Shares, registers, and agreements: The legal requirements of equity crowdfunding

For three years now, proprietary companies in Australia have been able to raise capital through crowd-sourced funding (CSF) in return for equity in the company, commonly referred to as equity crowdfunding. This process has enabled budding entrepreneurs across a vast range of industries, including music, fashion, financial services, fintech, property development, health and, of course, craft breweries, to get their businesses up and running. 

While there is clearly no shortage of interest in equity crowdfunding, the process is not without its challenges. There are several boxes that need to be ticked and obligations that must be met by businesses embarking on equity crowdfunding, so it is essential to know what you are getting into.

Who can use equity crowdfunding?

To be eligible, proprietary companies must:

• Have at least two directors — the majority of whom normally reside in Australia;
• Have their principal place of business in Australia;
• Have less than $25 million in both gross assets and annual turnover; and
• Not have a substantial purpose of investing in securities or interests in other entities or schemes.

The company can then choose an intermediary platform to facilitate the raising of funds, using a CSF offer document hosted by the platform.

The key obligations proprietary companies need to be aware of include: 

• Preparing annual financial and director’s reports;
• Having their financial reports audited if they raise $3 million or more from CSF offers; and
• Complying with existing related party transaction rules under the Corporations Act, which have previously only applied to public companies.

Establish an electronic members register

Equity crowdfunding inevitably comes with a crowd, so companies need to be mindful of whether their existing corporate structure and agreements can handle this influx of potentially thousands of new shareholders.

The Corporations Act 2001 (Cth) allows for the members register to be maintained electronically, with certain requirements.

The requirements of the act

1. Records can be reproduced at any time in written form such as a commercially available spreadsheet copied to a CD-ROM or USB.

2. The company takes reasonable precautions to guard against damage, destruction or falsification of the records.

3. Records cannot be more than 20 days out of date.

4. The information is retained for seven years.

Is a shareholders’ agreement needed?

To accommodate an equity crowdfunding offer and the introduction of new CSF shareholders, any shareholders’ agreement that already exists for the business will need to be reviewed and almost certainly substantially amended.

A CSF company can potentially proceed without a shareholders’ agreement, and ahead of making an equity CSF offer, put in place a more tailored and detailed company constitution.

Share classes

The act allows for the issue of only ordinary shares to CSF investors. Where a company has existing shareholders, it may be wise to set up different classes of shares with varying rights between them and the new CSF shareholders.

To preserve the rights of the existing shareholders, it may be necessary to convert their shares to one or more new classes before undertaking a CSF offer.

The purpose of establishing different share classes isn’t to deprive CSF shareholders of having appropriate input into the business, rather it considers the practical realities of running a business and ensuring that it can be done efficiently and effectively.

Director appointments

CSF companies are required to have at least two directors. For a CSF company, typically in the earlier stages, the founders of the company would probably want to retain the ability to appoint at least one director, so they have direct input into decisions made by the company board. The company may also like to give shareholders who hold a particular percentage of the share capital the right to appoint a director (or certain investors may require it).

Provisions made for appointing a director must have correlating provisions for their removal.

Other considerations and the future outlook

Aside from these fundamental elements, companies considering a CSF raising should also be mindful of:

• Thresholds for passing resolutions of shareholders (and quorums for a valid meeting);
• Defaults by shareholders;
• Dilution of shares;
• Rights of first refusal for transferring and issuing shares; and
• Drag along and tag along provisions.

While there are certainly some practical hurdles to clear as part of this process, the new CSF laws are supporting emerging companies and startups, by providing a further avenue for raising capital.