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Equity-Based Crowd-Funding and its Risks for Entrepreneurs

"Crowdfunding" refers to the use of small amounts of money from a large number of people to fund a venture.

“Crowdfunding” refers to the use of small amounts of money from a large number of people to fund a venture.

Background to Crowd-Funding and the JOBS Act

With the passage of the Jumpstart Our Business Start-ups (JOBS) Act in April of 2012, entrepreneurs will soon be able to give equity stakes in their start-up companies to individuals who invest through registered crowd-funding sites. While proponents of crowd-funding maintain that allowing start-up companies to sell equity through crowd-funding will boost capital for start-up companies, entrepreneurs should be aware of risks and drawbacks involved with crowd-funding.

Currently, companies who raise money through crowd-funding cannot provide equity in exchange for crowd-fund investments. Rather, their investments are rewarded with small tokens or perks, such as receiving a new product or having their name listed on a website.  Kickstarter is a common example of a “crowd-funding” site that allows contributions to startups in exchange for tokens or perks other than equity. Without journeying too deep into the swamps of security regulations, it suffices to explain that, prior to the JOBS Act, companies that sold securities had to either register those securities or qualify for an exemption to the registration requirement (e.g., selling only to accredited investors under Rule 506 of Reg D).  Absent registration, a company could not solicit its securities to potential investors who did not have a substantive and pre-existing relationship with the company.  Additionally, companies who issue securities to more than 500 investors and have more than $10 million in assets were required to essentially go public.  This made selling equity to a broad group of investors virtually impossible.

In response to the perceived compliance cost barrier for start-up companies, Congress and the Senate passed the JOBS act, which President Obama signed into law in April. Along with across the board financial deregulation, the law carved out an exception for crowd-funding in securities law. Under the JOBS act, companies may issue securities to investors, even absent a substantive pre-existing relationship, provided that the aggregate amount raised through crowd-funding is no more than 1 million dollars, the amount contributed by any investor in one year does not exceed limits based on the investor’s annual income, equity is issued through a registered crowd-funding portal, and certain other requirements are met. Also, crowd-fund investors no longer count towards the 500 investor limit.  The SEC has not yet promulgated regulations on crowd-funding, so details are still unclear on how the SEC will regulate crowd-funding portals.

Much has been written about the need to protect crowd-funding investors, who often overestimate their investment’s potential and tend to be less cognizant of investment risks, tax consequences, and the lack of a secondary market for their investments. While investor protection is important, crowd-funding may also pose dangerous pitfalls for entrepreneurs.

Crowd-funding may deter subsequent investors

First, entrepreneurs who rely on crowd-funding for their first round of investment may find it more difficult to attract venture capital or angel investors in subsequent financing. Start-ups that ultimately achieve an IPO typically require multiple rounds of financing, with each new round of investors negotiating terms with existing investors. In the case of a start-up that relies on crowd-funding for seed stage capital, subsequent investors will find it difficult, if not impossible, to negotiate with a large number of prior investors, each with a small stake in the company. The overall effect is that start-ups may find that their successful crowd-sourced financing may actually deter subsequent investments.

Crowd-funding may jeopardize IP rights

Second, companies eager to post their product or business idea on a crowd-funding site can easily lose any intellectual property rights they have in their products or ideas. While entrepreneurs  pursuing capital from traditional investors will typically engage in smaller, more controlled discussions, raising capital using crowd-funding necessarily involves disseminating the idea to the public. As such, the entrepreneur will not be able to control who has access to its information or impose confidentiality terms with would-be investors.

Difficulty in managing investor expectations

Entrepreneurs are notorious for overestimating the value of their company and underestimating their projected expenses. While venture capital firms may have more experience valuating start-up companies, crowd-fund investors often do not appreciate the amount of capital and length of time required for businesses to turn a profit, and expect their investments to make faster progress than the company is capable of. In an article titled “Success of Crowd-funding Puts Pressure on Entrepreneurs“, the New York Times describes several companies that quickly became overwhelmed with the task of managing the sudden influx of investors, and the entrepreneurs ultimately found themselves spending an exorbitant amount of time and effort responding to investors inquiries and demands.

Entrepreneurs should carefully assess whether crowd-funding is appropriate for their particular business needs

It goes without saying that the local bakery has different financing needs than a multi-national  company. Likewise, the social entrepreneur and the founder of the next Google will need to approach crowd-funding from separate angles. Some entrepreneurs will thrive on the ability to remain independent in crowd-funding, and can build a successful business off one round of financing. Others will find that crowd-funding poses unacceptable risks to their IP strategy and expose them to liability. As always, entrepreneurs should carefully assess their own business position and long-term strategy before approaching investors, especially if the investors are crowds of strangers on the internet.

 

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