In 2012, Congress passed the JOBS Act, which among other things, created a new exemption under federal securities laws for crowdfunding. Under the law, companies will be able to raise funds through crowdfunding in exchange for equity, without complying with the full registration requirements that apply to IPO’s. The question is, will the regulatory scheme still be so burdensome as to make crowdfunding a nonstarter, as opposed to a kickstarter?
Even though the JOBS Act was passed almost two years ago, companies still cannot use crowdfunding in exchange for equity. This is because the SEC has yet to issue final regulations for crowdfunding campaigns. The SEC did issue a proposed rulemaking which, with background information and economic analysis, came to more than 500 pages. That is not a good omen for a program that in concept is supposed to be regulatory-lite. The comments period closed in February, 2014, and the SEC has not yet finalized the regulations.
If we look at the proposed regulations, we see a number of components that are troublesome for startups. First, the crowdfunding must take place through a “crowdfunding intermediary,” and must be conducted through the crowdfunding intermediary’s platform. There is a whole set of proposed regulations that applies to crowdfunding intermediaries. Existing investment banks and crowdfunding platforms such as Kickstarter and Indiegogo that want to participate in this market will have to set up special crowdfunding intermediary units. Until final regulations are issued, however, nobody can move forward with setting up a crowdfunding intermediary. And until crowdfunding intermediaries are set up and ready to operate, startups will be unable to conduct a crowdfunding campaign.
A second issue is the disclosure requirements. While designed to be less comprehensive and detailed than a registration statement or prospectus, the disclosure requirements are significantly greater than the Form D that a company must file when doing a private offering. In addition, for crowdfunding campaigns where the goal is to raise more than $500,000, the company must provide audited financial statements. The preparation of disclosures and the requirement of audited financials will impose serious legal and accounting costs on any company seeking to raise money through crowdfunding.
If a company is successful with crowdfunding, it will have a fairly large stockholder base to deal with, for not a lot of money. For example, let’s say a company raises $750,000, with the average investor putting in $100. That means the company will end up with 7,500 stockholders. It will need to hire an investor relations person to handle notices to stockholders and maintain records of ownership, and it will need to conduct regular stockholder meetings, with all the notice and proxy requirements. All of this will impose significant costs on a startup company that should be focusing on getting its product to market. And these 7,500 stockholders won’t provide any further value to the company. Compare that to raising $750,000 from a venture capital firm. The company will be adding one stockholder, and annual stockholder meetings will be easy to plan and conduct. In addition, the venture capital investor will be able to provide a wealth of mentoring, advice, business connections, and other value-added benefits to the company to help it grow.
Because of these factors, I think crowdfunding for equity will be a rarely-used financing mechanism for startup companies. The compliance costs and the hassles of dealing with a large stockholder base will deter many companies from taking advantage of crowdfunding. That’s my opinion; what do you think?
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