CHAPTER 3

Is Crowdfunding Right for Your Company?

Generally, if you want to engage in traditional project crowdfunding (raising money for a specific project as opposed to raising money for a company), there isn’t much preparation involved. All you have to do is:

Select the right crowdfunding portal (one that specializes in the type of project you want to launch)

Develop a short description of the project, how much money you need, why you deserve it, and the minimum amount you want to raise within a specific timeframe

Post the description online

Wait for the money to roll in

There is no requirement that you have expertise or experience in the type of project (although as a practical matter it is difficult to obtain financing online without that) or even that you have a clear vision or prototype of the project once it’s developed. All you need is an idea, or even just a dream, and if you catch the imagination of enough people online, you can get crowdfunded.

However, that will not be the case with crowdfunding under Title III of the JOBS Act.

Crowdfunding Is Not for Everyone

Although theoretically any type of company, at any stage of development, can seek crowdfunding under Title III, as a practical matter only select companies will be able to do so effectively.

If you are thinking about launching a crowdfunding campaign under Title III, you will need to ask yourself three specific questions:

1.Is my company the right type of company to receive investments through crowdfunding?

2.Does my company meet the requirements of the JOBS Act and Regulation Crowdfunding?

3.Am I willing to put up with dozens, if not hundreds, of demanding, immature, possibly crazy individual investors with unrealistic expectations if our Title III crowdfunded offering is successful?

Let’s take a closer look at each of these questions so you can figure out if Title III crowdfunding is right for you.

Is Your Company Right for Crowdfunding?

The good news is that Title III crowdfunding opens the private equity markets to companies that traditionally have had trouble finding early-stage investors in the past. For example:

Companies organized as LLCs or other pass-through legal entities

Companies engaged in retail, service, or other industries that don’t involve high technology

Companies that are looking to franchise their concepts

Companies whose business models are not scalable, such that each dollar of investment produces only a limited amount of revenue or profit

The bad news is that only a relatively small number of companies will be able to qualify for crowdfunded offerings of their securities under Regulation Crowdfunding. There are two primary reasons for this.

First, the cost of putting together the offering statement, financial statements, and other documents required by the SEC and the funding portals that will manage the offerings will probably be beyond the reach of most start-ups or concept companies that haven’t yet put together a solid business plan.

Second, because of the tremendous liability Regulation Crowdfunding imposes on funding portals (discussed in Chapter 11), most of these portals will be extremely nervous about dealing with a company that they suspect doesn’t have its act together yet. As an accountant friend of the author put it, “No one will want to be the first portal that gets sued or prosecuted by the SEC because they were negligent in picking the right issuers or reviewing their offering materials.” As an issuer, you can expect that most funding portals will be looking at your company and your written documents with an electron microscope, looking for even the tiniest flaws that may expose them to liability.

That said, if your management team is disciplined and willing to put in long hours on legal and accounting paperwork, there is no reason why even a concept company (one with little more than an idea, although a well-articulated one with a high likelihood of success if proper funding is obtained) cannot obtaining crowdfunded capital under Title III.

Before you consider seeking Title III crowdfunded money, your company needs to put together a solid business plan. Hundreds of books have been written on the subject of business plans, a few of which are listed in the “Suggestions for Further Reading” section near the end of this book, but putting together a solid business plan boils down to answering twelve specific questions:

1.What is the product or service we are looking to develop?

2.Who are the customers for our product or service, and what needs and wants do they have that our product or service will answer?

3.Why will customers buy our product or service (in other words, how will our product or service appeal to the fears and passions of the targeted markets)?

4.How will we get our message across to our targeted markets and get the product or service into people’s hands (in other words, what advertising and promotion tools will be used to market and distribute our product or service)?

5.Who are our competitors, both direct (people and companies doing the exact same thing) and indirect (people and companies doing a different type of thing that solves the same customer problems our product and service does or that renders our product and service obsolete)?

6.Why is our product or service better than any competing product or service on the market or soon to be on the market?

7.Do we have the right people on our management team to develop our product or service and get it into the market in a reasonable amount of time?

8.Are the people on our management team and advisory board (an informal collection of business mentors) likely to impress potential investors with their credentials and expertise?

9.What are the resources (money, office space, equipment, people, professional services, time) we will need to launch this product or service, and how much will we have to spend on each resource during the first one to two years of our operations?

10.When will this company break even (generate enough revenue from sales to cover basic operating expenses on an ongoing basis) and thereby become self-sustaining?

11.If our company is successful, what will our exit strategy be (launch an IPO or sell out to a large public corporation interested in acquiring our product or service)?

12.What are the legal and economic risks involved in this business, can we insure against them, and if so, how much will that insurance cost?

Okay, that’s probably about fifteen or sixteen questions, and other, more-specific subquestions fall under each of the ones above, but you get the general idea. If you and your company don’t have compelling answers to each of these questions and cannot articulate them in a written business plan, your company is not ready for Title III crowdfunding. It’s that simple.

Qualifying Under the JOBS Act and Regulation Crowdfunding

To qualify for crowdfunding under Regulation Crowdfunding, the issuing company must be incorporated or organized under the laws of a U.S. state or territory. Unincorporated businesses cannot qualify for Title III crowdfunding.

The vast majority of Title III issuers will be C corporations and LLCs. The advantages and disadvantages of each are discussed in Chapter 4.

Public companies do not qualify for Title III crowdfunding under Regulation Crowdfunding, nor do companies based in foreign countries (although foreign companies can invest in U.S.-based crowdfunded offerings).

Companies that have engaged in any of the “bad acts” described in Rule 506(d) of Regulation D (discussed in Chapter 13) and companies whose principals have engaged in any bad acts are disqualified from Title III crowdfunding, as are issuers who concluded successful Title III crowdfunded offerings in the past but failed to file the required annual reports and other documents required to be delivered to crowdfunded investors on an ongoing basis (these are discussed in Chapter 7).

Investment companies (such as mutual funds and hedge funds) do not qualify for Title III crowdfunding, as otherwise there is a risk Wall Street firms would form crowdfunded pools of crowdfunded companies, or create holding companies that would invest in dozens if not hundreds of crowdfunded companies. This is unfortunate in some respects, as enabling investors to pool their investments in a single entity that would coordinate communications between a crowdfunded company and its investors would probably be a beneficial thing and would eliminate many of the “time vampire” issues of investor communications that are discussed in Chapter 8. But as this prohibition is contained in Title III of the JOBS Act itself (not Regulation Crowdfunding), there is probably nothing the SEC can do to correct that as this book goes to press.

Blank-check or shell companies formed for unspecified purposes or to acquire other companies cannot make offerings under Title III. Any company seeking crowdfunding under Title III must have an actual business plan, not a speculative one or one couched in alternative terms (for example, “if we raise $100,000 we will do X, but if we raise $250,000 we will do Y instead”). However, it is possible that Title III crowdfunded offerings may be tiered based on the amount of money raised and the planned use of proceeds at different levels of investment (for example, “if we raise $100,000 we will do X, but if we raise $250,000 we will be able to do Y and Z as well”).

Foreign companies cannot take advantage of Title III crowdfunded offerings. Regulation Crowdfunding is not clear on this point, but that may include U.S.-based subsidiaries of overseas companies.

Finally, public companies cannot make Title III crowdfunded offerings. If they could, there would be no need for SEC registration of public offerings, would there?

Handling Your Crowd of Investors If the Offering Is Successful

As will be seen in Chapter 8, this biggest challenge in Title III crowdfunded offerings of securities and the biggest potential obstacle to the development of a viable crowdfunded securities market have nothing to do with the offering process itself but rather what happens after a successful crowdfunded offering is completed.

Once your company successfully completes a Title III crowdfunded offering, it can’t just pocket the money and say “See ya!” to the dozens or perhaps hundreds of individuals and companies that invested in the offering.

Once you sell a piece or percentage of your company to an investor (as opposed to someone loaning your company money, as discussed in Chapter 4), they are your business partners. If they were issued voting securities (voting common or preferred stock for a corporation, voting membership interests for an LLC), they have the right to receive notice of investor meetings and vote on any matter for which investor approval is required by state law where the company is incorporated or organized.

Even if a company’s crowdfunded investors are issued nonvoting securities (non-voting common or preferred stock for a corporation, nonvoting membership interests for an LLC), Regulation Crowdfunding requires they be given annual reports and other financial statements, and state corporation and LLC law often requires they be given advance notice of certain major decisions affecting the company. If you fail to give them the required notice, that failure may invalidate the decision, even though the holders of your voting securities voted overwhelmingly in favor of the measure you proposed to them.

Even if your crowdfunded investors have no rights at all under your state corporation or LLC law, there is nothing to prevent them from calling your office day and night asking silly questions, making unrealistic or inappropriate demands on your company, or offering unsolicited (and sometimes stupid) advice. That is the price of having any outside investor in your company, of course, but that price is a lot higher in a crowdfunded offering of securities, for two reasons:

1.There are an awful lot more of them.

2.They are less sophisticated than investors in traditional accredited-investor private offerings of securities and therefore more likely to act unpredictably, irresponsibly, or unprofessionally.

Investors can be time vampires, requiring an inordinate amount of your management time that is much better spent developing and launching your company’s products and services. Most public companies have several employees devoted exclusively to shareholder communications or investor relations. As a start-up or early-stage company, you cannot afford to dedicate employees to those tasks.

Yet if you ignore your investors, even if Regulation Crowdfunding technically allows you to do so, you do that at your peril. It’s no secret that the Internet can sometimes be a very volatile, nasty, and dangerous place, where little problems and hiccups can be blown quickly and exponentially out of proportion by a negative, viral campaign on social media launched by one angry, self-appointed vigilante or a handful of them.

Probably the worst thing that can happen to a company that has successfully raised money via Title III crowdfunding is to see its crowdfunded investors turn into a disgruntled lynch mob that says nasty things about the company and its management online.

If you do decide to launch a Title III crowdfunding campaign for your start-up or early-stage company, you will have to decide if you are willing to put procedures in place to manage and communicate with your crowd after the offering is over. If you are not, then Title III crowdfunding is not for you. Stick with accredited investors or traditional friends-and-family offerings. Your elderly Aunt Irma who loaned you $5,000 isn’t likely to go viral on Yelp.com because she wasn’t invited to your company picnic.