On October 30, the SEC took another shot at legalizing equity crowdfunding, by passing final regulations that are much more streamlined and simpler than the original regulations. The new regulations will take effect sometime next spring or summer, at the earliest.

Under the new regulations, a company can raise a maximum aggregate of $1 million through crowdfunding during a 12-month period. The company must use an SEC-registered intermediary – either a broker-dealer or a funding portal. While the company still must file certain information with the SEC and provide it to investors, the new regulations are more relaxed about the required financial statements. If the offering is between $500,000 and $1 million, the financial statements must be “reviewed” by a public accountant, but they need not be audited (unless audited financials are available). This removes a significant cost barrier that had existed in the previous set of regulations. During any 12-month period, the aggregate amount of securities a company can sell to an investor through all crowdfunding offerings cannot exceed $100,000.

On the investor side, the investment limits for individual investors over a 12-month period, across all crowdfunding offerings, are:

  • If either the investor’s annual income or net worth is less than $100,000, he can invest the greater of (a) $2,000 or (b) 5% of the lesser of annual income or net worth
  • If both the investor’s annual income and net worth are equal to or greater than $100,000, she can invest up to 10% of the lesser of her annual income or net worth.

So let’s look at Joe Investor, who earns $75,000 per year and has a net worth of $35,000. Since Joe’s net worth is less than his annual income, he can invest the greater of $2000 or 5% of his net worth, which comes to $1750. So in this scenario, Joe can invest $2000 over a 12-month period.

Now let’s look at Melinda Investor, Joe’s much more successful younger sister. Melinda earns $200,000/year, and has a net worth of $350,000. Since her income is less than her net worth, Melinda can invest up to 10% of her $200,000 income, or $20,000.

Securities purchased through a crowdfunding offering generally cannot be resold for one year after purchase.

While the new regulations greatly simplify the process for doing equity crowdfunding, they don’t really address the main problem that faces any startup that wants to use this. How does the company deal with potentially thousands of new stockholders, many of whom may have invested only a few hundred dollars (if that much)? I call these people the Great Unwashed, because beyond a few handfuls of cash, none of these are value-added investors. None will be bringing their expertise and experience to the company, the way a good angel or venture capital investor does. And yet the startup must prepare an annual report that it has to provide to all these stockholders. It also has to hold an annual meeting, notify all these stockholders of the meeting, hold the meeting at a location where these stockholders can attend (if they want), and allow them to vote on various corporate matters, such as the board of directors. Now the company will need to use some of those new funds to hire an investor relations manager, or use an outside service, and will have to devote time to keeping the Great Unwashed happy.



The Risks of Crowdfunding

Crowdfunding is a relatively new method for companies to raise money for various projects. Companies solicit donations for a project from a wide cross-section of the public, in exchange for some kind of reward. For example, a company might offer t-shirts, or bandanas, or even allow pre-orders of its product, in exchange for the donations. What happens, however, if the company fails to follow through with the reward it promised? Nashville-based Altius Management is finding out the hard way – the State of Washington is suing Altius under the state Consumer Protection Act for failure to deliver on its promises or offer refunds.

In 2012, Altius started a Kickstarter campaign to raise $15,000 to fund development of a playing-card game called Asylum. Altius actually raised more than $25,000, but apparently failed to follow through either by shipping merchandise to its funders, or by refunding the donations. Thirty-one of those funders live in Washington, and the state filed suit on their behalf earlier this month, alleging unfair and/or deceptive acts under the state Consumer Protection Act, and requesting up to $2000 in damages for each violation. Altius has not yet responded to the complaint.

It is too early to predict the outcome of the Altius case, or even to predict whether other states might follow Washington’s example in pursuing crowdfunding deadbeats. Nevertheless, it is worth examining what a company’s obligations are when it engages in a crowdfunding campaign. There are numerous crowdfunding platforms, so I will just take a look at a few of the more prominent ones. Kickstarter is perhaps the best known crowdfunding platform, and the one used by Altius. Here are some excerpts from Kickstarter’s terms of use:

Is Crowdfunding a NonStarter or a Kickstarter?

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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