By Broc Romanek, Editor, TheCorporateCounsel.net
A lot of ink has been spilled about crowdfunding in the press, such as this Huffington Post piece that gives a plain vanilla take on crowdfunding (and here’s another piece). In addition, there are some misunderstandings in the press about the capital options that a company has – this infographic by Kiran Lingam and Anthony Zeoli can help sort that out.
Here’s some thoughts from members on crowdfunding (similar to this series of blogs a few years back): In response to a question about the effects of an initial crowdfunding investment on a possible later venture capital transaction, Patrick Reardon of The Reardon Firm had the following thoughts:
First, on your other point about representations and warranties in crowd-funding, please note that, while there may not be any reps or warranties in an initial crowdfunding round, there are the duties under SEC Rule 10b-5 and state securities laws to disclose all material information. So, one could view those as a form of statutorily-mandated representations and warranties.
Now to your point on later VC financings. Although my experience does not directly involving crowdfunding, my belief is that once a crowd-funder, always a crowd-funder. Well, if not “always,” at least to every conceivable statute of limitation expires.
The appeal of crowdfunding is that small (and often unsophisticated) investors make up the initial investors. Unfortunately, these people do not understand basic investment concepts like investment risks, dilution by subsequent investments, or corporate principles such as approval of related party transactions, dissenters’ rights, governance of the internal affairs of the entity by the state of formation, not the state where the investor resides, etc. For example, try explaining to a school teacher/investor why the company has to have a down-round venture capital financing for legitimate business reasons that don’t involve wrongdoing. Very likely, he or she will only see that his or her investment has decreased by X% in value.
Also, unsophisticated investors also often have unsophisticated attorneys. In Texas, I have seen cases where obvious corporate and securities law causes of action have been ignored, and other, what I consider off-the-wall causes of action, are pled. Our Texas courts have relatively lax pleading and procedural rules, and a significant portion of the trial bar will not bring cases in Federal courts. So you might get a securities law case brought under state law instead of Federal law, just to avoid the U.S. Dist. Cts. The effect of this is exacerbated by elected state judges who often have limited business litigation experience. Texas, unlike Delaware, does not have separate business courts.
Do not misunderstand. I am not singling out my home state. I think many states have a legal system similar to that I described above. The point is that foregoing all create far more than the usual uncertainty of possible claims. After years of representing professional investors, I feel that VC or other investors will see crowd-funded companies as fraught with unknown risks. This will scare off most professional investors from subsequent rounds.
That is why I say once a crowd-funder, always a crowd-funder. If your start-up company can limit itself to investments from accredited investors, I recommend a public solicitation under Reg. D, Rule 506(c), instead of crowdfunding.