Equity crowdfunding, hoped by many to be a promising new vehicle for capital formation for startups and other early stage companies, has yet to become operational under the JOBS Act – waiting on the SEC to promulgate proposed and final implementing regulations. With the interest and hype generated by the JOBS Act crowdfunding provisions, one thing is certain – the viability and utility of equity crowdfunding has both its supporters and detractors – with strong opinions on both sides of the debate.
Among the supporters are the legions of companies and individuals hoping to cash in as service providers to this nascent market. Among the many naysayers are some securities lawyers and regulators who see problems at every turn, and some VC’s, who have their own perspective on who should be raising capital and how it should be done.
The fact of the matter is this: Title III of the JOBS Act, which provides a structure to legitimize equity crowdfunding, is by reason of its pedigree an imperfect product. It suffered unduly from the machinations of the legislative process –being shaped by members of two houses of Congress and its myriad committees trying to reconcile a number of legitimate interests on a fast track, some of them in direct conflict. The very name of Title III of the JOBS Act, which is the crowdfunding section of the JOBS Act, bears this out: “Capital Raising Online While Deterring Fraud and Unethical Non-Disclosure Act of 2012”– The title of the law is itself an oxymoron of immense proportions. And to complicate matters further, there are a great deal of gaps and ambiguities in the law itself, many of which must be addressed through the SEC rulemaking process – expected to drag into 2014.
Size Matters
As in many areas of life, size matters. Equity crowdfunding is no exception. The dollar amounts that can be raised under the crowdfunding exemption are small, at least in relative terms, and the liability risk is disproportionately high. Added to this are the compliance costs and relative complexity of the equity fundraising structure envisioned by the JOBS Act.
- Limited Dollar Amounts – The JOBS Act exemption limits amounts raised in a 12 month period to $1 million. To get in the game and raise more than $100,000, a company seeking funds in this venue will need either “reviewed financial statements” (up to $500,000), or audited financial statements for raises between $500,000 and $1 million.
- Compliance Costs – The cost of a company engaging in equity crowdfunding will not be insignificant, in relation to the amount of funds sought. Until the SEC promulgates regulations, these costs will be difficult to gauge, but at the very least there will be accounting costs and the costs and fees of the crowdfunding portal itself. Also, each company will have another bridge to cross – do they rely on standardized documents generated by portals and ancillary service providers, such as CrowdCheck, or do they engage their own counsel to help them navigate through what some perceive as a potential legal minefield.
- Liability – This is an area which will drive both the costs and risks of engaging in equity crowdfunding. No doubt, equity crowdfunding has all the ingredients of an accident waiting to happen – historically high risk of failure for startups and early stage ventures; and hundreds or even thousands of investors in a venture who will likely see disappointment turn to anger as their investment capital evaporates. Unlike social crowdfunding, the primary motive for the majority of equity crowdfunders will be a return on their investment. And any way you slice it or dice it, when a company takes money from an investor, the regulatory deck is heavily stacked against the company and its control persons. The very risk of investor lawsuits will have a chilling effect on companies seeking to engage in smaller offerings – an issue which private insurance is unlikely to dissipate, due both to cost, limitations on coverage imposed by insurers, and legal impediments to insuring against liabilities arising out of securities laws violations.
- The Crowd – Unlike social crowdfunding, those seeking to raise equity from large numbers of investors in equity crowdfunding will undoubtedly discover that large numbers of investors are more likely to be a curse than a blessing, even if the venture is successful. A capitalization table with a large number of investors (as in hundreds or thousands) could be an impediment to subsequent financings through more traditional venture capital channels. However, with proper planning and documentation before the equity crowdfunding is launched there may be some legal workarounds for this issue.
The Road Ahead
To say equity crowdfunding is not perfect, perhaps even impractical, and fraught with peril to potential investors, should not be the end of the debate – but rather the beginning of undoubtedly what will be an ongoing process with a long and bumpy learning curve. Hopefully, out of the confusion will come a practical tool for some startups, and a recognition that there can and will (eventually) be better solutions to raising capital in the Internet age, in addition to equity crowdfunding. Undoubtedly there will be a need for further legislation and even more SEC rulemaking – both in the equity crowdfunding area and other capital raising avenues. For better or for worse, we are starting from a federal regulatory scheme which is 80 years old as well as a patchwork of disparate state Blue Sky regulation, all of which serve as a barrier to capital formation. This will be a slow and painful process, but the process has begun – and will serve as an impetus to break down outmoded and unnecessary barriers to capital formation in the Internet age, where information is more easily and economically transmitted, while at the same time providing a reasonable degree of protection to the investing public and the integrity of the capital markets.
By most estimates, equity crowdfunding under the JOBS Act is not expected to become a reality until sometime in 2014, when the SEC (hopefully) completes its rulemaking process, with proposed rules rumored to be published perhaps as early as September or October of 2013. For those entrepreneurs and companies contemplating what equity crowdfunding holds for them, there is more than ample time to consider existing alternatives to equity crowdfunding, depending on the particular business model and stage of development. The options do not depend on the enactment of crowdfunding regulations.
Companies with a viable business plan should consider other types of unregistered offerings, including private transactions with a small number of friends and family, or limiting the offering to “accredited investors” meeting the income and net worth tests of SEC Regulation D. Those seeking “seed capital” for certain types of new startups should also explore interest in local “accelerators” and “incubators”. And for some companies, social or donation crowdfunding, which is outside the purview of federal and state securities laws, may be a good option to explore.
About the Author – Samuel S. Guzik is a corporate and securities attorney and business advisor admitted to practice before the SEC and in New York and California, with over 30 years of experience. During this time he has represented a number of public and privately held businesses, from startup to exit, concentrating in financing startups and emerging growth companies. For additional information regarding Mr. Guzik and his firm, Guzik & Associates, please visit his website at www.guziklaw.com.
