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.

Angel Networks Help Start-ups Find Reclusive Investors

Angel networks have garnered a lot of publicity lately. In Minnesota, the Minnesota Angel Network launched with much fanfare. In California, AngelList continues to have great success. Why are these networks so important to start-up companies? Money. And because angels are often hard to find.

Start-up and emerging companies need money. They particularly need money during what is called the “valley of death.” This is the stage in a company’s development after completion of a prototype but before generating enough revenues from sales of products to keep the lights on. Companies need money to continue paying employees and paying the rent until the time they can begin selling to customers. Venture capitalists used to invest in pre-revenue companies during this stage, but have moved farther down the development spectrum to revenue-generating companies that are less risky. It is in this valley of death where start-up companies need angel investors who are willing to make a leap of faith.

Angel investors are individuals who have extra money available to invest in high risk, early-stage companies. Most qualify as “accredited” investors, which means that they have a net worth of $1 million or more or annual income of $200,000 or more ($300,000 with a spouse). $1 million isn’t what it used to be and a $200,000 income might not even cover tuition at a private college, so I won’t call these angel investors “wealthy.”

The challenge for start-ups is in finding angels. They don’t stand on the street corner with a sign that says “Angel Investor.” Angels are very reclusive and don’t want unsolicited calls from novice entrepreneurs or stacks of business plans from start-ups operating in industries in which they have no experience.

Because angel investors don’t want to be found, entrepreneurs who need money must spend a lot of time finding angels the old fashioned way—networking. The most successful capital raisers I’ve seen are the ones who are relentless. If you tell them no, they’ll ask you why and ask for the names of three more investors to contact. They pound the pavement until they’ve secured the funding they need.

Angels like to have a filter that eliminates the bad deals, and allows the good deals to get to them. This filtering process can be done through individuals such as entrepreneurs, founders, advisors, and professionals. Sometimes the greatest help I can provide a start-up is making an introduction to an investor.

Angel networks remove the inefficiency and time required in this process. In a network, angels sit idly by, waiting for an executive summary that catches their attention. The angel initiates and controls the communication. I expect that we’ll see more angel networks as the existing networks grow more successful.

All of this is a wonderful development for our entrepreneurial ecosystem. Good luck, Minnesota Angel Network. We need you.

Project Skyway—Episode 1: A New Hope

Tech incubator Project Skyway, welcome to Minnesota. What took you so long? When will all of your friends arrive?

Project Skyway, the new Twin Cities tech start-up incubator, held its inaugural bootcamp this past weekend at CoCo in St. Paul. As a member of the local tech start-up community, I was honored to be asked to participate in the bootcamp and given the opportunity to listen to aspiring tech entrepreneurs and teach them a thing or two.

On Friday night, the Project Skyway team, including visionary Cem Erdem and mover and shaker Casey Allen, mingled with all of the prospective Skywalkers (that’s what they call participating companies/entrepreneurs) and the glitterati of the local start-up tech scene. No, Cem did not wear a Darth Vader suit or claim that he was anybody’s father. However, Casey does remind me a little of C3PO, and one of the potential Skywalkers was kind of big and hairy like Chewbacca.

On Saturday morning, the Skywalker wannabees pitched each other’s deals. In the afternoon, the entrepreneurs participated in small group sessions with local start-up experts. Although I’m not bald, green, or pointy eared (yet), I played Yoda to a bunch of wide-eyed entrepreneurs, teaching these young Jedis the ways of the law. I was able to meet with all of the entrepreneurs from the 25 companies vying to be included in the final 10, and they didn’t have to travel to Dagobah. On Sunday, the start-ups were treated to advice about presentations and raising capital in the morning, and spent the afternoon pitching their deals.

The top legal issues for start-ups were abundantly clear—protecting equity and protecting intellectual property.

As novice entrepreneurs are prone to distribute equity like cocktails at the Mos Eisley cantina, much of the discussion addressed how to divvy up stock, how to force founders to earn that stock, and how to get the equity back into the company if one of the founders turns to the dark side and becomes a venture capitalist.

The intellectual property discussions centered on whether or not a software-based tech start-up should seek patent protection (always check with a patent attorney, but it’s probably not going to be worth the time and expense), and how to ensure that code developed by employees and consultants is, in fact, owned by the company. This discussion highlighted the tension between independent contractor software developers (whose tools are often incorporated into customer solutions or constitute proprietary platform technologies) and start-up companies, who are constantly drilled by lawyers, investors, and venture capitalists to own the technology.

Jedi mind tricks don’t work on VCs—“you will accept a $20 million pre-money valuation and non-participating preferred stock.”

The start-up teams were mostly comprised of men, in their late 20s, and based in Minnesota. Many of the business ideas were truly novel, and others provide solutions that are leaps and bounds ahead of their competitors.

I’m not sure how Cem, Casey, and their team are going to be able to narrow the 25 teams down to 10. Perhaps an inter-galactic battle looms. Cem, Casey, and the Project Skyway team have done their part. Now we all need to support Project Skyway and all of the Skywalkers. May the force be with them.

Catching the Buzz at MinneBar

I travel several times each year to the San Francisco Bay Area. When I’m there I often talk to Bay Area entrepreneurs, start-ups, investors, and other lawyers who work with start-ups. Each time I sense a tremendous amount of entrepreneurial energy. Techies are cranking out code from dawn ‘til dusk in local hangouts, entrepreneurs are pitching the next billion-dollar deal on every street corner, angel investors are pulling cash from their wallets and giving it to any startup with a sweet deck, and venture capitalists are elbowing each other to fund the next cool social commerce deal.

Well, maybe things in Silicon Valley aren’t quite the start-up nirvana that I’ve portrayed, but that’s the sense you get when you walk the streets of Palo Alto and Mountain View and talk to start-ups who have spent time in Silicon Valley. In fact, things have gotten so good in Silicon Valley lately that there are concerns about another tech bubble. Software developers and engineers are becoming difficult to find and very expensive, and office space is at a premium.

Recently, I caught a Silicon Valley-type buzz in the Twin Cities. I attended MinneBar. Attendance had more than doubled since I last attended a couple of years ago. In one of the day’s sessions, Jamie Thingelstad, local tech executive and uberpromoter of the local Minnesota tech scene, showed a simple bar graph of the event’s attendance rising from around 100 five years ago to more than 1,000 this year. That’s impressive.

MinneBar is an annual “(un)convention” of Minnesota techies. The goal of the annual event is to get members of Minnesota’s tech community together to share information and experience, meet each other, and even collaborate on projects. Participation and networking are the keys to the event. Throughout the day there were more than 60 sessions about software design and development, social media, hardware, start-ups, raising capital, and improving the Minnesota tech landscape. I caught the buzz.

Turning Minnesota into Silicon Valley North has been chattered about for years, but success has been slow. The reality is that Minnesota has a large and growing community of highly skilled techies ready and willing to innovate. The challenge to creating the buzz in Minnesota is to the rest of us. To me it comes down to leadership, success, and money. Members of the tech community and tech entrepreneurs need to promote tech and launch their start-ups here in Minnesota. This will generate a more robust and sustainable tech community and oodles of profitable tech companies. This success will lead to more money in the hands of technopreneurs, angels, and VCs, which will be used to fund the next batch of tech leaders. This circle of tech success needed a catalyst. Thanks MinneBar for providing the spark.

Awakening Minnesota’s Hibernating Entrepreneurial Economy

Each year at this time, the bears, wolves, and other animals native to Minnesota awake from their long winter slumber. Like these beasts, Minnesota’s entrepreneurial economy has been in hibernation for years. However, recent efforts undertaken by the State of Minnesota may yield an awakening.

In 2010, the Minnesota Legislature passed the Minnesota Science and Technology Act, which created the Minnesota Science and Technology Authority (MSTA). The mission of the MSTA is to “promote a business environment that fosters lasting and inclusive prosperity through the growth of innovation-based businesses and jobs.” Earlier this year, the MSTA distributed its strategic plan for Minnesota. The plan is informational and enlightening.

After reviewing the plan I was surprised to learn that Minnesota’s entrepreneurial economy really is in hibernation. I knew from firsthand experience in working with numerous start-ups trying to launch, raise capital, and grow that Minnesota start-ups faced financing and other challenges. But I was surprised to learn that in measuring entrepreneurial activity, Minnesota ranked near the bottom when compared to other states. In 2010 entrepreneurial activity, Minnesota ranked 42nd, a significant drop from 24th in 2007. Entrepreneurial activity is calculated by dividing the total number of entrepreneurs starting businesses by a state’s total population. In addition, in net high-tech business formation, Minnesota ranked 41st.

After several years of effort by various organizations that promote entrepreneurial activity, the State of Minnesota has recognized the hibernation and has taken its governmental stick and begun to poke at Minnesota’s slumbering entrepreneurial economy. In 2010, Minnesota adopted an angel investment tax credit, which provides angel investors with a credit of up to 25% of the dollar amount invested in qualified Minnesota start-up companies. While this tax credit came several years after similar credits were adopted by surrounding states such as Wisconsin and North Dakota, the effort was welcomed and necessary to catch up with these neighboring states. The state has also supported the establishment of the Minnesota Angel Network, an organization that will assist entrepreneurs in launching and funding new companies.

It will take more than a couple of pokes from state government to wake up Minnesota’s slumbering entrepreneurial economy. But at least the beast’s eyes are now open.