TWO MILLION DOLLARS in 10 hours is what the creators of the television series Veronica Mars raised via crowdfunding to develop a movie based on the show.1 While this may be an exception to the norm, the success of Veronica Mars is one of many examples of how valuable crowdfunding can be for film financing. Crowdfunding is a form of raising money from the public, typically through small individual contributions to fund personal, philanthropic, or commercial endeavors.
Recent legislation has created an opportunity for equity-based crowdfunding to become a useful financing tool for producers of independent feature films, documentaries, and other creative endeavors. Legal limitations on the sale of securities have generally limited crowdfunding to donations, but Title III of the recent JOBS Act created an exemption to federal securities laws to permit crowdfunding equity investment, including for entertainment projects.2 While the act mandated the SEC to issue the regulations within 270 days after passage, the commission has missed the deadline and is not expected to issue the final rules until later this year.
Once the SEC rules are implemented, small businesses and startups will be able to raise up to $1 million annually via crowd- funding through authorized broker-dealers or registered intermediary Web sites called funding portals. With the potential to provide investors with a financial return, equity-based crowdfunding is a new method of financing for independent film producers, and as such has already attracted interest. Since the JOBS Act passed in April 2012, approximately 6,800 domains have been registered with the word “crowdfunding” in the name.3 Donation-based crowdfunding has already proven successful. Arts-oriented projects generated around $66 million through donation-based crowdfunding in 2011, and the industry overall grew from $1.5 billion in 2011 to $3 billion in 2012.4
However, obtaining equity crowdfunding will entail significant business and legal considerations for filmmakers, funding intermediaries, and investors. For example, what are the practical applications and limitations of the proposed crowdfunding exemption for film financing? Will the transaction costs and procedures of equity-based crowdfunding outweigh the potential benefits? If equity- based crowdfunding entails higher transaction costs and investment caps, why not simply rely on donations? Before addressing these questions, a review of applicable film-financing issues and donation-based and equity- based crowdfunding is necessary.
Film Financing and Crowdfunding
The solicitation of funds from passive investors in exchange for a financial interest in an entertainment project raises federal and state securities compliance issues. The touch- stone of a security “is the presence of an investment in a common venture premised on a reasonable expectation of profits to be derived from the entrepreneurial or managerial efforts of others.”5 Passive investors are not actively involved in the management of the undertaking and invest in exchange for an economic interest.
The distinction between active and passive investors is important because it dictates what financing options are available as well as what the associated transaction costs will be. For example, a film producer who raises money from active investors (who act, for example, as executive producers and have approval rights over major decisions or other defined, sufficient forms of participation) is likely able to avoid dealing with federal and state securities law disclosure requirements and investor eligibility limitations. In contrast, equity investment offerings to passive investors either must be registered with the SEC and the appropriate state agency, or the offerings must qualify for an exemption and comply with any applicable state securities requirements.
Crowdfunding typically deals with passive investment offerings. Donation-based crowd- funding does not involve the sale of securities to investors, and those who donate do not receive a financial interest in the project. Donation crowdfunding therefore allows for low transaction costs. While donation-based crowdfunding has proven to be a successful financing tool, it has drawbacks, the most prominent of which are the lack of financial return and regulatory oversight. Equity-based crowdfunding, on the other hand, involves a potential return on investment and a detailed legal framework intended to protect investors. Filmmakers interested in equity-based crowd- funding need to be familiar with this frame- work.
The Crowdfunding Exemption
The recent equity-based crowdfunding ex- emption was added as the new Section 4(6) of the 1933 Securities Act. The law will allow issuers to raise up to $1 million in a 12-month period from qualifying investors and through authorized intermediaries.6 For offerings up to $100,000, the issuer must provide the intermediary (broker-dealer or funding portal) with its income tax returns for the prior year and certified financial statements. For offerings greater than $100,000 but less than $500,000, the issuer must provide financial statements reviewed by an independent public accountant in accordance with professional standards and procedures defined by the SEC. For offerings greater than $500,000, the issuer must provide audited financial statements.
Regardless of the funding amount, the issuer must provide 1) the issuer’s name, legal status, address, and Web site address, 2) the names of its officers and directors and of any person holding more than 20 percent of the shares of the issuer, 3) a description of the issuer’s business and anticipated business plan, 4) a description of the stated purpose and intended use of the proceeds, 5) the tar- get offering amount, 6) the price to the public of the value of the securities, and 7) a description of the ownership and capital structure of the issuer. These requirements apply to all Section 4(6) offerings.
Additionally, issuers may not advertise the offering except for notices that direct investors to intermediaries. Issuers may not compensate promoters unless authorized by the SEC rules, and issuers must file annual reports with the SEC as well as provide financial statements and reports to investors. Issuers must also comply with any additional rules set by the SEC.
Issuers that are not eligible to crowdfund under the new law include non-U.S. companies, required public reporting companies, investment companies (as defined under the Investment Company Act of 1940), mutual funds, private equity funds, asset management vehicles, business development companies, and companies disqualified under proposed rules similar to Rule 262 of the Regulation A exemption (the “bad actor” disqualifications).7
Limits will apply to investors as well as issuers. Generally, investors with an annual income or net worth of less than $100,000 can invest up to the greater of $2,000 or 5 percent of their annual income or net worth. Investors with an annual income or net worth of $100,000 or more can invest up to 10 percent of their annual income or net worth that does not exceed $100,000. The investment cap applies to all Section 4(6) transactions in a 12-month period.
Under Section 4(6), crowdfunding transactions must be conducted through an intermediary (i.e., a registered broker or funding portal). Funding portals are specifically defined under the law to facilitate Section 4(6) transactions. Thus, most Section 4(6) offers are unlikely to involve registered brokers, as the potential liabilities and transaction costs may outweigh the potential com- missions. Most offerings will likely go through funding portals, which are essentially third parties that list crowdfunding opportunities and provide matching services.
Under the JOBS Act, Section 4(6) intermediaries—i.e., funding portals—are obligated to ensure that each investor receives, reviews, and acknowledges understanding of the disclosure materials and completes an investor questionnaire that affirms the investor’s ability to bear the risk of the investment. In addition, the intermediary must per- form a background and securities enforcement check on the issuer, make the issuer’s disclosures available to the SEC and investors no later than 21 days before the first sale of securities, and ensure that no investor exceeds the maximum allowable investing limit. Funding portals must also take adequate steps to protect the privacy of investors, refrain from compensating parties for pro- viding identifying information on potential investors, and refrain from having any financial interest in an issuer using the intermediary’s services.
In addition to registering with the SEC, funding portals must also become members of a registered national securities association, the only one of which is the Financial Industry Regulatory Authority. Funding portals also may not offer investment advice or recommendations; solicit purchases, sales, or offers to buy the securities offered or dis- played on their Web sites or portals; compensate employees, agents, or other persons for solicitation or sale of securities displayed or referenced on the Web sites or portals; or hold manage, possess, or otherwise handle investor funds or securities.8
Issuers may not access the funds until the target amount is reached. Securities purchased under Section 4(6) transactions may not be transferred within a 12-month period from purchase unless the transfer is to the issuer, an accredited investor, or a family member, or is part of an offering registered with the SEC. Additionally, securities sold pursuant to Section 4(6) are “covered securities” under Section 18(b)(4) of the Securities Act of 1933, and therefore are preempted from state securities regulations. On the other hand, states in which the issuer’s principal place of business is located, and states in which more than 50 percent of the securities are sold may require a notice filing and fee.
Once the SEC passes the rules governing Section 4(6), there will be no shortage of funding portals ready to facilitate equity- based crowdfunding. However, it remains to be seen whether the regulatory framework will lead to widespread usage or simply create unreasonable transaction costs that will deter independent producers and small businesses.
Donation or Equity
Whether seeking donations or equity, film- makers can consider crowdfunding as a financing option, particularly in situations in which traditional financing options are unavailable. For example, crowdfunding can pay for movies with very small budgets. For motion pictures with larger budgets, crowd- funding can be a source of development funds, bridge financing, pre- or post-production funds, or prints-and-advertising funds. Donation-based crowdfunding has already become a popular way for independent filmmakers to raise funds. For example, producers of the Charlie Kaufman film Anomalisa raised over $400,000 in September 2012 via crowdfunding,9 and more than 15 films selected for screening in the 2013 Sundance Film Festival were crowdfunded.10
Donation-based crowdfunding appeals to people who are motivated to donate based on the artistic or humanitarian nature of the project and have no expectation of financial return. These offerings do allow people to donate in return for nonmonetary consideration. For example, producers of the yet-to-be released film The Canyons, starring Lindsay Lohan and James Deen, managed to raise $150,000 in one month through donation- based crowdfunding by offering rewards such as a script critique from the film’s director, Paul Schrader, or a one-week workout session with the film’s writer, Bret Easton Ellis.11 Popular donation-based crowdfunding sites for film- makers include Kickstarter and IndieGoGo.
The benefits of donation-based crowd- funding include the low transaction costs and minimal disclosure requirements. How- ever, certain factors may make donation- based crowdfunding unappealing. For example, there is little to no legal oversight, which may deter those desiring greater assurances that the funds will be applied as represented. Also, a signed DVD or credit on the film may be of little interest to investors.
Equity based crowdfunding on the other hand, appeals to investors interested in contributing to commercial ventures in exchange for a share of the financial reward. The potential for financial gain caters to a different, presumably larger, market of investors. However, noticeable drawbacks of equity-based crowd- funding include public disclosure of business information that filmmakers typically would rather keep private. The project’s officers and large shareholders will be subject to criminal background checks and liable for false disclosures. Moreover, the filmmakers may find it burdensome to deal with a large number of small investors.
Equity Crowdfunding for Filmmakers
Questions remain as to how practical equity- based crowdfunding under Section 4(6) will actually be, particularly as a new financing tool for filmmakers. Critics of the proposed law argue that it places overly burdensome obligations on intermediaries and that the compensation may not be commensurate with the costs and potential liabilities.12 While the SEC has yet to issue the final rules implementing Section 4(6), the JOBS Act sets forth a rather detailed framework for how the equity crowdfunding offerings will operate. Even still, filmmakers looking to raise capital through Section 4(6) will likely have many questions regarding how to properly conduct such an offering. For example, can a filmmaker raise funds through donation-based and equity-based crowdfunding? The two methods are not mutually exclusive. Section 4(6) does not prohibit issuers from pursuing a donation- based crowdfunding and equity-based crowd- funding offering for the same project. Film projects, music albums, and video games may be ideal for concurrent donation and equity- based crowdfunding. In addition to broadening the potential investor base, a dual campaign may cross-promote the project and provide grassroots marketing. It may also be possible for a filmmaker to use equity crowd- funding in conjunction with other securities exemptions. The Section 4(6) exemption limits the aggregate amount sold “to all investors” by the issuer to $1 million within a 12-month period. Accordingly, sales pursuant to other exemptions arguably do not count against the $1 million cap.
What are the differences between a Section 4(6) offering and an offering pursuant to Rule 504, which also has a $1 million cap, 12- month period, and no limit on the number of investors? The two exemptions are similar in many ways, and in fact, Rule 504 arguably entails fewer disclosure requirements. However, unlike Section 4(6) offerings, Rule 504 offerings may only be offered to investors with which the issuer has a pre-existing relationship.13 In addition, while both offerings have no limit on the number of investors, Rule 504 offerings do not preempt state securities laws, and most of the comparable state law exemptions place limits on the number of investors, particularly non-accredited investors.
Filmmakers should also be aware that activities permitted under certain exemptions may be expressly prohibited under Section 4(6). For example, while the crowdfunding exemption does not place a cap on the number of non-accredited investors, other federal exemptions do. Regulation D, Rules 505 and 506 limit the number of non-accredited investors for a single offering to 35.14 Another potential conflict exists under Regulation D, Rule 504—which allows for general solicitation15—because issuers under Section 4(6) are specifically prohibited from advertising the offering except to direct investors or intermediaries. Simultaneous use of other exceptions may therefore be risky unless the offering can be divided into separate transactions without running afoul of the integration doc- trine. Under this doctrine, issuers may not circumvent registration requirements by claiming separate exemptions for one or more parts of a transaction that in reality belong to a single financing plan.
The SEC uses a five-factor test to deter- mine when to treat separate offerings as part of a single transaction. The five-factor test for integration examines whether the offerings 1) are part of a single financing plan, 2) involve the same type of security, 3) are made around the same time, 4) provide the same form of consideration, and 5) are for the same general purpose.16 Given the breadth of the five factors, application of the integration doctrine can be unpredictable,17 and not all five must be met for offerings to be integrated. In fact, the SEC has indicated that any one or more of the factors may be determinative.18 Therefore, issuers with multiple but related offerings must ensure there is a clear and legitimate rationale against integration.
The Integration Doctrine
Filmmakers seeking to use Regulation D ex- emptions to finance a film’s production bud- get in excess of the $1 million cap will likely be limited by the integration doctrine. Theoretically, filmmakers may be able to separate the offering into different transactions by conducting one offering to raise funds for the development stage of a film and another for the production stage. In order to avoid integration, the two offerings will need to be sufficiently distinguished. A producer may seek development funds to acquire rights to a literary property and commission a screen- play to sell to a studio, talent agency, or production company, and pay investors with the proceeds of the sale. However, these circumstances are not common with independent films, as the development and production activities are often tied together operatively and financially.
May a producer issue a Section 4(6) offering for development and production funds for a film and subsequently may a distributor issue a Section 4(6) offering for print and advertising funds for the same film?
For example, a distributor may decide to conduct equity-based crowdfunding to sup- port the prints-and-advertising costs for a slate of films it acquires. If the maker of a film that is licensed to the distributor has also raised funds via equity crowdfunding, the two offerings can be argued to be different transactions, even though they are associated with the same film. While the issuers may be different, the securities laws exempt trans- actions. Therefore, the integration doctrine must be applied, and conducting two Section 4(6) offerings in this context would likely be permissible.
Issuers must also be aware of the disclosure obligations and advertising limitations. First, an issuer is defined as “any person who is a director or partner of the issuer, and the principal executive officer or officers, principal financial officer, and controller or principal accounting officer of the issuer (and any per- son occupying a similar status or performing a similar function) that offers or sells a security in a transaction exempted by the provisions of Section 4(6), and any person who offers or sells the security in such offering.”19 Therefore, issuers can theoretically be liable for any material misstatements or omissions in connection with an offering by its key officers, directors, and employees. Defenses avail- able to issuers include proof that the investor had actual knowledge of the misstated or omitted information or should have been aware of the information had the investor taken reasonable care and inquiry.
How will filmmakers be permitted to pro- mote the offerings to potential investors? The JOBS Act prohibits issuers from advertising the offering except for directing investors to the intermediaries—that is, registered broker-dealers or funding portals. However, funding portals are prohibited from soliciting purchasers, but broker-dealers are not. The JOBS Act also prohibits the use of a promoter unless the terms of the promoter’s compensation are disclosed in the issuer’s disclosure materials. Given the regulatory framework, what is likely to evolve are funding portals with specific areas of focus, such as independent films, or music, video games, or restaurants. Portals will not necessarily promote specific offerings but rather types of offerings to targeted investors.
Another area of concern for filmmakers is the potential to lose the exemption after receiving money in excess of the aggregate amount for Section 4(6) transactions. The rules place the burden on the intermediary to ensure that this does not occur. The JOBS Act, however, specifically allows issuers to raise the defense that they did not know that an investor exceeded the cap, and that in the exercise of reasonable care, they could not have known. Therefore, as long as the intermediary complies with the SEC guidelines, the exemption should presumably apply regard- less of whether funds are received from ineligible investors. Concerns such as these may be clarified by the final SEC rules.
Depending on how the final SEC rules are structured, equity-based crowdfunding may be either an exciting and valuable new financing tool for filmmakers and other entrepreneurs or an overly burdensome and costly undertaking. Some commentators have opined that the mandatory disclosure and regulatory requirements make equity crowd- funding too complicated and expensive. The SEC may, however, structure equity crowd- funding rules to protect investors while pro- viding a valuable new fundraising source for issuers. Given the constant demand for additional sources of financing by filmmakers and the growing success of donation-based crowdfunding, the Title III exception will very likely be used to make movies. Given the massive anticipation and preparation from those who are eager to participate in equity- based crowdfunding ventures, the rules and procedures will likely evolve over time to facilitate a burgeoning new form of capital finance.