Consider Crowdfunding at Your Own Peril ·Entrepreneur
Murray Indick and Jesse Finfrock
Crowdfunding made its much-awaited debut last summer to great fanfare. The new Regulation Crowdfunding rules enacted in May 2016 -- designed to facilitate small-scale investment into private businesses -- permit securities crowdfunding under the JOBS Act of 2012 such that anyone, not just accredited investors, can acquire an equity stake directly in a company. Yet despite the rapturous articles and frenzy of social media postings, early data from the Securities and Exchange Commission (SEC) suggests that capital raised under Regulation Crowdfunding is likely to remain a small portion of overall 2016 capital raised.
Regulation Crowdfunding was conceived to enable small companies to raise small amounts of capital from ordinary folks. The new rules allow companies to raise up to $1 million over a 12-month period, and investors are able to contribute up to $2,000 or a set percentage of their annual income or net worth (5 percent if an investor’s annual income or net worth is below $100,000 and 10 percent if it is above $100,000). The transactions take place over intermediary platforms, which face additional requirements for advertising and disclosure imposed largely to protect the investors.
Initial data provided by SEC Chair Mary Jo White shows that only $4.4 million in funds was committed by investors under the Regulation Crowdfunding rules within the first two months. Additional Morrison & Foerster LLP (MoFo) research reveals that, as of the beginning of November, there have been fewer than 150 offerings raising an aggregate of just under $20 million over the 19 platforms regulated and permitted by the SEC.
So why has there been a slow uptake of financing through Regulation Crowdfunding, and what should you be thinking about? Here’s the most important question to ask yourself when determining whether to pursue a crowdfunding approach -- Is crowdfunding good for your business?
The question often arises because entrepreneurs need initial capital to launch their businesses. The earliest cash generally comes from friends and family -- and credit cards -- but increasingly, entrepreneurs seek out incubators or accelerators that provide business guidance alongside of initial capital. Angel investors and high-net-worth individuals, either as individuals or through networks like Angel’s List, can play this role as well to varying degrees.
Arguably, though, some small startup companies may benefit from an increased investor base and easier access to capital that comes from Regulation Crowdfunding. Such democratized financing can enable new products, markets and businesses to grow and succeed organically with strong buy-in from its community and customers. This view also sees crowdfunding as beneficial to investors, and even society at large, since equity ownership is diversified among people who are often not direct shareholders or investors in companies.
However, Regulation Crowdfunding may not work for some startups, especially those with a social or environmental purpose, that are particularly uncomfortable giving away equity at such an early stage and for potentially little cash. So entrepreneurs -- often those in consumer product markets -- see crowdfunding as their last best alternative to bootstrapping. Beyond this, Regulation Crowdfunding also imposes the following potential significant issues that all startups need to think about and weigh when considering whether it is a worthwhile tradeoff for them before proceeding down this financing road.
Reporting requirements.
A company that elects to take advantage of Regulation Crowdfunding is required to file comprehensive documentation with the SEC before making a securities offering. The filing will contain extensive information about the company -- including names of the company’s directors and officers, anticipated business plans, financial data such as debt and the company’s risk factors -- and will be publicly available. In addition, the company will need to update this information once a year going forward, and file annual financial statements that may need to be audited. Finally, the company is required to file public “progress reports” disclosing material changes to investors for any crowdfunding securities offering that was not completed or terminated.
Additional costs.
According to initial assessments, there are likely to be significant administrative and accounting costs, much of which are due to the heavy reporting requirements discussed above. There will also be institutional costs. For example, all crowdfunding transactions must take place through a single “intermediary” -- a platform that is SEC approved and registered -- which may charge a fee or take an equity position in the company as compensation.
Promotion and advertisement.
Any public announcement about the offering, including advertising and promotions, are limited to:
A statement that the company is making an offering (and the name of and link to the intermediary platform conducting the offering)
The offering terms
Contact information and a business description of the company.
A company may hire a promoter, but disclosure of whether the promoter received compensation is required on each communication.
Financing limitations.
For companies that want to raise small amounts of capital, Regulation Crowdfunding may be an attractive option. However, the new rules prohibit companies engaged in crowdfunding from raising more than $1 million within a 12-month period, which for many high-growth startups is prohibitively low.
In addition to the limitations placed on the companies, there are also restrictions on how much each investor can contribute. Because each investor’s contribution is limited, companies will need to manage many more shareholders than they typically would in a seed financing round. Not only is it a burden on a small company to manage many investors, but institutional investors may not be inclined to invest alongside numerous unknown and unsophisticated shareholders. As a result, companies that take advantage of Regulation Crowdfunding may find it is difficult to bring in later stage capital when ready to scale -- a critical issue since scaling is often an even bigger challenge for startups than finding initial seed capital.
To date, we have not seen any U.S. companies that have raised venture capital from outside funds after first raising capital under the new Regulation Crowdfunding rules -- although a U.K. crowdfunding platform that crowdfunded itself did receive later venture capital support.
Investor relations.
Investing is about more than money since companies often seek strategic investors who can help them with introductions, future capital raising or business guidance. However, crowdfunding is unlikely to become a major source of deal flow for professional early-stage investors. The types of companies that are mainly utilizing these platforms are smaller slow-growth companies and -- largely due to the financial limitations of Regulation Crowdfunding -- are not the types of companies that achieve the scale/return that professional investors prefer. Because of this, a company that requires experienced and strategic investors is unlikely to find them on a crowdfunding platform.
Given all of the challenges noted above, many startups that had hoped to benefit from Regulation Crowdfunding may be better served by electing a more traditional venture capital approach. For some, if not most, the reporting requirements, costs and restrictions, management difficulties and the lack of professional early-stage investors in crowdfunding will outweigh the benefits. From our vantage point, the proponents of crowdfunding have more work to do before their ultimate vision is realized.
