April 14, 2014
Will 'Crowdfunding' Change the Capital Raising Process Forever? (Part 1 of 2)

By Cliff Ennico
Creators.com

As I'm writing this, the U.S. Securities and Exchange Commission ("SEC") is preparing to hand down final regulations allowing startup companies to use "crowdfunding" techniques to raise capital, for the first time in U.S. history.

For those who aren't familiar with the concept, crowdfunding means soliciting money from people who are part of your social network online, whether you know them or not. Crowdfunding websites such as Kickstarter.com and IndieGoGo.com allow people to tap their social networks to raise money for projects, such as a new book or motion picture, a prototype invention, or a medical procedure that isn't covered by health insurance.

For over 80 years, SEC regulations have prohibited companies from using "general solicitation" and "general advertising" (such as newspaper or magazine ads) to raise money before launching an initial public offering (IPO).  Within days, that prohibition will become history.

(Full disclosure: I have a personal stake in what the SEC does.  My new book, "The Crowdfunding Handbook", due out this summer, describes the law changes and how startup companies can best take advantage of them.) 

But will crowdfunding really become the way for early stage companies to raise money?  Here is my totally biased (but educated) best guess.

First, the Bad News 

While I am generally a fan of the crowdfunding movement, I don't think the new regulations will have as revolutionary an impact on the capital markets as its promoters suggest.

First of all, the cost of launching a crowdfunded offering is likely to be very high, and perhaps prohibitive for startups and other companies that haven't yet proven their concept.  The new regulations require companies to prepare a detailed Offering Statement describing their business plan, the nature of the securities they are offering, and the risks of investing in the company, and post the Offering Statement on a "funding portal" website that is registered with the SEC (at the present time we do not know if Kickstarter.com or IndieGoGo.com plan to register as portals - a number of smaller startups, such as EquityNet.com and SeedInvest.com, have indicated their intent to do so).

Because of the high malpractice risk associated with private offerings of securities, lawyers and accountants are likely to charge substantial fees to assist in preparing companies' Offering Documents.  The new regulations also require companies seeking more than $500,000 a year through crowdfunding to obtain "audited" financial statements, the cost of which will likely be prohibitive for companies that haven't already been through one round of venture financing.

Second of all, the new regulations impose significant liability on the funding portal websites that facilitate crowdfunded offerings.  If the website posts an Offering Statement that contains material errors, or certifies an investor as "accredited" (wealthy enough to afford to lose their entire investment) who doesn't meet the SEC's definition of accredited, it can be sued by all injured parties and lose its SEC registration. 

To avoid liability funding portals will need to hire lots of employees to scrutinize individual offerings.  Even if the portals outsource those employees to India or elsewhere in the developing world, the costs will be significant, and the portals will have to charge high fees to cover those costs - Fees that most early stage companies cannot afford.

Finally, even if a crowdfunded offering is successful, the time and effort involved in managing a crowd of dozens or hundreds of individual investors will be beyond the abilities of most startups.

Now, the Good News

Before my readers get out their pitchforks and torches and start "doxing" me as a heretic, let me say that there is one aspect of the new crowdfunding regulations that is truly groundbreaking, and which has the potential to revolutionize at least one corner of the securities industry.

In addition to allowing crowdfunded offerings of securities, the new regulations allow companies to use general solicitation and general advertising to raise capital, as long as they allow only accredited investors to purchase their shares.

It has always been extremely difficult for startup companies to find the right "angel investors". Traditionally, angel investors - wealthy millionaire next door type individuals who provide capital, networking contacts and advice to startups - are an unorganized, isolated bunch who make investments through personal connections in early stage companies based in their home state or region.  The most social of them belong to an "angel forum" consisting of 10 to 15 people who meet once a month at a local restaurant or country club.

They are often ignorant of investment opportunities in other states (or countries), or in industries other than the one they know thoroughly from their years of working in corporate America.

By giving angel investors the ability to register as accredited investors on websites such as AngelList (http://angel.co), the new regulations will make it much easier for startups to find angel investors, and for angel investors to find promising startups, free of geographic or other limits.

More next week . . .

Cliff Ennico (cennico@legalcareer.com) is a syndicated columnist, author and host of the PBS television series 'Money Hunt'.  This column is no substitute for legal, tax or financial advice, which can be furnished only by a qualified professional licensed in your state.  To find out more about Cliff Ennico and other Creators Syndicate writers and cartoonists, visit their Web page at www.creators.com.  COPYRIGHT 2014 CLIFFORD R. ENNICO.  DISTRIBUTED BY CREATORS SYNDICATE, INC.  Permission granted for use on DrLaura.com.

 

Posted by Staff at 12:06 PM