Invest in Startups using Crowdfunding (2019)

invest in startups

Should You Invest in a Crowdfunded Offering for Start-ups?

This blog for start-ups or early-stage companies looking to raise capital investment via crowdfunding. And also explains several best ways to Invest in Startups using Crowdfunding.

 

Nonetheless, people who run early-stage companies frequently invest in other early-stage companies or act as advisers or mentors to them.

 

Also, if you are thinking about investing in a crowdfunded company, you probably already have some sort of relationship, personal or business, with the people who are reading the rest of this blog and want to know what they are getting into.

 

The rules that govern crowdfunded offerings—Title III of the JOBS Act and Regulation Crowdfunding—have a lot to say about issuers and funding portals but hardly anything to say about investors, including who can or cannot invest in crowdfunded offerings. So I decided to put together what little information there is for investors into a single blog.

Just keep three things in mind:

 

1. This is not a primer for investing in companies generally. There are plenty of blogs out there about general investing principles, and you should read at least two of them before you consider making any sort of investment in securities.

 

2. I am assuming that you have identified a crowdfunded company you want to invest in (or have received an offering announcement from someone you know on social media) and want to know how to go about doing it. There are so many factors in deciding which companies to invest in and which to avoid that they really deserve.

 

3. The information in this blog is just that—information—and should not be construed as investment advice of any kind.

 

Why Are You Investing in a Crowdfunded Company?

Crowdfunded Company

The vast majority of start-up companies in the United States fail within a few years of being formed. Why would anyone want to invest in such risky ventures?

 

Basically, there are two reasons for investing in a crowdfunded company. Either:

1. You know the company founders personally or through social media.

2. You are a high-risk investor (also known as a gambler), you think you have uncovered the next Facebook, and you want to get in on the ground floor before everyone else knows about it.

 

If you are in the first category—you know the company founders (or are related to them), you like them, you care about them, and you want to see them succeed—then you won’t really care about much of the information in this blog. You are making this investment out of affection, not for a return on your investment.

 

You really do not care if you lose your entire investment; it’s the thought that counts (although if the company tanks and you lose a lot of money, you may be thinking a bit differently about the founders afterward). You should not apologize to anyone for feeling this way about your investment: motives such as these have fueled much of traditional project and gift crowdfunding.

 

If you are in the second category (the get-rich-quick investor), you are exactly the person the SEC and Congress were worried about when they passed the crowdfunding regulations.

 

The federal government cares about you, you see, and it doesn’t want you doing anything crazy and losing all your money. The crowdfunding regulations are designed 100 percent with you in mind. You should feel honored.

 

It doesn’t really matter which type of crowdfunding investor you are, as long as you know which type you are and are prepared to act accordingly.

 

Can You Legally Invest in a Title III Crowdfunded Offering?

Crowdfunded Offering

While Regulation Crowdfunding contains detailed rules about who can and cannot issue crowdfunded securities, there are hardly any rules about who can and cannot be an investor. Generally, anyone who is twenty-one or older and has a pulse can invest in crowdfunded securities.

 

You do not even have to be a citizen or resident of the United States. While foreign companies cannot issue crowdfunded securities in the United States, they are free to invest in them, as are foreign individuals.

 

The only exception would be an offering of securities in a subchapter S corporation; shareholders of those tax-advantaged corporate entities must be either U.S. citizens or green card holders.

 

For that reason, it is highly unlikely subchapter S corporations will engage in crowdfunded offerings under Regulation Crowdfunding.

 

Even some people who don’t have a pulse can be crowdfunded investors. If you wish to invest in a crowdfunded offering through your IRA, SEP-IRA, or another retirement plan, Regulation Crowdfunding does not stop you.

 

(although there may be issues about whether an investment in crowdfunded securities is a legal investment for your plan or constitutes a prohibited transaction under federal pension laws; you will need to speak to your investment adviser about that before making a crowdfunded investment that way).

 

Similarly, corporations, trusts, and other legal entities are not legally prohibited from investing in crowdfunded offerings (although if they buy too many shares they may turn the issuer into a holding company that cannot legally issue crowdfunded securities; this is an issue you will need to discuss with the funding portal before making a specific investment).

 

In short, anyone of legal age can invest legally in crowdfunded securities. The only legal restriction is that you can’t buy too many of them. That restriction is discussed in Calculating Your Investment Limit Under Title III.

 

Using Crowdfunding to Raise Money for a Funding Portal

Crowdfunding to Raise Money

A start-up funding portal is an entrepreneurial company just like any other. As long as it meets the qualifications for crowdfunded issuers under the JOBS Act and Regulation Crowdfunding, there is nothing to legally prevent a funding portal from using crowdfunding techniques the same as any other issuer to raise start-up capital.

 

Crowdfunding Rules

Crowdfunding Rules

On April 5, 2012, President Barack Obama signed into law the Jumpstart Our Business Startups Act (JOBS Act, for short, which gives you an idea of what the government seeks to achieve with this statute).

 

The act, described by one early commentator as a “dog’s breakfast,” is an eclectic combination of law changes designed to make it easier for emerging growth companies to raise capital without having to deal with the sometimes onerous requirements of federal and state securities laws.

 

The JOBS Act is divided into six sections, or titles, each of which addresses a specific area of securities law compliance for different types of companies.

 

Some of these titles do not refer directly to crowdfunded offerings of securities, the primary topic of this blog, but are discussed briefly in order to give a reader a better understanding of the JOBS Act’s scope and impact on the marketplace for private offerings of securities.

 

The Cost of Crowdfunding

Cost of Crowdfunding

Crowdfunding was intended to give access to start-ups and early-stage companies that are under the radar screen and invisible to traditional venture capitalists, angels, and other professional investors. The way Regulation

 

Crowdfunding is written, however, these are the very entrepreneurs who— with three possible exceptions, which I will discuss in the following pages— will be unable to take full advantage of Title III crowdfunding.

 

The cost of preparing a written and detailed business plan, together with the legal and accounting fees necessary to convert the plan into an offering statement meeting the requirements of Regulation Crowdfunding, will be prohibitive for many if not most start-up companies.

 

I have joked with friends in the financial world that the JOBS Act should really have been titled the Attorneys’ and Accountants’ Full Employment Act of 2012 because of the extensive professional work that will be required to get even the simplest crowdfunded offering to market. Not that I’m complaining, mind you!

 

The more established and mature private companies that have the capital and management time to devote to these tasks are precisely the companies that probably are already on investors’ radar screens and can take advantage of more traditional private placement offerings and angel investments.

 

While crowdfunded offerings may provide additional capital, especially if tied to a targeted project to which the proceeds of the offering can be dedicated, it may well be easier and less costly for emerging companies to work a little harder to find traditional sources of capital. After all, as someone once pointed out, “It is always easier to raise the second million dollars than the first hundred thousand.”

 

Liability of Issuing Companies (and Their Professional Advisers)

As an attorney can tell you, the cost of obtaining malpractice insurance for securities law work is astronomical. Securities law is the obstetrics and gynecology of the legal malpractice world: it requires the most expensive malpractice coverage and faces the highest probability of claims of any legal specialty.

 

Most securities lawyers I know tell me that their insurance premiums for securities law coverage are 50 to 75 percent of their total annual malpractice insurance premiums, often in the range of $5,000 to $10,000 a year (or more if there has been a claim against the attorney).

 

Why is that? Because when investors get angry, investors sue. And the first people they sue are the lawyers, accountants, and other professionals who made possible what they perceive (often incorrectly) as a fraudulent investment.

 

Although I have helped put together friends-and-family offerings for my clients for more than thirty-five years, I would hate to be the first attorney to prepare an offering statement under Regulation Crowdfunding. One small mistake and I would be toast.

 

With crowdfunding, an attorney’s or accountant’s malpractice risk will be even greater than it has been. Most attorney malpractice insurance policies are capped at $1 million per lawsuit, with a maximum cap of $2 million to $3 million per year. When there are only a handful of investors in an offering, they can’t bring a class-action lawsuit for millions of dollars that would exceed the policy limits.

 

With dozens or hundreds of investors in a Regulation Crowdfunding investment, they can, and you can bet there will be plaintiffs’ lawyers aplenty looking to cash in when a crowdfunded company crashes and burns.

 

From a litigation perspective, Title III has the potential to replace mesothelioma (also known as “asbestos-related injuries”) as the number one moneymaker for plaintiffs’ attorneys.

 

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Funding Portal Liability

Funding Portal Liability

Now let’s consider the funding portals authorized by Regulation Crowdfunding. Under Regulation Crowdfunding, these portals assume liability if either or both:

  • An offering statement they have reviewed and promoted online contains any material misstatement of fact or omission
  • An investor the portal has certified as an accredited investor turns out not to be so because of misstatements or errors in the documents

 

As a middleman or facilitator of the crowdfunding process, the funding portal has double the risk and potential legal liability of either the issuing company or the investor(s). If I were advising a funding portal under the current Regulation Crowdfunding, I would advise it to:

 

Tighten its terms and conditions so they are even more restrictive than Regulation Crowdfunding—for example, by requiring additional backup and support that Regulation Crowdfunding does not currently require (the “investment due diligence” that is commonly performed by investment banks when engaged in an IPO

 

Require collateral from a company and its founders (such as personal guarantees backed by mortgages on the founders’ homes) for securities-law-related claims before taking on that company as a new crowdfunding client. Make sure its fees and commissions are high enough to justify taking on the extensive legal risks posed by a Regulation Crowdfunding offering

 

Why would anyone in their right mind want to start and operate a funding portal? Because of the high risk of liability, portals will be extremely capital intensive to set up and extremely labor intensive to operate.

 

How many clerks (some of whom will require at least paralegal if not actual legal training) will a portal need to review offering documents from five different issuers looking to launch their offerings at the same time?

 

How much will the portal have to pay these people for their salaries, employee benefits, payroll taxes, and liability insurance? Will the portal be able to outsource these activities to companies in India or elsewhere in the developing world?

 

Those additional costs, needless to say, will be reflected in the fees and commissions the portals will unquestionably charge their issuers and investors.

 

 

And for Some Even Better News

There are three situations in which I think an early-stage company should consider an offering under Regulation Crowdfunding as it is currently drafted, even with all its faults and limitations:

 

The Small Business with a Huge Following

Let’s say you are the owner of a well-known restaurant in your area, a manufacturing or distribution business serving a primarily local or regional market, or a company selling a particular line of antiques, collectibles, or household items on eBay or Amazon.

 

Because your company doesn’t have tons of equipment or other assets, and cash flows vary from quarter to quarter, you are not eligible to obtain a traditional or Small Business Administration-guaranteed loan from a bank.

 

You might qualify for a microloan of up to $50,000, but you need more than that to finance working capital or expand your business. There is, however, something you do have: a large number of customers and other fans in your Outlook contacts, hundreds if not thousands of friends on Facebook, and hundreds if not thousands of followers on Twitter. People love your business, but few of them qualify as “accredited investors.”

 

If that describes your business, you may be a candidate for Regulation Crowdfunding.

 

Keep in mind that crowdfunding was originally established as a way for people and businesses to tap into their social media followers in order to raise money for personal or business projects.

 

Let’s face it: it’s highly unlikely that someone surfing Kickstarter or one of the other crowdfunding websites will stumble across a total stranger’s project and decide, on the spur of the moment, to invest in it (unless it’s generating lots of buzzes elsewhere in online and offline media).

 

But if you know the people or company that launched the crowdfunding campaign, or have received notice of the campaign via your Facebook, Twitter, and other social media connections, you might take a look at it, and you might invest a small amount of money.

 

Success under Regulation Crowdfunding, as in crowdfunding generally, will depend on the quantity and quality of a company’s existing contacts, on social media and elsewhere, who can be leveraged into becoming actual investors.

 

The Start-Up Looking for Market Validation

Market Validation

A number of commentators on the JOBS Act have pointed out (I think correctly) that many early-stage companies will be fearful of raising money via Regulation Crowdfunding for fear they will alienate the well-heeled accredited investors they will need for future, and much larger, rounds of financing.

 

It is well-known that sophisticated angel investors are reluctant to invest in companies with many friends-and-family shareholders already in place.

 

I see one possible exception to that argument, though: the company that is looking to validate either its market or its technology and has had difficulty attracting angel and venture capital investors for that reason.

 

Let’s say, for example, that your company has created a new consumer product. You’ve scrounged up the money to develop a prototype and get a patent on the product, but you’re far short of the capital needed to manufacture the product in large quantities and line up a distribution deal with Walmart and other major retailers.

 

Here’s what you could do: you could get someone to manufacture one thousand units of the product, and then launch an offering under Regulation Crowdfunding where investors would receive X shares in your company per $100 (or $1,000) of investment plus one of the units of your product. (Again, your presence on social media and ability to network online will be crucial to the success of the offering.)

 

If your offering sells out, it will demonstrate to later, more sophisticated investors that your product has market potential and deserves to be manufactured in larger quantities. After all, what better market research is there than people who have demonstrated they will buy not only your product but your company as well?

 

It will really help if (1) your crowdfunded offering closes out extremely quickly, showing strong market demand, and (2) some of your investors are players in your industry, for example, executives of distributors or retailers who would carry your product if it were available in sufficient quantities.

 

This would demonstrate to potential investors that the market, distribution, and other factors are there if only you could manufacture the product in sufficient quantities, buy the necessary equipment, and so forth.

 

The Upstairs-Downstairs Offering

Upstairs-Downstairs

One thought that occurred to me (and, to be fair, other commentators on the JOBS Act as well) is that an early-stage company might want to launch two offerings simultaneously:

 

An accredited-investor-only offering of preferred shares under Title II (using general solicitation and advertising) for most of the money needed to grow. A Title III crowdfunded offering of common shares for nonaccredited investors such as friends, family, customers, and other people sourced online who do not qualify as accredited investors.

 

For it to work, you would have to make sure not to include in the general solicitation of the Title II offering an advertisement of the terms of the Regulation Crowdfunding offering, unless that advertisement follows the tombstone format authorized by Regulation Crowdfunding and otherwise complies with the advertising restrictions for a Title III offering.

 

You will need to satisfy yourself (and the SEC) that the purchasers in the Regulation Crowdfunding offering were not solicited by means of the Title II offering, to avoid “integration” of the two offerings under Rule 502(a) of Regulation D.

 

Of course, if the total of the two offerings is less than $1 million, and you do not contemplate a follow-on offering within the next twelve months, the integration question may not matter. 

 

It may well be that Title III crowdfunding will perform best as a plug-in or add-on capital source for a company that is raising capital using more traditional means.

 

Issuing Your Securities to Investors

Securities to Investors

Certificated Securities

Certificated means that the investor receives an actual certificate—a piece of paper made from dead trees—as evidence of his or her shares in your company.

 

When you incorporated your company, your lawyer probably sent you a corporate minute blog—a three-ring binder with room for your corporate resolutions and other important corporate papers. That minute blog had a section called “Certificates” with preprinted certificates for you to fill in when you issue them to somebody.

 

I have formed literally hundreds of corporations in my career, and I can tell you two things about those certificates:

1. There aren’t nearly enough of them to accommodate a crowdfunded offering of securities.

2. The information required to be placed on the front and back of each certificate with the designations, relative rights, preferences, and limitations of the class of stock represented by the certificate isn’t there.

 

You and your management team will have to type that information on each certificate—every bleeding one—by hand. If you run out of certificates or didn’t have enough in the first place, you will have to order more.

 

This process will take at least a week to two weeks, so be sure to order the extra certificates before you begin your crowdfunded offering.

 

LLCs are not required to have certificated membership certificates, although the LLC laws in virtually every state permit LLCs to issue them. The information required in a membership certificate is basically the same as that in the corporation statute, with one or two minor exceptions that your attorney can explain to you.

 

I always recommend that my LLC clients issue membership certificates to their investors: they look nice, investors feel they got something for their money, and if your company crashes and burns, they might have some residual value as collectibles on eBay.

 

Uncertificated Securities

Uncertificated means there is no physical security—the number of shares is recorded on the issuer’s blogs and records and exists only as electronic data entry.

 

The corporation laws of most states require corporations to send holders of uncertificated shares a written statement of the information required on stock certificates for certificated shares.

 

While it is tempting to treat all crowdfunded securities as uncertificated and just send the required statement by email (or even less personally, to rely on the confirmation statement from the funding portal as containing the required information), I’m in favor of issuing actual certificates to your investors, for the reasons stated above.

 

Complying with State Blue-Sky Laws

Title III of the JOBS Act expressly preempts state securities laws requiring registration or filing of documents in connection with crowdfunded offerings. That does not mean, however, that your company is off the hook when complying with these laws.

 

Title III does not restrict the states’ ability to take enforcement action with respect to fraud or deceit by issuers or funding portals.

 

Especially for smaller offerings of $100,000 or less, which will certainly be deemed too small for the SEC to care about, it is more likely than not that your company will be sued by a state regulator if it commits fraud or otherwise makes material misstatements in Title III crowdfunded offering documents.

 

States are also allowed under Title III to impose fees for Title III crowdfunded offerings if (1) the issuer is located in that state and/or (2) more than half of the participating investors in the offering reside or have a place of business in the state.

 

You will need to check with your lawyer to see if any state rules require you to pay a fee, especially if both your company and most of your crowdfunded investors are located in the same state.

 

Coping with Your New Partners

investor community

When you have investors, you have responsibilities. Today’s crowd can easily turn into an unruly mob tomorrow, as anyone who’s ever been flamed on social media knows only too well. Communications with your new investors are critical to avoiding misunderstandings, rumormongering, and outright revolt in your crowdfunded community.

 

Even if your investor community is quiet and complacent, keep in mind that Regulation Crowdfunding requires them to hold your shares only for a period of one year. You don’t want a mass exodus of investors at the end of that year; word of that gets around quickly and will tarnish your company’s reputation in a hurry.

 

Developing a Shareholder Communication Program

Shareholder

Now is the time—as soon as the investors’ money hits your company bank account—to develop a program of communicating regularly with your shareholders.

 

Communicate Regularly and Often. When it comes to investors, silence is not golden. The less often your investors hear from you, the more nervous they become. Frequent and regular communication with your investors will prevent or solve 90 percent of the problems you will ever have with these folks.

 

Your company should do three things right away:

 

1. Open an account with Constant Contact or another email communications service and create a list with the email addresses of all your investors, founders, management team members, advisers, and principal customers.

 

2. Select one of your employees (preferably one who writes well) to create a monthly email newsletter that, after review and approval by the company founders, you will send to everyone on the email list.

 

3. Create a separate email address where investors can send their comments, suggestions, and other communications, and have one of your key employees check that address at least twice a day (including weekends—many investors are “part-timers” who will send messages only on weekends).

 

Your Company E-Newsletter. What should you say in each e-newsletter? Basically, each newsletter should be a progress report dedicated to answering the investor question, “How’s it going?” At the very least, send copies of all updates to your Form C disclosures to every one of your investors via email as soon as the updates have been filed on EDGAR.

 

When you receive favorable media attention, forward copies to all your investors with a short cover note.

 

In your e-newsletter, “accentuate the positive,” reporting everything good that happens to your company, but do not “eliminate the negative”; when you have suffered a reversal of fortune, notify your investors immediately and let them know your plans for turning things around.

 

It is not good for your investors to find out bad stuff about your company before you tell them about it. While some investors will still grumble about the bad news, most will forgive you because they will perceive that you are still on top of your game.

 

Here is the most important rule regarding e-newsletters: Say something, even if you have nothing to say.

 

It will come as no surprise to you that most people don’t read e-newsletters. How many of the dozens of e-newsletters cluttering your inbox do you actually open and read top to bottom? Probably very few. Most of the time, you just skim the heading and maybe the first couple of sentences.

 

Do you understand why this guy called me on the phone rather than send me an email?

 

Now, I’m not recommending that any reader plug gibberish into an email delivered to investors. It’s just an illustration of how to write one: spend most of your time on the first couple of paragraphs, and spend less and less time on the information that follows. Don’t spend so much time making each newsletter so perfect that you fail to get it out regularly to your community.

 

One of the advantages of having a crowd of investors is that you have access to their knowledge, experience, and personal networks. Don’t hesitate to ask for advice or feedback when sending your e-newsletters. That makes your investors feel that they are part of the team and that you want to know their opinions (even if you don’t).

 

You may also find, to your pleasant surprise, that there’s someone in your crowd who can really help your company get to the next level. You will want to know about such people and develop special relationships with them. Just make sure they aren’t after your job.

 

Don’t forget to post a link to each e-newsletter on your company website(s) and all your social media pages. After all, that’s how you found these people in the first place, and where you are likely to find more.

Also, don’t forget to give readers the opportunity to opt out of the e-newsletter submissions as required by federal and state anti-spam laws.

 

Responding to Your Investors. The person charged with reading emails sent to your investor hotline (the special email address you created just for the investors) should be trained to respond quickly—and briefly—to each email, you receive from an investor.

 

Most email inquiries will deal with fairly routine matters. Don’t be surprised if some messages ask about job opportunities at your company, with an attached resume from a relative of the investor who just graduated from Nowhere U.

 

with a degree in Victorian English literature. While you would almost certainly ignore such an email from a member of the general public, you are not always free to do so if it’s from an investor.

 

If an investor email surfaces a problem, however, that must be dealt with immediately. Your investor-relations employee (that’s what they call them in big companies) needs to be told to report such messages to you and the other company founders immediately so a prompt response can be prepared and sent to all investors.

 

Dealing with Time Vampires, Mata Haris, and Know-It-Alls

It happens to all start-up and early-stage companies: one or two of your investors are emailing you every day asking silly questions, volunteering useless information, and otherwise making a royal pain of themselves and taking up valuable management time.

We have a special name for such people in our industry: time vampires.

 

Most time vampires are relatively harmless. They probably just don’t have enough to do or want to feel like they’re part of your management team even though they legally aren’t.

 

The best way to deal with such people is to give them a task or project to work on, especially one involving lots of research time that will get the investor out of your hair for a while. Who knows? The research may actually prove useful.

 

A more dangerous type of time vampire is the person who thinks he or she knows more about how to run the company than you do. Most of the time these people just have outsized egos that will be satisfied with a little stroking. But there are two more dangerous types of know-it-all investor:

 

1. Someone who has a relationship with one of your competitors and has infiltrated your company through crowdfunding to get intelligence that he passes on to your enemy

 

2. Someone who really does know more about your industry and your marketplace than you do and has the credentials to prove it; if such an expert investor becomes too disgruntled with your company’s performance, she could easily turn into an instigator who will launch and lead an investor revolt

 

If you suspect someone in your crowd is a Mata Hari investor, there are three basic strategies you can consider:

1. Limit the amount of sensitive, inside information you send investors as part of your regular communications.

 

2. Do research on the investor and, if you uncover his relationship with a competitor, out him to the community at large (just be sure you are 100 percent accurate, otherwise you will be staring down a libel lawsuit from a very hostile investor indeed).

 

3. Contact the investor discreetly, point out the evidence and offer to repurchase her shares for the same price your investors paid in your crowdfunded offering (if you do this, be sure the investor agrees in writing to remain silent about your repurchase and to refrain from disparaging your company in any future communications).

 

When dealing with a know-it-all investor, it’s best to remember the famous quote from the film The Godfather, Part II: “Keep your friends close, but your enemies closer.”

 

You will need to embrace the know-it-all, suck up to his ego, and make sure he has only positive things to say about your company: if properly managed, a know-it-all can become a convincing and influential champion of your company within the investor crowd.

 

When You Have to Change Your Business Plan

Business Plan

If you have put together your crowdfunded offering documents the right way, you have included the following statement in several places where it could be clearly seen by investors:

 

“Our business plan is based on our assessment of market opportunities as they exist today; management reserves the right to change our plan, and possibly pursue a different direction for our company, due to changes we perceive in the marketplace, advances in technology, the legal or regulatory environment, the competitive picture, or any other factor affecting the company, its products, and services.”

 

It’s always difficult for companies to change direction, especially when it becomes necessary to turn a luxury liner around in a bathtub, but it becomes much more difficult when a company has lots of investors sitting in the Class C cabins wondering what’s going on.

 

More sophisticated and experienced investors will understand the need to make changes, but some less experienced or naïve investors may feel you have committed a bait-and-switch crime with their money.

 

As in all dealings with investors, communication is key to a successful change in plans. There are three key steps:

 

1. Issue a special e-newsletter to your investors announcing the change in plans and the reasons for the change, and invite them to participate in a free webinar to discuss the proposed change.

 

2. Prepare a PowerPoint slide deck and use it to host an online webinar where investors are encouraged to comment and ask questions about the proposed change (consider doing more than one if attendance at the first webinar is low).

 

3. File a Form C-U (progress update) with the SEC regarding the change.

 

If the proposed change is extremely unpopular, to the point that you and your cofounders fear an investor revolt, you should consider offering to buy back your investors’ shares on a limited-time-only, first-come-first-served basis, for the same price they paid for their shares plus a small amount of interest (basically what they would have earned on a bank certificate of deposit during the same time period).

 

You will need to find the money to pay for their shares and will need to involve your attorney and accountant, as corporate repurchases of shares are subject to state corporation laws and may have unpleasant federal income tax consequences for your company and the investors.

 

Do not even think about launching a Title III crowdfunding offering of securities to raise money to repurchase shares from investors in your previous Title III crowdfunded offering!

 

Although I confess there would be certainly admirable chutzpah in doing so, I have to believe there is at least some limit to people’s stupidity, such that your offering would be laughed off the funding portal.

 

You have a big, big problem.

big problem

There is no easy way to get out of this one. Investors in any company love to sue when things go wrong. They will not only sue your company, but they will try to pierce the corporate veil (a lovely image—it derives from the death of Polonius in Shakespeare’s Hamlet) and sue you and your co-founders personally as well.

 

They may even sue your lawyers, your accountants, your funding portal, and anyone else involved in your offering in an effort to prove they knew about undisclosed weaknesses in your business plan and didn’t warn investors about them (what lawyers call securities fraud).

 

It is not inconceivable that an entire class of plaintiffs’ lawyers will spring up to help crowdfunded investors bring class-action lawsuits to recover their money, or at least achieve lucrative settlements.

 

Frankly, if Title III crowdfunding goes nowhere and fails to become a popular means of raising capital for small companies, it will be for this reason: company founders and their professional advisers not wanting to take the risk of a class-action lawsuit by disgruntled investors.

 

Still, most start-up companies fail in the first few years of operations, and you did warn your investors up front, in capital letters, that, “INVESTMENT IN SECURITIES OF THIS TYPE IS HIGHLY RISKY, AND THERE IS A CHANCE YOU COULD LOSE YOUR ENTIRE INVESTMENT.”

 

You did say that in your offering documents, right? If you didn’t, you have not only violated Regulation Crowdfunding but set yourself up for a whole world of hurt.

 

Of course, if you still have your investors’ money, you can always get out of trouble by announcing your company’s failure, publicly taking responsibility, apologizing for the failure, and giving your investors’ their money back. They won’t be happy, but they aren’t likely to sue over a small or inconsequential monetary loss.

 

In the real world, of course, you won’t realize your company has failed until after your investors’ money has all been spent. Here is what you need to do, with the understanding that no amount of explanation, groveling, or falling on your sword will prevent righteously angry investors from seeking redress in a court of law.

 

First, prepare an email announcement of your company’s failure and send it to all of your investors. The announcement should contain the following information:

The date on which your company will cease business

An explanation, in reasonable detail, of the reasons behind your company’s failure

 

A statement, in plain English, that while you “regret” having to break this bad news to investors, the circumstances behind your company’s failure were not known or “reasonably foreseeable” by you or your management team at the time of your Title III crowdfunded offering

 

A statement that you have explored alternative means of staying in business but have found no viable way to continue your operations

 

A detailed accounting of how your investors’ money was spent, down to the very last penny (the investors will need to see that you did not use any of their investment money to pay personal expenses or bills that were unrelated to the company’s business plan;

 

ideally, if you can, you should also say that none of the investors’ money was used for salaries or other management compensation to the company founders)

 

A statement that investors will be entitled to share in any proceeds of your company’s liquidation and the sale of your company’s assets, if anything is left after payment of the company’s debt (remember that debt always has to be paid off in full before you and your fellow shareholders get anything; if you have shares of preferred stock outstanding, those will have to be paid off in full as well)

 

A statement that investors should “consult with their tax advisers” to determine if any portion of their investment can be deducted for federal income tax purposes as “worthless investments”

 

Can Your Investors Write Off Your Company Failure on Their Taxes? After reading that last bullet point, some of you are probably thinking, “Hey, wait a minute—you mean my investors can write off their investments in my company on their taxes?

 

Whew—you had me worried there for a minute. Why didn’t you tell me before that I can walk away from my company and not get sued by angry investors who will be only too happy to have tax deductions?”

Not so fast.

 

Whenever the IRS allows you to write off something on your taxes, there’s always a heap of conditions.

 

In order for your investors to write off their investments as total losses, the shares they purchased may have to qualify as Section 1244 stock.

Section 1244 of the Internal Revenue Code allows losses from the sale of shares of small, domestic corporations (sadly, LLC membership interests do not qualify for Section 1244 treatment) to be deducted as ordinary losses instead of as capital losses up to a maximum of $50,000 for individual tax returns or $100,000 for joint returns.

 

To qualify for Section 1244 treatment, the corporation, the stock, and the shareholders must meet certain requirements. The corporation’s aggregate capital must not have exceeded $1 million when the stock was issued, and the corporation must not derive more than 50 percent of its income from passive investments.

 

The shareholder must have paid for the stock and not received it as compensation, and only individual shareholders who purchase the stock directly from the company qualify for the special tax treatment.

 

This is a simplified overview of section 1244 rules; because the rules are complex, companies looking to hedge their bets against failure in a crowdfunded offering are advised to consult a tax professional for assistance.

 

Even if your shares do not qualify for Section 1244 treatment, investors may be able to deduct their losses under Section 165 of the Internal Revenue Code, but their deductions will be capital losses, which in general are not as valuable as the ordinary losses they would receive had your shares qualified for Section 1244 treatment.

 

Once you have released your announcement and have dealt with the inevitable barrage of shareholder emails, it is time to consult with your attorney and wind down your company.

 

You will need to follow the procedures in your state corporation or LLC statute for dissolving your company, winding up its affairs, selling its assets, paying off your company debts, and distributing the balance to your shareholders. You will also need to file Form C-TR on EDGAR, terminating your obligation to continue filing periodic reports with the SEC.

 

When the Revolution Has Begun

You wake up one bright, shiny morning, open your front door to get your newspaper, and there on your front lawn are a crowd of people waving pitchforks and torches, preparing vats of tar and feathers, and tying a hangman’s noose around the branch of your favorite oak tree.

 

It’s your crowd, and they are not happy.

 

Shareholder revolts rarely happen out of the blue, and you will rarely be surprised by them. When investors are unhappy, they let you know in no uncertain terms well before they consider taking legal or other action against you and your cofounders.

 

The best time to deal with an investor revolt is well before it happens, by proper communication using the methods described in this blog.

 

There are two types of shareholders. In the first, they post negative comments and reviews about your company, its products, services, and management on social media and elsewhere.

 

A member of your management team (the same person who is responsible for investor relations) should be monitoring Yelp.com and other review-oriented websites for mentions of your company (you should be doing this anyway, using tools such as Google Alerts to inform you of the online posting of any kind affecting your company).

 

The minute you see a negative or critical posting from one of your crowdfunded investors, someone on your management team should immediately contact that investor and do everything possible to set matters right.

 

If you sense that a handful of investors have launched a smear campaign against your company online, it may be best to deal with them as a group: invite them to a conference call or other online meeting to discuss their grievances and see if there’s a way to resolve them without dramatically changing the direction of the company.

 

In extreme cases, you may have to amend your charter documents (the articles of incorporation if you are a corporation, the operating agreement if you are an LLC) to give your crowdfunded class of investors the right to appoint one or more members to your company’s board of directors (board of managers for LLCs).

 

By doing so you ensure that they will have a seat at the table with the right to oversee, comment on, and otherwise influence your management decisions. That may calm your crowd down, but there are disadvantages:

 

Because your company now has an outside director, you will have to call formal directors’ meetings complying with your state corporation or LLC laws.

Your outside directors may insist that you purchase insurance covering them against any liability they may incur by acting as directors. 

 

Venture capitalists and other professional investors who may invest in your company in future years will want to appoint directors of their own and may not want to share the table with directors they perceive as less experienced in that role.

 

The second type of investor revolt involves legal action, which may take two forms: a class-action lawsuit or a proxy fight.

 

In a class-action lawsuit, your investors would pool their resources to hire an attorney to sue your company. Investors would be invited to participate in the class, and those participating in the class would share in any settlement.

 

The class-action lawsuit would take one of two forms: a direct action (shareholders sue for violation of their rights as shareholders) or a derivative action (shareholders sue third parties on behalf of the corporation based on your management team’s failure to take appropriate action in the corporation’s best interests).

 

In a proxy fight, your investors would pick several of their members to run for office as directors of your corporation and present their dissident slate to compete with your management team for approval at your company’s next annual meeting of shareholders.

 

If a majority of your company’s shareholders approve the dissident slate offered by your crowd, then you and your co-founders have been voted out of office and will have to quit the company you founded (although you would continue to hold your shares in a company that’s now being run by your adversaries).

 

Of course, if you and your management team hold the majority of the corporation’s shares (highly recommended), then there will be little chance of a proxy fight.

 

If you and your co-founders have given up so much of your company that you own less than 50 percent of your company’s shares, then all bets are off, as a mere handful of investors with small holdings of securities may be the swing votes that determine the future course of your company.

 

If it appears your shareholders are getting ready to take legal action of any kind against your company, you may have no choice but to file for bankruptcy under the federal Bankruptcy Code.

 

By doing so, you will freeze any legal action your shareholders may be contemplating against your company and give yourself the opportunity to work out differences with your shareholders under the supervision of a bankruptcy court, in the hopes of gaining a favorable settlement that will allow you to emerge from bankruptcy.

 

Bankruptcy proceedings are extremely expensive and time-consuming and will probably kill off any hope your company may have of generating investment in the future, as bankruptcy proceedings would have to be disclosed in any future offering of securities.

 

The “Upstairs-Downstairs” Offering

A (potentially) very effective way for start-up technology companies to raise money under the JOBS Act may be a two-tiered offering structure that I call an “upstairs-downstairs” offering.

 

An upstairs-downstairs offering would be a simultaneous launch of two offerings:

 

An offering of preferred stock (or LLC membership interests with preferred distributions) or convertible debt securities to accredited investors only under Title II of the JOBS Act and new SEC Rule 506(c)

 

A Title III crowdfunded offering of nonvoting common stock (or nonvoting LLC membership interests without preferred distributions) for friends, families, customers, employees, advisers, mentors, and others whose contributions to the company deserve to be rewarded but who do not qualify as accredited investors under the federal securities laws

 

An upstairs-downstairs offering allows a company’s founders to reward their friends, families, and other supporters in a way that doesn’t jeopardize their ability to raise money from sophisticated venture capital players.

 

Generally, venture capitalists, angel investors, and other accredited investors do not like to rub elbows with people they feel (rightly or wrongly) do not belong in the room.

 

They want the right to get their money out first if the company crashes and burns, and they want significant influence, input, and control over the way the company is managed. In contrast, most Title III investors are looking only to share in some small way in your company’s (and your) success.

 

While some may have dreams of getting rich, few people will expect to play a significant role in your company for only a $100 or $1,000 investment.

 

By denying voting rights to Title III investors and giving your Rule 506(c) investors preferred shares, you have given the players what they want without really taking anything away from your Title III investors.

 

Another way to do an Upstairs-Downstairs offering, although one that will be possible only for larger companies, would be to combine a “mini-IPO” offering under Tier II of the new Regulation A-Plus (adopted under Title IV of the JOBS Act) with an offering under Regulation Crowdfunding.

 

Can You Launch Another Crowdfunded Offering Right After You Complete Your First One?

Regulation Crowdfunding expressly permits follow-up offerings of crowdfunded securities up to a maximum of $1 million over a rolling twelve-month period. Whether you should do so, of course, is a different matter.

 

It is axiomatic that success breeds success. A successful Title III offering may make it easier for your company to launch a second, third, or fourth offering because if you do things properly, your pool of potential investors increases geometrically with each offering (your investors tell their friends, who tell their friends, and so forth).

 

If there has been significant growth in your company’s social media profile since the first Title III offering, it may be particularly worthwhile to launch a follow-up offering, as you will be making essentially the same pitch to a new group of people.

 

But that success may come with a price: the more crowdfunded offerings you launch that are successful, the bigger the number of investors you have to manage on an ongoing basis. Keeping track of a couple of dozen investors is much, much easier than managing hundreds or thousands of them.

 

Also, the more crowdfunded investors you bring on board, the more difficult it will be to raise capital from more sophisticated accredited investors, who don't like sharing the table with lots of small investors, any one of whom could potentially wreak havoc by going rogue and posting negative information about your company online.

 

Before you launch a following Title III crowdfunded offering, it might be a good idea to poll your existing investors to see how they feel about the idea. Some may see your decision as an admission that your management team goofed with the first offering by not asking for enough money.

 

More important, investors are always nervous about being diluted by subsequent offerings that reduce the percentage of a company’s total shares they own.

 

They will want to know that the subsequent offering will be at a higher price per share than they paid so that they will have a smaller piece of a much larger and more valuable pie. If they see their piece of the pie shrinking without an increase in the value of the company, they won’t like that, and you want to manage their adversity before you launch the follow-up offering.

 

Some Things to Consider When Launching a Follow-Up Offering

Here are a few things to consider when launching a follow-up offering:

You will have to prepare entirely new Form C disclosures and supplemental materials for the following offering; these may be updated versions of your previous offering documents but will have to be filed separately with the SEC and the funding portal.

 

You will have to justify the new offering by claiming new financial needs in the “use of proceeds” section of your Form C disclosures.

You will have to disclose the prior offering and its success in your Form C disclosures.

 

If you have not filed your Regulation Crowdfunding annual report (Form C-AR) on EDGAR on time, you may be barred from the following offering until that filing has been made and you have otherwise caught up with all required filings.

 

Your funding portal will undoubtedly charge additional fees for hosting your following offering (although these are likely to be lower than they were in the previous offering because you and your portal have a better idea of what to expect).

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