Crowdfunding – But Not by the Crowd
What the Recently Passed JOBS Act Does and Does Not Do for Entrepreneurs and Startups
Among other things, the JOBS Act provides for “crowdfunding” under Title III, “Capital Raising Online While Deterring Fraud and Unethical Non-Disclosure Act of 2012.” Crowdfunding occurs when a large number of people pool small sums of money and other resources to support efforts initiated by other people or organizations. Such pooling of money and resources typically occurs via the Internet for any variety of purposes, including funding political campaigns, disaster relief, small loans (microcredit), artists, and even startups. In the United States, this has largely been done on a donation basis (IndieGoGo; Kickstarter) or a loan, where the lender can only expect to be repaid principal. The JOBS Act contains two titles that attempt to make it easier for companies to crowdfund by offering equity.
Far from the simplistic vision of crowdfunding initially contemplated by earlier bills brought before Congress, in an effort to reduce fraud and protect investors and companies, Title III of the JOBS Act layers on regulatory requirements well beyond the information that is often delivered in connection with the funding of a startup under existing exemptions available under the U.S. securities laws, such as for private offerings to accredited investors or to a limited number of investors.
Where Title III looks like an exercise in overregulation, with few bells and whistles, Title II of the JOBS Act, “Access to Capital for Job Creators,” provides for crowdfunding conducted by accredited investors with few regulatory requirements. Title II requires the Securities and Exchange Commission within 90 days of enactment to revise its rules to lift the ban on general solicitation and advertising in offerings, where the purchasers in the offerings are all accredited investors (high-net-worth or high-income investors), which essentially permits crowdfunding by accredited investors without a lot of regulation.
Proponents of crowdfunding argue it has the promise to increase access to capital for traditional startup companies, and particularly for businesses not typically considered attractive to venture capital investors (non-tech companies, companies with modest aspirations for growth, or limited exit event potential). Some of these businesses are the type that socially responsible investors would like to invest in, such as a neighborhood coffee shop in need of new equipment. Further, crowdfunding has the possibility of opening up a previously off limits market, the startup market, to average middle class investors.
That said, opening up the startup market to the public at large could cause harm by allowing the least sophisticated investors to invest in the most risky businesses. Most startups fail. Investing in a startup, particularly at the very early stages, might be thought of almost like playing the lottery or casino gambling. Potential investors will need to understand that there is a reasonable chance that they will lose their entire investment.
There is also a concern that the general public (as opposed to investors versed in the risks associated with investing in startups, such as angel investors or venture capitalists) will select investments based on products or services instead of the business plan, model, and team. Permitting crowdfunding without regulation would make the U.S. capital markets start to look like the Wild West with rampant fraud.
What the JOBS Act does for middle-class investors
The JOBS Act seeks to balance these risks with the potential upsides of crowdfunding by capping the allowable size of investments made by investors in Title III offerings. Specifically, the Act permits crowdfunding of private U.S. companies, provided that:
(1) The aggregate amount of equity sold to all investors by the company does not exceed $1,000,000
(2) The aggregate amount sold to any investor does not exceed:
a. The greater of $2,000 or 5 percent of the annual income or net worth of an investor, as applicable, if either the annual income or the net worth of the investor is less than $100,000
b. 10 percent of the annual income or net worth of an investor, as applicable, not to exceed a maximum aggregate amount sold of $100,000, if either the annual income or net worth of the investor is equal to or more than $100,000
(3) The transaction is conducted through a regulated crowdfunding intermediary (broker or funding portal)
(4) The company complies with certain information delivery requirements
Furthermore, nonaccredited investors seeking to participate in crowdfunding a company will need to:
(1) Review investor-education information
(2) Positively affirm that he or she understands that the investor is risking the loss of the entire investment and that such investor could bear such a loss
(3) Take a quiz demonstrating an understanding of the level of risk generally applicable to investments in startups, emerging businesses, and small issuers and the risk of illiquidity
Companies will be required to make available to potential investors and the SEC certain company information, including an anticipated business plan and, most significantly, a description of the company’s financial condition, including, scaled disclosure depending on the offering amount, with offerings in excess of $500,000 requiring audited financial statements.
What the JOBS Act does for accredited investors
While the ability to crowdfund a company for equity is novel, the real news in the JOBS Act comes in Title II, which requires the SEC by July 4, 2012 to make it easier for companies to raise money from accredited investors. Specifically, the JOBS Act requires the SEC to revise its rules to lift the prohibition on general solicitation and general advertising for offers and sales of securities where all of the purchasers are accredited investors, and the company has taken reasonable steps to verify that purchasers are accredited investors. Lifting the ban on general solicitation to accredited investors greatly increases the potential capital to which companies have access and the investing opportunities of accredited investors.
Further, the JOBS Act increases the opportunities for online group funding of startups by exempting platforms, co-investors and those providing ancillary services (due diligence, provision of standard documents) from the requirement to register as brokers or dealers with respect to securities offered and sold under Title II. This is in contrast to Title III platforms which either need to register with the SEC as broker or a funding portal. While the SEC has yet to promulgate rules regulating Title II platforms and Congress provided few details as to what those regulations should look like, potentially Title II platforms will be a lot less regulated than Title III platforms.
The low dollar amounts permitted to be raised together with the heavy information delivery requirements of Title III may make crowdfunding by the public at large only likely to be taken advantage of by a few companies. This is despite what appears to be an enormous appetite on the part of the American public for investing in startups, since people are already crowdfunding product development without the possibility of participating in an equity upside.
Between the absence of investment caps either per investor or in the aggregate and, at least for now, the minimal information delivery requirements, Title II seems to be where the action will be. If more money can be raised while complying with fewer regulatory requirements on Title II platforms, Title III platforms run the risk of becoming a ghetto filled with companies that would not be able to withstand the scrutiny of angels or venture capitalists, which means that the startups that the average middle class investor would have access to will be even more risky investments than the startup market on average.
This splitting approach—allowing the public at large to gamble small dollars and private U.S. companies to take in money from the crowd up to 1 million dollars at a time and allowing wealthy individuals to invest large dollar amounts in public, private, domestic, and foreign companies—may seem elitist; in other words, only the wealthy know how to evaluate the growth potential of startups. And, who is to say that the University of Chicago M.B.A., someone versed in evaluating businesses, is less qualified to determine whether or not to invest in a startup than someone who inherited a lot of money with no prior business experience? Accredited investor status alone does not translate into the ability to evaluate the investment worthiness of a startup, but may be a proxy for determining how much money an investor can afford to gamble.
What it means for American startups
Getting funding from a large number of shareholders in small amounts raises some potential challenges. Imagine a startup run by two founders out of a garage that wants to raise $500,000 through crowdfunding, and they raise the money from 5,000 shareholders with an average investment of $100. Now this startup went from a girl, a guy, a garage, and a dream to a girl, a guy, a garage, a dream—and 5,000 shareholders.
Imagine the record keeping implications. Further, a large number of shareholders may have state corporate law implications, for example, some state corporate laws may require increasing the number of directors of a company as the number of shareholders increases. These shareholders will also have various rights under state law and may be able to compel an annual meeting, block certain transactions, or hold up a possible exit event because of the large number of appraisal rights, and be able to institute shareholder derivative suits.
For startups that are typically funded by founders (cash, credit, ability to finance their house, or sweat equity) at first and then once the business gets going by friends and family, having a large number of unacquainted shareholders may prove to be an administrative and liability nightmare.
The use of selective offerings, under the pre-JOBS Act rules, allows startups to have control over who their shareholders are and ensure that they are not selling their shares to a competitor. Once startups are seeking investors beyond their friends and family, they are looking for angels and venture capitalists that come not only with cash, but with experience. Startups need supportive shareholders to help them grow their businesses. Selling their shares through a general solicitation on a platform open to the public may add new layers of risk to an already risky situation, unless, for one thing, startups are given some control of who gets to be a shareholder.
Since Title II allows for higher dollars to be invested and companies can achieve offering targets from fewer investors, concerns around large numbers of shareholders dwindle compared with Title III rules. And with fewer potential investors, companies will have greater ability to do due diligence on such investors before they allow them to invest.
Because people just want to say that they participated in cool ideas or supported a good cause, Internet-enabled crowdfunding in recent years has seen great success in providing capital to funding artists, creative productions, nonprofit ventures, and even some companies (though not through equity). Given this success, one cannot help but assume that crowdfunding equity will only increase in popularity.
Still, this represents a significant shift in how American investors are accustomed to investing and how companies are accustomed to raising capital. There will be growing pains. Investors will lose money and companies will get in over their heads. The JOBS Act opens up the opportunity, but seeks to limit the damage that can be done to investors and companies, alike. It is yet to be seen whether crowdfunding is a passing trend that will leave us with lessons learned or a dominating force in capital-raising only in its infancy.
Kristen A. Young is a corporate associate in the Boston office of Sullivan & Worcester LLP, where she represents clients in a broad range of general corporate matters, including corporate formation, venture capital financing, crowdfunding, mergers and acquisitions, securities law compliance, public and private offerings, and other commercial and financial transactions. Image courtesy of Reset San Francisco.
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