In today’s age of social media success stories, there is something superficially interesting about crowdfunding as a high-level idea. There has certainly been no shortage of attention to crowdfunding in the press and from business people. But in looking at the new JOBS Act exemption for crowdfunding, I see lots of reasons why many companies will avoid it. While this list could be expanded – and will need to be revised as the SEC adopts rules to implement the new exemption – to get things started I offer up these ten reasons:
- Limits M&A exits. Having a large mass of crowdfunded investors may make a company an unappealing M&A target. An acquirer will be unable to buy the company using acquirer securities as consideration, since the acquirer would likely not have a viable exemption for issuing those securities to the target’s crowdfunded investors, and registering an M&A deal could be impracticable.
- Expensive to use. The JOBS Act exemption requires issuers to use a broker-dealer or an SEC-registered “funding portal,” which are required to provide specified disclosures to investors and to comply with myriad requirements (the JOBS Act crowdfunding provisions span over ~10 pages). The cost of these new and unknown regulatory compliance steps will be passed on to issuers. This seems like an expensive way to raise a small amount of money (no more than $1M per year, ~$2k per investor).
- Civil suits likely. The JOBS Act exemption provides that investors can sue to get their money back (with statutory interest) if the company’s disclosure to investors is inadequate. Giving adequate securities law disclosure is complicated, and the types of companies using crowdfunding may not be in a position to spend money on securities lawyers. I suspect there will be a host of disclosure issues that emerge in crowdfunded deals. Plaintiff’s lawyers may be drawn to these deals. There may even be investors who participate in these deals strictly to pursue class action suits, similar to the way that some investors opportunistically buy public company securities.
- Regulatory enforcement likely. The JOBS Act exemption requires companies to provide disclosures publicly, so even regulators will be able to see them. State regulators have already expressed concern that crowdfunding will be an area where con artists target unsophisticated and vulnerable investors, so you should expect regulatory emphasis on issuers in this space. Securities regulators are trained lawyers and accountants whose job is to consider the technical adequacy of disclosure, and I suspect it will not be hard for them to identify a host of disclosure issues.
- Limits future financings. The diligence issues associated with confirming securities law compliance in prior crowdfunding deals could be extensive. VC funds or other institutional investors may not be willing to incur those costs, or to risk bankrolling suits by crowdfunded investors. It seems unlikely that many law firms will issue legal opinions regarding crowdfunding transactions. This can make it harder for a company to raise money down the road.
- Administrative hassle. As crowdfunding can result in an unusually large number of security holders, companies may face large volumes of routine inquiries, notices, stock transfers, certificate replacements, and other investor relations matters. This concern could be more pronounced given the lack of any investor sophistication standards in the exemption, which could result in unrealistic or needy stockholders.
- Selling unusual securities. Even legitimate companies trying to use this exemption may feel compelled to do goofy things to make the consequences of the exemption more manageable. For instance, small companies may attempt to minimize the costs of dealing with potentially hundreds of crowdfunded investors by, for instance, selling non-voting common stock coupled with an irrevocable power of attorney – a security like that may not exactly scream “trust me” to investors. Here is our prior blog post about limiting voting rights in a second class of stock; while this might work for Facebook, it might not be as palatable for an early-stage startup.
- Foreseeable optics problems. Not only are regulators warning that fraudsters will flock to crowdfunding deals, but fraudsters are agreeing. This can depress investor interest and create a market stigma around the exemption.
- No “backup” exemptions. Most companies currently raise money through exemptions under Regulation D. One of the nice things about using these exemptions is that, should there be a small non-compliance with provision, companies can often reasonably take the position that their transaction was nevertheless exempt under other exemptions available for non-public offerings. For crowdfunding, it does not seem possible that there could be a “backup” exemption for a variety of reasons, including that the terms of the exemption require public disclosure about the offering.
- Not currently usable. The JOBS Act’s exemption for crowdfunding is not currently usable. It requires SEC rulemaking, which likely won’t be done for another year, and thereafter will require compliance steps (such as funding portal registration), which will likely require additional time. In the medium-term, no one should be selling unregistered securities via crowdfunding. See the SEC’s notice to this effect.
While there may be something novel and exciting about the idea, crowdfunding presents many concerns relating to highly important topics for many entrepreneurs and investors. I suspect that these concerns will limit the traction of this exemption, particularly with VC-backed companies. It will be interesting to see how law and practice develop with respect to this exemption, but in the meantime I expect companies, investors, and their advisors to take a cautious approach and carefully consider their other fundraising options.