped-up-20140613-3a2o6.html. 7

studies have shown that fraud in Investment Crowdfunding has been, thus far, quite rare. 8 Regardless of the risks, Investment Crowdfunding still provides a better alternative to the most popular forms of crowdfunding today. Currently, the most widely used form of crowdfunding has been Rewards Crowdfunding, where forprofit operating companies solicit startup or other funding in exchange for special recognition, prizes, and/or status. This is equivalent to contributors donating money to a for-profit business for almost nothing in return. Investment Crowdfunding, at a minimum, provides contributors the opportunity to share in the potential success of the companies that they fund. In our estimation, passing the NC JOBS Act and allowing for the proliferation of Investment Crowdfunding in North Carolina would be an immediate boon to the North Carolina economy and would be a strong driver of growth and wealth creation well into the future. 8 See e.g. Crowdfunding s Potential for the Developing World, 2013, Finance and Private Sector Development Department, Washington, DC: World Bank. at 90. (Stating that in the seven years that Investment Crowdfunding has taken place in Australia very little fraud has been reported.) 8

Paul Foley, Partner Winston-Salem 336 607 7389 New York 212 775 8712 Pfoley@KilpatrickTownsend.com- Authors Paul Foley concentrates his practice in the areas of securities and corporate law, with a particular focus on investment fund formation, investment adviser regulation, and corporate representation, including mergers and acquisitions. Mr. Foley regularly represents investment advisers, hedge funds, mutual funds, private equity funds, venture capital funds, funds of funds, institutional investors, brokerdealers, financial institutions and other entities with regard to complex federal and state securities regulatory matters. Will Joyner, Partner Winston-Salem 336 607 7342 Raleigh 919 420 1763 Wijoyner@KilpatrickTownsend.com Will Joyner concentrates his practice in the areas of general business and corporate law, mergers and acquisitions, venture capital and private equity financings, securities regulation and complex commercial agreements. Mr. Joyner frequently works with emerging growth and technology companies, both on the company side and the investor side. In addition, he regularly represents public companies as well as closely-held middle market businesses in a variety of large and complex transactions. Mr. Joyner s significant transactional experience also includes technology transfer and licensing arrangements, as well as joint ventures and other strategic partnering arrangements across a variety of industries. Jeffrey Skinner, Partner Winston-Salem 336 607 7512 Atlanta 404 815 6414 Jskinner@KilpatrickTownsend.com Jeffrey Skinner leads the Investment Management Team at Kilpatrick Townsend, where he focuses his practice on investments, investment funds and investment advisers. Mr. Skinner has extensive experience assisting clients with making investments, obtaining investors and navigating the complex securities and other laws surrounding investing. Mr. Skinner regularly counsels clients about their business goals, needs and legal challenges. He assists clients with navigating regulatory issues and requirements, entering into joint arrangements with commercial and investment partners, and closing business investments. Kate McCurry, Associate Winston-Salem 336 607 7359 KMcCurry@KilpatrickTownsend.com Ms. McCurry regularly advises clients on structuring, forming, and offering private investment funds, including hedge funds, private equity funds, funds of funds, and real estate funds. She also regularly advises investment advisers with regard to various securities, compliance, and business matters, including drafting and reviewing investment advisory agreements and other material contracts, developing and implementing customized compliance policies and procedures, and registration on Form ADV. 9