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?
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?
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
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.
Of course, a funding portal using crowdfunding techniques will need to find another funding portal to manage its offering, and other funding portals will be unlikely to want to help you if they see your operation as a potential competitor.
In soliciting crowdfunding assistance from a funding portal, you will need to convince its management that (1) you are operating in a specialized niche that poses no threat to them and (2) once you are up and running you will be in a position to refer business to it or otherwise assist it in developing its business plan.
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.
Title I: The IPO On-Ramp
Title I of the JOBS Act established a new process and disclosure regime for IPOs of securities. The statute creates a new class of companies called emerging growth companies (EGCs);
An emerging growth company is defined as an issuer with total annual gross revenues of less than $1 billion (subject to inflationary adjustment by the SEC every five years) during its most recently completed fiscal year.
For those companies that qualify as EGCs, Title I creates a simplified IPO process or IPO on-ramp. Instead of preparing and filing a formal IPO registration statement and prospectus, EGCs can obtain confidential SEC staff review of draft IPO registration statements, scaled disclosure requirements, no restrictions on “test the waters” communications with qualified institutional buyers.
And institutional accredited investors before and after filing a registration statement, and fewer restrictions on research (including research by participating underwriters) around the time of an offering.
Title II: Private Placements and New Rule 506(c)
Title II of the JOBS Act directs the SEC to eliminate the ban on general solicitation and general advertising for certain offerings under Rule 506 of Regulation D, provided that the securities are sold only to accredited investors.
Rule 506 of Regulation D, has traditionally been the most popular means for conducting a private offering because it permitted issuers to raise an unlimited amount of money and preempts state securities laws.
As long as all purchasers in the offering were accredited investors (very wealthy and/or sophisticated people) and up to thirty-five nonaccredited investors (everyone else). No general solicitation or general advertising was allowed in a traditional Rule 506 offering.
Title II directs the SEC to revise Rule 506 to provide that the prohibition against general solicitation or general advertising in Rule 502(c) shall not apply to offers and sales of securities made pursuant to Rule 506, provided that all purchasers of the securities are accredited investors or the issuer “reasonably believes” them to be accredited, investors.
Title II further requires that issuers using general solicitation or general advertising in connection with Rule 506 offerings take reasonable steps to verify that purchasers of securities are accredited investors, using methods to be determined by the SEC.
If an issuer is not comfortable making this effort, it can still use a traditional Rule 506 offering (no general solicitation or advertising, purchasers limited to accredited investors, and up to thirty-five other investors).
On July 10, 2013, the SEC approved final rules under Title II that eliminate the prohibition against general solicitation and general advertising in certain offerings of securities pursuant to Rule 506 of Regulation D.
The rules create a new form of the offering under Rule 506(c) that permits issuers to use general solicitation in connection with the sale of securities in private placements if the purchasers of all securities are accredited, investors and the issuer takes reasonable steps to verify that the purchasers are accredited, investors.
The new rules leave intact Section 4(a)(2) of the Securities Act, which exempts from registration transactions by an issuer “not involving any public offering,” and existing Rule 506(b), which provides a safe harbor under Section 4(a)(2) for offerings conducted without general solicitation.
Under Rule 506(c), issuers will be permitted to approach prospective investors even without a preexisting relationship. Advertisements, articles, notices, or other public communications will be permitted, as will public seminars and meetings to promote the offering.
The bad news here is that there will be a greater risk of running afoul of federal and state antifraud rules while engaging in general solicitation activities under Rule 506(c), such as live speaking engagements and webinars where it may be difficult if not impossible for company founders and promoters to hold their tongues when necessary.
Rule 506(c) requires issuers to take “reasonable steps” to verify accredited investor status. Unlike Rule 506 offerings, where general solicitation is not used, an investor will not be able to self-certify his status by filling out an accredited-investor questionnaire.
While such questionnaires will no doubt continue to be used, an issuer under Rule 506(c) will have to perform some due diligence on each of her investors, such as reviewing federal income tax returns, personal financial statements, bank and brokerage statements, credit reports, and other financial information, and/or requesting certification letters from the investor’s brokers, lawyers, and accountants confirming the information in the questionnaire.
An issuer relying on Rule 506(c) will have to fill out and File SEC Form D (a sales report) no later than fifteen calendar days before commencing general solicitation and general advertising and include specific disclosures in its general solicitation and advertising materials.
In a traditional Rule 506 offering involving no general solicitation, Form D is not due until fifteen calendar days after the first sale of securities in the offering. On Form D, an issuer must state whether it is relying on Rule 506(c) or a traditional private placement under Rule 506 (one without general solicitation) and will not be able to change it later if it makes a mistake.
Because of its anticipated impact on angel investor offerings, the text of new Rule 506(c) deserves to be quoted in full:
(c) Conditions to be met in offerings not subject to limitation on manner of offering—(1) General conditions. To qualify for exemption under this section, sales must satisfy all the terms and conditions of §§230.501 and 230.502(a) and (d).
(2) Specific conditions—(i) Nature of purchasers. All purchasers of securities sold in any offering under paragraph (c) of this section are accredited, investors.
(ii) Verification of accredited investor status. The issuer shall take reasonable steps to verify that purchasers of securities sold in any offering under paragraph (c) of this section are accredited, investors.
The issuer shall be deemed to take reasonable steps to verify if the issuer uses, at its option, one of the following non-exclusive and non-mandatory methods of verifying that a natural person who purchases securities in such offering is an accredited investor; provided, however, that the issuer does not have known that such person is not an accredited investor:
(A) In regard to whether the purchaser is an accredited investor on the basis of income, reviewing any Internal Revenue Service form that reports the purchaser’s income for the two most recent years and obtaining a written representation from the purchaser that he or she has a reasonable expectation of reaching the income level necessary to qualify as an accredited investor during the current year;
(B) In regard to whether the purchaser is an accredited investor on the basis of net worth, reviewing one or more of the following types of documentation dated within the prior three months and obtaining a written representation from the purchaser that all liabilities necessary to make a determination of net worth have been disclosed:
(1) With respect to assets: Bank statements, brokerage statements and other statements of securities holdings, certificates of deposit, tax assessments, and appraisal reports issued by independent third parties; and
(2) With respect to liabilities: A consumer report from at least one of the nationwide consumer reporting agencies; or
(C) Obtaining a written confirmation from one of the following persons or entities that such person or entity has taken reasonable steps to verify that the purchaser is an accredited investor within the prior three months and has determined that such purchaser is an accredited investor:
(1) A registered broker-dealer;
(2) An investment adviser registered with the Securities and Exchange Commission;
(3) A licensed attorney who is in good standing under the laws of the jurisdictions in which he or she is admitted to practice law; or
(4) A certified public accountant who is duly registered and in good standing under the laws of the place of his or her residence or principal office.
(D) In regard to any person who purchased securities in an issuer’s Rule 506(b) offering as an accredited investor prior to September 23, 2013 and continues to hold such securities, for the same issuer’s Rule 506(c) offering, obtaining a certification by such person at the time of sale that he or she qualifies as an accredited investor.
The SEC also created new Rules 506(d) and (e), providing that companies that have run afoul of the securities laws in the past (by committing one or more of the “bad acts” that disqualify issuers from offering securities under Regulation A) could not avail themselves of the new unlimited “accredited investor only” offerings.
Basically, a company cannot take advantage of Rule 506(c) offering if it, or any of its directors, officers, or principals:
Has been convicted, within ten years before such sale (or five years, in the case of issuers, their predecessors, and affiliated issuers) of any felony or misdemeanor in connection with the purchase or sale of any security;
Involving the making of any false filing with the SEC; or arising out of the conduct of the business of an underwriter, broker, dealer, municipal securities dealer, investment adviser, or paid solicitor of purchasers of securities
Is subject to any order, judgment, or decree of any court of competent jurisdiction, entered within five years before such sale, that, at the time of such sale, restrains or enjoins such person from engaging or continuing to engage in any conduct or practice in connection with the purchase or sale of any security;
Involving the making of any false filing with the SEC; or arising out of the conduct of the business of an underwriter, broker, dealer, municipal securities dealer, investment adviser, or paid solicitor of purchasers of securities
Is subject to a final order of a state securities commission (or an agency or officer of a state performing like functions); a state authority that supervises or examines banks, savings associations, or credit unions; a state insurance commission (or an agency or officer of a state performing like functions); an appropriate federal banking agency;
the U.S. Commodity Futures Trading Commission; or the National Credit Union Administration that at the time of such sale (i) bars the person from association with an entity regulated by such commission, authority, agency, or officer; engaging in the business of securities, insurance, or banking; or engaging in savings association or credit union activities, or
(ii) constitutes a final order based on a violation of any law or regulation that prohibits fraudulent, manipulative, or deceptive conduct entered within ten years before such sale
Is subject to an SEC order that, at the time of such sale, suspends or revokes such person’s registration as a broker, dealer, municipal securities dealer, or investment adviser; places limitations on the activities, functions, or operations of such person; or bars such person from being associated with any entity or from participating in the offering of any penny stock
Is subject to any order of the commission entered within five years before such sale that, at the time of such sale, orders the person to cease and desist from committing or causing a violation or future violation of Section 5 of the Securities Act or the antifraud provisions of any federal securities law
Is suspended or expelled from membership in, or suspended or barred from association with a member of, a registered national securities exchange or a registered national or affiliated securities association for any act or omission to act constituting conduct inconsistent with just and equitable principles of trade
Has filed (as a registrant or issuer), or was named as an underwriter in, any registration statement or Regulation A offering statement filed with the commission that, within five years before such sale, was the subject of a refusal order, stop order, or order suspending the Regulation A exemption.
or is, at the time of such sale, the subject of an investigation or proceeding to determine whether a stop order or suspension order should be issued; or
Is subject to a U.S. Postal Service false representation order entered within five years before such sale, or is, at the time of such sale, subject to a temporary restraining order or preliminary injunction with respect to conduct alleged by the United States Postal Service to constitute a scheme or device for obtaining money or property through the mail by means of false representations
Under new SEC Rule 506(e), the issuer is required to furnish to each purchaser, during a reasonable time prior to sale, a description in writing of any matters that would have triggered disqualification under Rule 506(d) but occurred before September 23, 2013.
The failure to furnish such information in a timely fashion will not prevent an issuer from relying on Rule 506(c) if the issuer establishes that it did not know and, in the exercise of reasonable care, could not have known of the existence of the undisclosed matter or matters.
As I will state in this blog’s Afterword, I believe it is Title II of the JOBS Act—as opposed to the crowdfunding provisions in Title III—that will actually facilitate crowdfunding, at least by the more seasoned early-stage private companies that tend to attract accredited investors.
That said, there are a few “gotchas” in Title II.
First, Title II leaves intact the general solicitation and general advertising prohibition for offerings that include any “non-accredited” investors, such as employees, product developers, and other people contributing sweat equity for their shares.
These people would have to be brought on board as founders (and their number would be strictly limited as under previous law) well before a company offers securities under Title II.
Second, an issuer who plans to rely on Rule 506(c) but fails to comply to the letter with the rule’s requirements may not be able to rely on the residual exemption under Section 4(a)(2) of the Securities Act, as issuers who rely on the traditional Rule 506 offering have always been able to do, because of that section’s express prohibition on general solicitation and general advertising.
Third, while the JOBS Act expressly preempted state securities laws that might otherwise prevent or restrict an offering under the Title III crowdfunding provisions of the JOBS Act, the same blanket preemption does not apply to offerings under new Rule 506(c).
While the National Securities Markets and Improvements Act of 1996, discussed in the previous blog, generally preempts state securities laws requiring registration at the state level of Rule 506 offerings (including offerings under Rule 506(c)), offerings under Rule 506(c) may still be subject to notice filing requirements (and possibly fees) in some states.
Determining whether a Rule 506(c) offering triggers notice-filing requirements and payment of fees will likely involve additional diligence for issuers currently relying on blue-sky exemptions conditioned on the prohibition of general solicitation, with attention to the specific rules of each state.
Finally, while the JOBS Act preempts any state blue-sky laws requiring registration of securities at the state level, the states are still allowed to enforce their antifraud rules to target Rule 506(c) private placements, as well as crowdfunded offerings, for fraud. Crowdfunded offerings will often involve a high degree of risk.
Start-ups have a high rate of failure, and—let’s face it—some offerings will likely involve fraud or at least sloppiness in complying with the securities laws. Given the $1 million limits on the size of the offering, the SEC will not be likely to engage in significant enforcement activities.
So the burden of enforcing the crowdfunding marketplace for securities may well fall to the states, and there may be fifty different sets of rules and fifty different regulators.
Given that the states have also been given responsibility for overseeing funding portals, the message Titles II and III send to issuers may well be, “You register with the feds, but you answer to your state regulator(s) if anything goes wrong.”
Title III: Crowdfunded Offerings of Securities
Title III is the heart of the JOBS Act, containing the provisions that will allow crowdfunded offerings of securities on the Internet. On October 23, 2013, the SEC issued a proposed Regulation Crowdfunding containing rules and regulations implementing Title III.
After a period of public comment, the final version of Regulation Crowdfunding was approved by the SEC on October 30, 2015, with an effective date of May 16, 2016.
Title III added a new Section 4(a)(6) to the Securities Act to permit companies to engage in crowdfunded offerings of securities without having to go through the public offering registration process. The exemption is subject to the following conditions:
The aggregate amount an issuer may sell to all investors in reliance on the new exemption may not exceed $1 million in any twelve-month period (offerings made under other exemptions such as Regulation A do not count toward the $1 million limits).
An investor is limited in the amount he or she may invest in crowdfunding securities in any twelve-month period.
• If either the annual income or the net worth of the investor is less than $100,000, the investor is limited to the greater of $2,000 or 5 percent of his or her annual income or net worth.
• If the annual income or net worth of the investor is $100,000 or more, the investor is limited to 10 percent of the lesser of his or her annual income or net worth, to a maximum of $100,000.
(the SEC justified this approach by expressing concern about the number of U.S. households—approximately 20 percent—where there is a sizable gap between net worth and annual income, and the ability of these households to withstand the risk of loss).
• Regulation Crowdfunding treats investors who fall within both of these definitions as being able to take advantage of the higher investment limit.
The transaction must be made through a broker-dealer registered with the SEC or through a funding portal (a new designation under the Securities and Exchange Act of 1934) that meets the requirements.
The issuer must comply with numerous disclosure and other requirements, described in detail elsewhere in this blog.
Title III of the JOBS Act also added new Section 4A to the Securities Act of 1933, containing numerous hoops that issuers, funding portals, and investors will need to jump through to launch a successful crowdfunded offering. Regulation Crowdfunding, which implemented these requirements, contains nearly seven hundred pages of new regulations.
The bottom line on Title III of the JOBS Act and Regulation Crowdfunding is that companies desiring to use the crowdfunding option will have to go through much of the paperwork involved in an IPO or an offering of securities under the “simplified public offering” rules in the SEC’s
Regulation A, although on a streamlined scale. Once a successful Title III crowdfunded offering is completed, the issuing company will have to file annual reports with the SEC and deal with dozens, or perhaps hundreds, of investors whose level of sophistication and maturity will be all over the map, just like public companies do.
Title IV: Expanded Availability of Regulation A
Title IV of the JOBS Act created a new Section 3(b)(2) of the Securities Act to allow companies to issue up to $50 million in securities under Regulation A (up from $5 million).
Although the details of certain provisions of the new exemption must be decided by future SEC rulemaking, Title IV of the JOBS Act does specify several important requirements of the new exemption:
Offering Limitation. The new exemption will allow companies to issue up to $50 million in securities under Regulation A (up from the $5 million currently available) within the prior twelve-month period.
Unlike the $5 million limitations under Regulation A, which has remained in place since 1992, the SEC is required every two years to consider raising the $50 million limitations.
Unrestricted Resales. Similar to offerings under Regulation A, securities sold under the new exemption will be freely tradable upon issuance to investors in the offering.
Testing the Waters. Similar to offerings under Regulation A, issuers that rely on the new exemption may confidentially solicit investor interest prior to filing offering statements with the SEC. However, the SEC must conduct a further rulemaking to determine the terms and conditions placed on such solicitation.
Audited Financial Statements. Unlike issuers who conduct offerings under Regulation A, issuers relying on the new exemption must file audited financial statements with the SEC on an annual basis upon completion of the offering.
The SEC must conduct a further rulemaking to determine whether audited financial statements should also be required as part of the offering statement.
Liability. The civil liability provisions of Section 12(a)(2) of the Securities Act apply to people offering or selling such securities pursuant to the new exemption.
Offering Statement. Companies relying on the new exemption may need to file an offering statement with the SEC. However, the SEC must conduct a further rulemaking to determine the requirements of any such offering statement.
Periodic SEC Reporting. Unlike Regulation A, companies relying on the new exemption may be subject to periodic SEC reporting upon completion of the offering. However, the SEC must conduct a further rulemaking to determine specific filing requirements, if any.
Specifically, the SEC must consider requiring periodic disclosure about a company’s business operations, financial condition, corporate governance principles, and use of investor funds.
Title V: Changes to Definition of “Public Company” in the Securities and Exchange Act of 1934
Title V of the JOBS Act amends Section 12(g) of the 1934 Securities and Exchange Act, which governs the annual reports and other documents required to be filed with the SEC by publicly traded companies. The amendments raise the threshold number of shareholders required to trigger securities registration requirements with the SEC.
Registration under the 1934 act has significant consequences. Registered companies must file periodic reports, adhere to the proxy rules, prohibit short-swing profits, and comply with other requirements of the federal securities laws. These provisions protect investors but also add significant cost to a company’s operations.
Title V changed the requirements for registration in a complicated fashion. The amendment increased the threshold for registration from five hundred holders of record to two thousand.
But it provided that companies with five hundred nonaccredited investors must register. The JOBS Act also excluded from the total of those employees who acquired shares through certain compensation plans.
Title V of the JOBS Act increased the threshold for registration in Section 12(g) to two thousand people of record or five hundred people “who are not accredited, investors.”
In addition, the provision excluded from the definition of “holder of record” those people who received securities through employee compensation plans.
The legislation instructed the SEC to adopt a safe harbor implementing the provision and to examine whether it needed additional enforcement authority to prevent evasion of the requirement.
Title VI: Special Provisions for Banks and Bank Holding Companies
Title VI of the JOBS Act raises the threshold for banks and bank holding companies for mandatory 1934 act registration from five hundred shareholders of record to two thousand (and unlike Title V, there is no limitation to the number of non-accredited investors).
Since passage of the JOBS Act, a bank or a bank holding company is required to register its securities when its total assets exceed $10 million and any class of its equity securities is held of record by two thousand or more people.
As with other types of issuers, this number does not include employees who acquired their securities through an exempt employee compensation plan or holders who acquired their securities through crowdfunding offerings.
Title VI also amended Section 12(g)(4) of the 1934 act, which provides a mechanism for deregistration. Issuers may terminate the registration of certain securities by filing a certification with the SEC that the number of holders of record of the class of securities in question has fallen to fewer than three hundred people.
Title VI sets the threshold at one thousand two hundred for banks and bank holding companies. (It remains three hundred for other types of issuers.)
What the Author Really Thinks of Crowdfunding
Throughout this blog, I have taken great pains not to editorialize or give my personal views of crowdfunding, its future potential as a means of raising capital for entrepreneurs and small businesses, or the likelihood that crowdfunding will revolutionize the securities industry.
First, Bad News
Although Title III of the JOBS Act and Regulation Crowdfunding are excellent attempts at loosening the restrictions that have held back small business capital raising since the Great Depression, they do not go far enough to ensure that crowdfunding will be the revolutionary new financing tool its promoters intended it to be.
There are a number of reasons for this.
The 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
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.
Don’t Get Me Wrong
There will certainly be crowdfunded offerings of securities under Title III and Regulation Crowdfunding —just not as many as crowdfunding’s promoters and cheerleaders think there will be.
As currently drafted, there is a risk that Title III will end up in the same place as the SEC’s Regulation A, which has been around since 1964 but has generated only a handful of successful offerings as compared to those under the SEC’s Regulation D.
Now for the Good News
Before my readers get out their pitchforks and torches and start “doxing” me as a heretic on their social media pages, let me say there is one aspect of the new crowdfunding scheme that is truly groundbreaking and has the potential to revolutionize at least one corner of the securities industry.
That aspect is Title II of the JOBS Act, relating to offerings made by general solicitation and advertising to accredited investors only, which I predict will totally transform the angel investor industry.
Traditionally, angel investors—millionaire-next-door types of individuals who provide capital and advice to start-up and very early-stage companies— are an isolated bunch of loners.
Their investments tend to be purely local, to companies based in their hometowns or counties. The most social of them belong to an angel club consisting of not more than ten people who meet once a month at a local country club or restaurant.
They are often ignorant of investment opportunities in other states (or countries), especially in industries other than the one they know thoroughly from their years of working in corporate America. Probably the greatest challenge in the entire venture capital industry is introducing promising new start-up companies to the right angel investors.
One of the goals I and my colleagues had when we put together the MoneyHunt television show in the early 1990s was to create a portal—yes, we actually used that word back then—to help isolated angel investors around the country identify the most promising start-ups, no matter where they were geographically based or what industry they were in.
Title II crowdfunding, which enables websites dedicated to accredited-investor-only offerings to reach out to investors via general solicitation and general advertising methods, has the potential to be precisely that portal, opening up angel investment to scores of start-up and early-stage companies that today don’t even have a clue where to begin looking for such folks.
Even better, Title II crowdfunding will enable these websites to build up a database of qualified accredited-investor angel investors that they can share to find the perfect fit for a particular start-up or entrepreneur.
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
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
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.
The Longer-Term Picture
Looking at the longer-term picture, crowdfunded investments have the potential to become the norm for private equity investment in early-stage companies.
The people who promoted Title III were absolutely right in pointing out to Congress and the SEC that investors today are a lot savvier and have access to lots more information at their fingertips (literally) than investors.
In early-twentieth-century America could even imagine, making the investor protections of the federal and state securities laws much less necessary than they were in Franklin D. Roosevelt’s day.
It’s just that I think it will take longer to get there than the current wisdom says it will. Change, especially in an industry so tradition-bound and cautious as the securities industry (yes, I am saying that without irony), happens only slowly and incrementally.
It will take longer than a few years for the industry, and its regulators, to accept the hypothesis that the crowd knows more collectively than the individuals within it.
Getting Your Money from the Funding Portal
While an offering is pending, Regulation Crowdfunding requires a funding portal to direct investors to transmit funds to a “qualified third party” (usually a bank, brokerage firm, or other financial institution) that has agreed in writing to hold the funds for the benefit of, and to promptly transmit or return the funds to, whoever the funding portal directs.
Upon completion of a crowdfunded offering, the funding portal is required to direct the qualified third party to transmit funds to the issuer on the later of the following dates:
The date on which the total invested funds exceeds the target offering amount (or the minimum offering amount described in the issuer’s Form C disclosures) and the five-business-day cancellation period has elapsed for all investors. Twenty-one days after the offering commenced. The funding portal is also required to deliver:
To each investor: a confirmation of her transaction at the time her funds are released to the issuer
To the issuer: a list of the names, addresses, and other contact information for each investor who participated in the offering, along with the number of securities purchased by that investor and the total amount of his investment
Issuing Your Securities to Investors
Now you and your management team have work to do. Because funding portals under Regulation Crowdfunding are prohibited from handling securities or money, you will have to deliver your securities to each investor in your crowdfunded offering or provide some other evidence of their interest in your company.
Debt securities such as promissory notes almost always exist in physical form. You should have a separate note for each investor and send the original note to each investor, keeping only photocopies for your company records.
Equity securities are different. Under the corporation laws of virtually every state, securities can be either “certificated” or “uncertificated.”
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.
Under the corporation laws of virtually all states, a corporation must have stock certificates for each class of its capital stock (common and preferred) that state on their faces:
The name of the issuing corporation and that it is organized under the law of the state of X. The name of the person to whom the certificate was issued The number and class of shares the certificate represents
In addition, the designations, relative rights, preferences, and limitations applicable to the class of stock represented by the certificate must be summarized on the front or back of each certificate.
Alternatively, each certificate may state conspicuously on its front or back that the corporation will furnish the shareholder this information on request in writing and without charge.
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 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.
COMMUNICATING WITH YOUR CROWD
Keeping Your Crowd Under Control
Once your crowdfunding offering is complete, you have dozens, if not hundreds, of new business partners. Yes, you read that correctly. I said partners—not shareholders, not investors, not LLC members.
The reason is simple: the people who invest in your company are, for all legal and practical purposes, partners. They may not have the right to vote on management decisions, but they have the right to speak, they have the right to be heard (or at least tolerated in a professional manner).
They have the right to complain, and they have the right to file a class-action lawsuit or launch a takeover of the company if they are really, really unhappy with the way things are going.
In some states, disgruntled investors also have the right to petition state courts to dissolve and liquidate your company if they feel things aren’t going anywhere fast.
Coping with Your New Partners
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
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
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.
When It’s Time to Throw in the Towel
You have completed a successful Title III crowdfunded offering. You raised a ton of money. You spent it all trying to launch your business plan. And the business went nowhere.
A follow-up offering of securities won’t help. The idea was a bad one or wasn’t right for the times. Your company is dead: dead as a doornail (with apologies to Charles Dickens).
You have dozens or hundreds of investors waiting for a return on their investments, and now you have to break the news that your company is worthless, your investors will have to write off their investments, and you are going back to school to learn a profitable trade.
You have a big, 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.
Going Back for Seconds: Launching Multiple Crowdfunded Offerings
Raising money for your company through crowdfunding techniques is a little bit like getting hooked on drugs, alcohol, or other addictive substances: if your experience is a good one overall, you probably won’t be able to wait until the next hit.
Generally, as I’ve hinted throughout this blog, the fewer investors your company has, the better and easier it will be to keep them happy and on board for the long haul.
Managing a crowd of hundreds or thousands of investors is easy for large public companies with the staff and budget to have an investor-relations department wholly devoted to the task.
It is far more difficult for a start-up company that needs to devote 100 percent of its management time to developing the products and services that will ensure the company’s success, with as few distractions as possible.
While Title III crowdfunded offerings may be an excellent way (heck, perhaps the only way) for start-ups and concept companies to raise the capital necessary to start down the entrepreneurial path, your long-term goal in managing finances should be to raise money from fewer and fewer, and better and more sophisticated investors as you grow your business.
Can You Launch Other Offerings at the Same Time as Your Crowdfunded Offering?
Generally, yes. Title III does not prohibit you from having concurrent (simultaneous) offerings of your company’s securities. Regulation Crowdfunding specifically states that Title III offerings are not to be “integrated” with other offerings for purposes of determining the limitations on those other offerings.
So, for example, if you are raising money from accredited investors in an offering under SEC Rule 506(b), which prohibits general solicitation and advertising, the fact that you are using general solicitation methods in your Title III crowdfunding will not “taint” your Rule 506(b) offering as long as you don’t make any general solicitation of the latter offering.
But—and it’s a big but—an issuer conducting a concurrent exempt offering for which general solicitation is not permitted will need to be satisfied that purchasers in that offering were not solicited by means of the offering made in reliance on Regulation Crowdfunding.
For example, the issuer may have had a pre-existing substantive relationship with such purchasers. Otherwise, the solicitation conducted in connection with the crowdfunding offering may preclude reliance on Rule 506(b).
The amount your company can raise under Regulation Crowdfunding in any 12-month period is limited to $1 million. So, if your company raises $800,000 in an offering that closes on June 30, it will have to wait until July 1 of the following year if it wants to raise more than $200,000 under Regulation Crowdfunding.
Similarly, if an affiliate of your company (defined as an entity “under common control with” the issuer) or a predecessor of the affiliate, has raised capital under Regulation Crowdfunding during the preceding 12 months, that offering will limit the amount your company can raise under Regulation Crowdfunding until the 12-month period has expired.
Although the SEC allows concurrent offerings of securities under different exemptions, it may be difficult as a practical matter to keep each offering within its particular “silo” of regulations.
Your funding portal and advisors will need to keep a watchful eye on the progress of each offering to make sure they don’t “cross paths” in such a way as to lose their specific exemptions.
Keep in mind, though, when launching private offerings of securities outside the JOBS Act, that the old restrictions on those offerings remain in effect. So, for example:
When making an offering under SEC Rule 506(b), you cannot use general solicitation or general advertising to promote the offering and cannot have more than thirty-five investors who are not accredited, investors.
When making an offering under SEC Rule 504, you cannot use general solicitation or general advertising to promote the offering and cannot raise more than $1 million from private offerings (other than Title III crowdfunded offerings) during a twelve-month rolling period.
You may be required to file your offering documents with state securities regulators under state blue-sky laws that haven’t been specifically preempted by the JOBS Act.
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).