You can find countless articles and blogs that provide a general overview on fundraising using a private placement memorandum (PPM), or as many people today refer to it today as raising money through Equity-Based Crowdfunding, but how do you actually do it?
When I searched for information on the topic to share with my clients I didn’t find anything useful.
As you know by now, I saw that as an opening to fill a need so I decided to write a comprehensive blog on the subject. This blog is for people who are interested in knowing how it all works.
In this post I will cover the steps involved in conducting an Equity-Based Crowdfunding campaign (formally known as conducting a Private Placement offering) for your entertainment project.
NOTE: I may refer to Equity Crowdfunding as conducting a Private Placement offering throughout the post but they are the same thing).
Check out this post if you would like to be clear on the different types of Crowdfunding.
Also, I am covering Equity Crowdfunding in the context of raising money for Indie Films, but this method can actually be used to raise money for any type of business or project.
Brief Overview on Film Finance and PPMs
There are a number of ways to finance your Film. I discussed a number of them in a couple posts that I did earlier this month in my Guide to Independent Film Financing.
- Personal Loans
- Product Placements
- Deferred Compensation
- “Donation Crowdfunding” (i.e., Kickstarter and Indiegogo),
BUT the method that has the biggest potential to attract larger sums of money is Equity Crowdfunding!
What is Equity Crowdfunding?
Formally, it is conducting a Private Placement offering to raise funds, which is governed by both federal and state securities laws.
It must comply with the procedures and regulations set forth by the Securities and Exchange Commission (SEC), and each state where an investor resides. Basically, you have to set up a company that holds the rights to your project, and sell equity in that company to raise funds.
This type of fundraising has been around for about 80 years, but it was difficult to justify because the set up is expensive and the fundraisers conducting the offering and issuing the equity (we will call them “issuers”) were only allowed to raise money from people whom they already knew.
That is until now! In September 2013, the SEC rolled out a new rule that allows for the general solicitation of funds (for you lawyers out there…it was an amendment by last year’s JOBS act to Regulation D, Rule 506 of the Securities Act of 1933 Regulation D, adding a new Rule 506(c)). This is much more appealing to issuers because now a filmmaker can solicit funds through social media and other Internet portals.
You can click below to learn more about the new rules.
That gives you a good background on where we are today.
Below are the steps that will help you conduct a successful Equity Crowdfunding campaign.
How To Setup A Successful Equity Crowdfunding Campaign
STEP 1 – Set Up An Entity That Will Own Your Project
To properly conduct an Equity Crowdfunding campaign, you should first set up a corporation or limited liability company for many reasons, such as:
Reducing Personal Liability For Owners – owners of corporations maintain separate business and personal identities. If you’re incorporated, your personal assets are protected from any liability incurred by your business.
Tax Liability Savings – corporations are taxed at a lower rate and have other tax advantages. You can also deduct business-related expenses.
Increased Credibility for Investors – Investors, and their professional advisors, will want to see a proper legal structure before they invest. Also, you need to have stock that you can sell!
More Protection for Investors – Investors will want to know that their investment will not disappear if something happened to one of the owners or principals (i.e., death, jail). A company’s life extends beyond the individuals who run it, and an investor’s interest will continue despite the occurrence of an unfortunate event.
Ease of transferring ownership – the sale of stock or interest is a relatively easy process.
You probably don’t want to use one of the many online formation companies out there to form an entity for fundraising. Although it’s hard to mess up filing Articles of Incorporation or Organization, the substantive paperwork needs to be proper to avoid problems.
You need a professional, especially given the fact that California revised its entire LLC law earlier this year (See New LLC Law for more information). Those old forms that are floating around the Internet are now obsolete.
A company set up to work in conjunction with Equity Crowdfunding has particular issues to consider.
Some of the questions that need to be addressed are:
- Should you form an LLC or a Corporation?
There are pros and cons to both structures. Both will protect you from liability if the company gets sued, LLCs are more flexible with structure and have less required formalities; however, corporations may offer more ways to avoid tax liability.
- Should you issue multiple classes of stock?
You may want to have multiple classes of stock with different attributes (i.e., priority payout, no voting rights).
- Do you plan to set up an escrow account to hold your funds?
Depending on your intent, you may be required to set up an escrow account for the investments funds. Even if you are not required to do so, it may be advantageous to set one up.
- How will the “revenue pool” be divided up between investors and company founders?
There are customary standards to consider but this could be a negotiating point with your investors.
There are also many issues that need to be determined with respect to how the company will be managed. It is impossible to cover all scenarios, but these are good guideline questions.
STEP 2 – Plan For Your Offering
Since Step 1 typically takes a few weeks to complete, you will have time to plan your offering. Like anything in life, it is important to take a step back and think before jumping into a major endeavor like Equity Crowdfunding.
You want to make sure that you can pull all of the elements together and give yourself the best chance to succeed. To maximize your chances for success, you need to have a quality project and a well-structured offering. This includes exceptional elements that will stand out when you generate interest from an investor, such as, a great screenplay, an angle to make the project successful (i.e., recognizable talent, the “right” genre), a reasonable and feasible budget, respected advisors, and solid documents.
What is a quality script? What is the right genre? Who is the right talent to attach? I’ll defer to my film industry colleagues for answers to these creative matters. My role is to focus on the business and legal matters.
The following should be consider when structuring the offer:
- What are the terms of your offering? First, you should know the budget of your project, the amount of money you need to raise, and determine how much equity you intend to sell. This sounds simple, but many times I have had people come to me and say that they want to sell 100% of their stock to raise the entire budget for their film. That means that if they successfully raise their budget then they won’t own any equity in their own film! Unless this is a charity project, selling 100% of the film’s stock doesn’t make sense because the producers will not reap the benefits of a successful film. You don’t want to be an unintentional charity project.
- Who will be the company’s management and key personnel? Your film is a business! It needs to have competent management running it, and key personnel that support it (i.e., an advisory board). When you are dealing with investors, they are going to do background checks on everyone involved before they write you a check, so keep that in mind before you name Uncle Fester, who got in trouble for securities fraud 5 years ago, as your CFO.
- What is going to be the draw? Whether it is impressive talent attached to your project or executives with a stellar track record, there needs to be something that makes your project attractive to investors. If you are weak in one area then you need to beef up your business plan in another area to compensate. For example, if your list of attached talent is not strong then you need to focus on how strong similar projects with average talent did (i.e., horror films).
- How much money are you trying to raise? There are different levels of Private Placement offerings, which I will explain below. The amount of money that you are seeking will have an influence on your choice of the PPM structure, organization, and offering terms.
- Have you created a business plan for your project? Many people believe that when you hire a company or a law firm to draft a PPM then there is no need to have a business plan. Wrong. To the contrary, you need a strong, comprehensive business plan to begin with because all of that information is included in your PPM (I like to refer to a PPM as being a business plan on steroids). It is analogous to cooking. The elements in your business plan are the “ingredients”. The PPM drafting is just the cooking process. I don’t care if you hire the law firm of Name, Name, and Name, LLP [feel free to insert what firm you believe to be a prestigious law firm] to draft your PPM, if you start with watered-down ingredients then the result is going to be, at best, mediocre. You want to have a strong, complete, and convincing business plan so that your PPM is persuasive to potential investors.
- Have you researched the expenses related to using an escrow account for your investment funds? This one can be tricky. For Equity Crowdfunding campaigns that are seeking large funds, an escrow account is required; however, many investors will want this in place regardless of the amount being raised as a safeguard. Setting up an escrow account involves selecting a bank, entering into escrow instructions, and possibly hiring an escrow agent. Start looking into your options early so that you know where funds will go before you get investors who are ready to send you money.
- Which states do you plan to target for your Equity Crowdfunding? You or your legal counsel need to know in which potential states your investors may live so that the proper state disclosures can be included in your PPM. Also, every state has a notification requirement so you want to be aware of these as soon as possible.
- How are you going to keep track of the PPMs that are distributed and deal with other document control issues? You should have a specific process in place to distribute and track PPMs. You may want to destroy draft documents of the PPM to prevent mix ups or other problems.
As you can see, there is a lot of planning involved so it is never too early to get started.
STEP 3 – Choose the correct exemption for your fundraising campaign.
If you have representation, this step needs to be done in consultation with them because both you and your counsel need to discuss why the amount of money you are seeking may need to change. For example, if your budget is close to one of the established dollar limits for an exemption, then many times it makes sense to satisfy the qualifications of a higher exemption in case you need additional money. Otherwise, you may need to have your PPM re-drafted when your budget passes the dollar limit.
Regulation D Exemptions – As background, Regulation D is a series of six rules, Rules 501-506, establishing three transactional exemptions from the registration requirements of the 1933 Act. Without getting too technical, there are three main exemptions:
Rule 504 applies to transactions in which no more than $1,000,000 of securities are sold in any consecutive twelve-month period. Rule 504 imposes no ceiling on the number of investors, permits the payment of commissions, and imposes no restrictions on the manner of offering or resale of securities. It also does not prescribe specific disclosure requirements. Generally, the intent of Rule 504 is to let the laws in place in each state called “Blue Sky” laws monitor these fundraising efforts.
Rule 505 applies to transactions in which not more than $5,000,000 of securities is sold in any consecutive twelve-month period. It allows sales to thirty-five “non-accredited” investors and to an unlimited number of accredited investors. Accredited Investors are basically those people or entities who can afford to invest and not worry about paying their bills. It is defined in Rule 501 of Regulation D, as recently amended by the Dodd-Frank Wall Street Reform and Consumer Protection Act. Rule 505 does not permit the use of general solicitation or general advertising to sell securities.
Rule 506(b) has no limit on the funds that can be raised! It allows sales to not more than thirty-five “non-accredited” investors and an unlimited number of accredited investors. Rule 506 has more stringent requirements and, until last year, also prohibited the use of general solicitation or general advertising to sell securities, however, not there is an exception for fundraising efforts that comply with the new Rule 506(c).
Rule 506(c) Now to the good part! This is what I was referring to in my introduction. There is now an exemption that allows general solicitation and general advertising! Yes, if you qualify under Rule 506(c), you can advertise your project on TV, over the Internet, through social media, and any other method you desire.
Although the entire world can see your Rule 506(c) offering, only “Accredited Investors” are allowed to actually invest, and the verification process for determining whether an investor is accredited is more strict then the other Rules. These strict verification requirements are going to be a pain to comply with; however, it appears that if this is satisfied then the SEC is not overly concerned with requiring Financial Statements in your PPM, which is a stated requirement under Rule 506(b).
It is probably easier to verify the net worth of an investor than putting together Certified Financial Statements for a film. You still need some kind of financials to convince the investor to invest but you would have to hire a CPA to generate a Certified Financial Statement.
It is important to point out that all Regulation D exempt offerings must follow all of the anti-fraud and civil liability provisions of the various federal and state securities laws, including compliance with issuer’s obligation to notify offerees and purchasers of any updates and corrections to the PPM throughout the process.
What about the widely anticipated crowdfunding laws that allow for donation-based crowdfunding?
Those proposed rules are not effective as of the date of this post so I will refrain from comment (who knows what will happen between now and when those rules become effective). Currently, they are known as Section 4(a)(6), Regulation A-1, and Regulation A-2, but that is all that is definitively known about these proposed new rules.
So these are the first three steps in setting up your Equity Crowdfunding campaign.
- Forming your entity
- Preparing your offering
- Determining the proper Reg. D exemption
Please join me next post as I will cover the actual drafting of the PPM and discuss other important steps.