Monday, April 15, 2013

Crowdfunding: Legal Eagles Take a Chicken Little Approach

When it comes to crowdfunding, the legal community has taken a “sky is falling” view of the proposed funding mechanism for startup companies. Crowdfunding has created an enormous buzz within the startup finance community. In fact, my fellow authors on entreVIEW blog have written about it enough that it’s among the top 20 most frequent tags since we launched our blog for entrepreneurs a couple of years ago. However, regulators and practitioners have not only thrown cold water on the idea, they have also begun to squawk about its approaching perils. If you’re excitedly expecting that crowdfunding will fundamentally transform the way companies raise capital, the legal community is telling you to think again.

Unlike traditional donation-based Crowdfunding through sites like Kickstarter, equity Crowdfunding involves the sale of ownership interests in a company to a large number of investors via the Internet (or other means of “general solicitation”). Crowdfunding was included in the federal JOBS Act passed more than a year ago to facilitate capital raising of up to $1 million annually by early stage companies. Companies selling shares are currently prohibited from “general solicitation,” which involves the offer of shares to people you don’t know via public means such as offers made via the Internet, advertisements, or cold call. The enormous change proposed by Crowdfunding in the JOBS Act is the removal of the prohibition on general solicitation to unsophisticated potential investors . This means that companies could be permitted to offer shares of their stock on websites, billboards and radio ads, just like kitchen gadgets, life insurance and Viagra. 

The startup and fundraising communities are excitedly waiting for Crowdfunding to become effective. However, the legal community is taking an entirely different view. I recently attended a national legal education seminar on private company financings. The expert panel included representatives of the SEC, which is responsible for adopting regulations to give effect to Crowdfunding but has not done so after more than a year of waiting. Also on the panel were state securities law administrators who are responsible for investigating fraudulent capital raising activities.  

Simply put, federal and state regulators are horrified at the prospect of Crowdfunding. One state regulator acknowledged that she and her 49 state counterparts are “freaking out” about the impending rampant investor fraud and the lack of resources to address the problem, which they believe will lead to a decrease in investor confidence and less investment. State regulators view the world as being full of unscrupulous fraudsters waiting to prey upon unsuspecting widows and orphans. They have the right to be concerned as there are certainly a number of these fraudsters separating the elderly and unsophisticated from their retirement funds.  

Representatives of the SEC made it clear that they are not in a hurry to adopt regulations that will commence Crowdfunding. If it were up to them, it seems to me that they would wait forever. Congress, on the other hand, has reportedly been getting impatient.

Whether Crowdfunding will have a significant positive impact on financing will depend on the scope of the regulations adopted by the SEC. Onerous regulations requiring audited financial statements, extensive offering disclosure documents and limits on amounts that can be invested (all telegraphed as possibilities by the JOBS Act legislation) will put Crowdfunding six feet under, similar to the Small Corporate Offering Registration (“SCOR”) adopted ten years ago for similar purposes. Burdensome requirements that eviscerate Crowdfunding seem like counterproductive overkill. Many practitioners believe the Crowdfunding regulations will be “unworkable.” Companies struggling to raise money could use a little help. But help from Crowdfunding does not appear likely. 

Unlike the doomsday view of equity Crowdfunding the regulators and practitioners (much like my colleague, Dan Tenenbaum in this prior post) gave a much warmer response to permitting general solicitation of accredited investors under Rule 506, which was also part of the JOBS Act. Accredited investors are wealthy persons or entities who are viewed as being more sophisticated and able to sustain a loss of investment in risky ventures based on their income or assets. They can also be referred to as “angel” investors. Most companies raising capital in private securities offerings today do so exclusively from accredited angel investors. Permitting general solicitation to reach these persons is a logical extension. What is really important is that investors are actually accredited (and the SEC has proposed regulation for “verification” of  accredited status) and not whether the investor learned about an investment from a web site or an advertisement. Based on the feedback of regulators and practitioners, general solicitation of accredited investors is likely to have a significant impact on startups raising capital in the future. 

The unfortunate truth is that Crowdfunding may be DOA and startup companies will continue to face the challenges of raising capital through more traditional means. However, based on my more than 20 years of experience, unsophisticated investors gained through Crowdfunding will be more numerous, demanding, bothersome and litigious than accredited angel investors anyway. Perhaps the premature death of equity Crowdfunding is a blessing in disguise.

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