A Strategic Approach to Crowdfunding

By Roger Royse, Crowdfunding Beat Guest Contributor,

It’s been more than two years since the President signed the JOBS Act, which introduced the radical concept of letting the wisdom of the crowd instead of the conservatism of the regulator determine the sale of securities. The Crowdfunding movement (as expressed in the JOBS Act) is the result of the perfect storm of technology, legislation and market acceptance of the idea of leveraged fundraising models. There are now several new ways to raise money, and selecting the right approach, and avoiding the wrong one, are important considerations for every startup entrepreneur. See slideshows Crowdfunding and The Current State of Crowdfunding.   What do the new developments mean for a startup that now seeks capital? The past few years have opened up 3 main avenues for raising money: (i) donation or rewards-based crowdfunding (think Kickstarter or Indiegogo as examples); (ii) publicly solicited financings and (iii) . os-equity-crowdfunding-orlando-expert-panel-20-001 (1) Donation-Based Crowdfunding – Money for Nothing Despite the debate about equity crowdfunding, the scene is still dominated by donation-based (or rewards) crowdfunding, which has exploded in the last five years. Businesses can now seek donations on websites like Kickstarter and Indiegogo and, while not typical, there are success stories of businesses raising million dollar sums within just a few weeks. Donation based crowdfunding is best suited to young businesses that are still testing their model.   Websites provide businesses a platform upon which to raise money for whatever purpose they see fit (within reason) without having to give away any ownership interest in the business. In return for the public’s donations, the business offers rewards linked to the product for which they are seeking funds. Rewards vary from a thank you email for a $1 donation to a personal meeting with the business owner for a donation in the thousands of dollars. Many donors donate at a level where the reward is the actual product for which funds are being raised. cfb11 When used in this way, donation-based crowdfunding looks a lot like collecting pre-payments for goods and services. One of the key benefits of the donation model is the lack of securities regulation. That said, those raising money should make sure they follow through on their commitments. Earlier this year, the Washington attorney-general initiated a lawsuit against an individual for an alleged failure to deliver packs of playing cards to donors after collecting money through Kickstarter.   Equity Crowdfunding Title III of the JOBS Act Title III equity crowdfunding will allow companies to raise up to $1 million through a broker-dealer or registered funding portal. The issuer will be required to make disclosures to the SEC at least 21 days prior to the first sale and audited financial statements will be required for issuances above $500,000. Neither the issuer, nor the broker-dealer/funding portal, will be able to solicit investments and there will be caps on how much individual investors can invest in a given year. The JOBS Act instructed the SEC to draft regulations legalizing equity crowdfunding by the end of 2012. The SEC finally released proposed regulations in October 2013 and the comment period expired on February 4, 2014. Six months later the final regulations are still nowhere to be seen; however, based on the statute and the proposed regulations, Title III is unlikely to be very useful. For starters, the transaction costs will be relatively high after you add up brokers’ fees, accounting and audit, attorneys’ fees, and insurance due to the requirements (mostly added in the Senate version of the bill) for (in some cases) audited financial statements, a business plan, registered broker dealers and a heightened standard of liability for anyone who touches one of these offerings. In addition, many companies may be put off by the prospect of numerous small and unsophisticated shareholders. In conclusion, don’t hold your breath for this type of crowdfunding.     Funding Portals Under Rule 506 While Title III received much of the attention, most of the action has occurred under Rule 506, which provides two main forms of exemption. Broadly, under Rule 506(b) an issuer can issue securities to up to 35 non-accredited investors, but cannot use general solicitation in doing so. Conversely, under Rule 506(c) an issuer may conduct general solicitation, but it cannot issue securities to any non-accredited investors. Private Placements. In 2013, the SEC released two no-action letters that implied that issuers could use funding portals for Rule 506(b) issuances so long as access to the portal is restricted to accredited investors. Numerous “internet VCs” sprung up in the wake of these rulings (and, in fact, before the rulings).     Now, there is a healthy competition for deal flow by investor groups that form “one off” funds comprised of relatively large groups of accredited investors to invest through highly automated internet based funds. This has been more of a technology development than a legal one, since the internet has simply streamlined an existing investment process and allowed it to be leveraged more efficiently. As a practical matter, this development has freed up billions of dollars of new angel capital that may not have otherwise found its way into the startup world. Publicly Solicited Issuances. While Title II is hopeful, and 506(b) private placements are dominant, the future belongs to 506(c) publicly solicited transactions. Under 506(c), a company can advertise and publicly solicit the sale of its securities, provided that all eventual investors are verified as “accredited” with appropriate evidence such as tax returns, financial statements, or a letter from the investor’s lawyer or accountant. There are other requirements, such as increased Form D reporting, but all in all, the ability to advertise the sale of securities has huge potential. Many sites have been successfully marketing the sale of securities under this exemption and we can expect many more to figure it out going forward. Conclusions and Thoughts So what is a startup to make of this confusing array of options? Here are some general guidelines: If your company is newly formed, unestablished and you have not yet gotten “traction” (i.e. revenues or customer validation), consider rewards or donation based funding. Equity investment will be a hard sell without any sales metrics and pre sales or donations may be your best bet to raise money and prove the concept. If the startup has traction, a 506(b) offering has a lower hassle factor as a regulatory matter whether you seek funding on a private portal or the old fashioned way (with people with whom you have a pre-existing relationship). If the startup not only has good fundamentals (team, traction, technology) but is also in an affinity business (one that is cool, easy to understand, or otherwise hot), 506(c) publicly solicited fundraising may allow you to access (potentially) billions of dollars of new capital and may be worth a shot. In any case, strategy is important, as your company will want to take its best shot and target its most likely vehicle for raising money. By Roger Royse   Royse Law Firm

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