CHAPTER 8
Keeping Your Crowd Under Control
Once your crowdfunding offering is complete, you have dozens, if not hundreds, of new business partners. Yes, you read that correctly. I said partners—not shareholders, not investors, not LLC members.
The reason is simple: the people who invest in your company are, for all legal and practical purposes, partners. They may not have the right to vote on management decisions (denying them this right is recommended—see Chapter 4), but they have the right to speak, they have the right to be heard (or at least tolerated in a professional manner), they have the right to complain, and they have the right to file a class-action lawsuit or launch a takeover of the company if they are really, really unhappy with the way things are going.
In some states (listed in Appendix 5), disgruntled investors also have the right to petition state courts to dissolve and liquidate your company if they feel things aren’t going anywhere fast.
Coping with Your New Partners
When you have investors, you have responsibilities. Today’s crowd can easily turn into an unruly mob tomorrow, as anyone who’s ever been flamed on social media knows only too well. Communications with your new investors is critical to avoiding misunderstandings, rumormongering, and outright revolt in your crowdfunded community.
Even if your investor community is quiet and complacent, keep in mind that Regulation Crowdfunding requires them to hold your shares only for a period of one year (see Chapter 10). You don’t want a mass exodus of investors at the end of that year; word of that gets around quickly and will tarnish your company’s reputation in a hurry.
Developing a Shareholder Communication Program
Now is the time—as soon as the investors’ money hits your company bank account—to develop a program of communicating regularly with your shareholders.
Communicate Regularly and Often. When it comes to investors, silence is not golden. The less often your investors hear from you, the more nervous they become. Frequent and regular communication with your investors will prevent or solve 90 percent of the problems you will ever have with these folks.
Your company should do three things right away:
1.Open an account with Constant Contact or another email communications service and create a list with the email addresses of all your investors, founders, management team members, advisers, and principal customers.
2.Select one of your employees (preferably one who writes well) to create a monthly email newsletter that, after review and approval by the company founders, you will send to everyone on the email list.
3.Create a separate email address where investors can send their comments, suggestions, and other communications, and have one of your key employees check that address at least twice a day (including weekends—many investors are “part timers” who will send messages only on weekends).
Your Company E-Newsletter. What should you say in each e-newsletter? Basically, each newsletter should be a progress report dedicated to answering the investor question, “How’s it going?” At the very least, send copies of all updates to your Form C disclosures to every one of your investors via email as soon as the updates have been filed on EDGAR.
When you receive favorable media attention, forward copies to all your investors with a short cover note.
In your e-newsletter, “accentuate the positive,” reporting everything good that happens to you company, but do not “eliminate the negative”; when you have suffered a reversal of fortune, notify your investors immediately and let them know your plans for turning things around. It is not good for your investors to find out bad stuff about your company before you tell them about it. While some investors will still grumble about the bad news, most will forgive you because they will perceive that you are still on top of your game.
Here is the most important rule regarding e-newsletters: Say something, even if you have nothing to say.
It will come as no surprise to you that most people don’t read e-newsletters. How many of the dozens of e-newsletters cluttering your inbox do you actually open and read top to bottom? Probably very few. Most of the time, you just skim the heading and maybe the first couple of sentences.
A friend of mine—a very successful author and consultant—sends out an e-newsletter once a week to hundreds of subscribers, including your humble author. One day a few months ago, I was scanning my inbox and deleting all the junk mail (including, I’m sad to say, this person’s e-newsletter most of the time) when I saw his latest one, with the word “crowdfunding” in the heading. At that time I had just begun writing this book and was hungry for any information about what was then a virgin topic. So, for the first time in I can’t tell you how many months, I actually opened his e-newsletter and started reading it.
The first three paragraphs were terrific and actually helped me organize one of the chapters of this book. After the first three paragraphs, which were below the fold on my computer screen, the text suddenly changed into a bunch of gibberish that looked to be written in Latin.
I emailed the author and told him there was something wrong with his e-newsletter feed. About an hour later, he called me on my cell phone. Here is what he told me:
“Good to hear from you, Cliff. Listen, I just got your email about my newsletter. Thanks for your comment, but I’m afraid I have a dirty little secret. I put that pseudo-Latin gibberish in all my e-newsletters after the first couple of paragraphs. In my experience, people read only the first couple of sentences in any newsletter, but they feel cheated if the message is too short. So rather than write a long-winded essay that no one will read, I just spend my time each week crafting the two paragraphs and then plug in the gibberish. Would you believe that in the years I’ve been doing that e-newsletter, you are the first person to bring this to my attention?”
Do you understand why this guy called me on the phone rather than send me an email?
Now, I’m not recommending that any reader plug gibberish into an email delivered to investors. It’s just an illustration of how to write one: spend most of your time on the first couple of paragraphs, and spend less and less time on the information that follows. Don’t spend so much time making each newsletter so perfect that you fail to get it out regularly to your community.
One of the advantages of having a crowd of investors is that you have access to their knowledge, experience, and personal networks. Don’t hesitate to ask for advice or feedback when sending your e-newsletters. That makes your investors feel that they are part of the team and that you want to know their opinions (even if you don’t). You may also find, to your pleasant surprise, that there’s someone in your crowd who can really help your company get to the next level. You will want to know about such people and develop special relationships with them. Just make sure they aren’t after your job.
Don’t forget to post a link to each e-newsletter on your company website(s) and all your social media pages. After all, that’s how you found these people in the first place, and where you are likely to find more.
Also, don’t forget to give readers the opportunity to opt out of the e-newsletter submissions as required by federal and state antispam laws.
Responding to Your Investors. The person charged with reading emails sent to your investor hotline (the special email address you created just for the investors) should be trained to respond quickly—and briefly—to each email you receive from an investor.
Most email inquiries will deal with fairly routine matters. Don’t be surprised if some messages ask about job opportunities at your company, with an attached resume from a relative of the investor who just graduated from Nowhere U. with a degree in Victorian English literature. While you would almost certainly ignore such an email from a member of the general public, you are not always free to do so if it’s from an investor.
If an investor email surfaces a problem, however, that must be dealt with immediately. Your investor-relations employee (that’s what they call them in big companies) needs to be told to report such messages to you and the other company founders immediately so a prompt response can be prepared and sent to all investors.
Dealing with Time Vampires, Mata Haris, and Know-It-Alls
It happens to all start-up and early-stage companies: one or two of your investors are emailing you every day asking silly questions, volunteering useless information, and otherwise making a royal pain of themselves and taking up valuable management time.
We have a special name for such people in our industry: time vampires.
Most time vampires are relatively harmless. They probably just don’t have enough to do or want to feel like they’re part of your management team even though they legally aren’t. The best way to deal with such people is to give them a task or project to work on, especially one involving lots of research time that will get the investor out of your hair for a while. Who knows? The research may actually prove useful.
A more dangerous type of time vampire is the person who thinks he or she knows more about how to run the company than you do. Most of the time these people just have outsize egos that will be satisfied with a little stroking. But there are two more dangerous types of know-it-all investor:
1.Someone who has a relationship with one of your competitors and has infiltrated your company through crowdfunding to get intelligence that he passes on to your enemy (years ago these were called Mata Hari investors, named for a famous World War I spy)
2.Someone who really does know more about your industry and your marketplace than you do and has the credentials to prove it; if such an expert investor becomes too disgruntled with your company’s performance, she could easily turn into an instigator who will launch and lead an investor revolt
If you suspect someone in your crowd is a Mata Hari investor, there are three basic strategies you can consider:
1.Limit the amount of sensitive, inside information you send investors as part of your regular communications.
2.Do research on the investor and, if you uncover his relationship with a competitor, out him to the community at large (just be sure you are 100 percent accurate, otherwise you will be staring down a libel lawsuit from a very hostile investor indeed).
3.Contact the investor discreetly, point out the evidence, and offer to repurchase her shares for the same price your investors paid in your crowdfunded offering (if you do this, be sure the investor agrees in writing to remain silent about your repurchase and to refrain from disparaging your company in any future communications).
When dealing with a know-it-all investor, it’s best to remember the famous quote from the film The Godfather, Part II: “Keep your friends close, but your enemies closer.” You will need to embrace the know-it-all, suck up to his ego, and make sure he has only positive things to say about your company: if properly managed, a know-it-all can become a convincing and influential champion of your company within the investor crowd.
When You Have to Change Your Business Plan
If you have put together your crowdfunded offering documents the right way (see Chapters 4 and 5), you have included the following statement in several places where it could be clearly seen by investors:
“Our business plan is based upon our assessment of market opportunities as they exist today; management reserves the right to change our plan, and possibly pursue a different direction for our company, due to changes we perceive in the marketplace, advances in technology, the legal or regulatory environment, the competitive picture, or any other factor affecting the company, its products, and services.”
It’s always difficult for companies to change direction, especially when it becomes necessary to turn a luxury liner around in a bathtub, but it becomes much more difficult when a company has lots of investors sitting in the Class C cabins wondering what’s going on.
More sophisticated and experienced investors will understand the need to make changes, but some less experienced or naïve investors may feel you have committed a bait-and-switch crime with their money.
As in all dealings with investors, communication is key to a successful change in plans. There are three key steps:
1.Issue a special e-newsletter to your investors announcing the change in plans and the reasons for the change, and invite them to participate in a free webinar to discuss the proposed change.
2.Prepare a PowerPoint slide deck and use it to host an online webinar where investors are encouraged to comment and ask questions about the proposed change (consider doing more than one if attendance at the first webinar is low).
3.File a Form C-U (progress update) with the SEC regarding the change.
If the proposed change is extremely unpopular, to the point that you and your cofounders fear an investor revolt, you should consider offering to buy back your investors’ shares on a limited-time-only, first-come-first-served basis, for the same price they paid for their shares plus a small amount of interest (basically what they would have earned on a bank certificate of deposit during the same time period). You will need to find the money to pay for their shares, and will need to involve your attorney and accountant, as corporate repurchases of shares are subject to state corporation laws and may have unpleasant federal income tax consequences for your company and the investors.
Do not even think about launching a Title III crowdfunding offering of securities to raise money to repurchase shares from investors in your previous Title III crowdfunded offering! Although I confess there would be a certain admirable chutzpah in doing so, I have to believe there is at least some limit to people’s stupidity, such that your offering would be laughed off the funding portal.
When It’s Time to Throw in the Towel
You have completed a successful Title III crowdfunded offering. You raised a ton of money. You spent it all trying to launch your business plan. And the business went nowhere. A follow-up offering of securities won’t help. The idea was a bad one, or wasn’t right for the times. Your company is dead: dead as a doornail (with apologies to Charles Dickens). You have dozens or hundreds of investors waiting for a return on their investments, and now you have to break the news that your company is worthless, your investors will have to write off their investments, and you are going back to school to learn a profitable trade.
You have a big, big problem.
There is no easy way to get out of this one. Investors in any company love to sue when things go wrong. They will not only sue your company, but they will try to pierce the corporate veil (a lovely image—it derives from the death of Polonius in Shakespeare’s Hamlet) and sue you and your cofounders personally as well. They may even sue your lawyers, your accountants, your funding portal, and anyone else involved in your offering in an effort to prove they knew about undisclosed weaknesses in your business plan and didn’t warn investors about them (what lawyers call securities fraud). It is not inconceivable that an entire class of plaintiffs’ lawyers will spring up to help crowdfunded investors bring class-action lawsuits to recover their money, or at least achieve lucrative settlements.
Frankly, if Title III crowdfunding goes nowhere and fails to become a popular means of raising capital for small companies, it will be for this reason: company founders and their professional advisers not wanting to take the risk of a class-action lawsuit by disgruntled investors.
Still, most start-up companies fail in the first few years of operations, and you did warn your investors up front, in capital letters, that, “INVESTMENT IN SECURITIES OF THIS TYPE IS HIGHLY RISKY, AND THERE IS A CHANCE YOU COULD LOSE YOUR ENTIRE INVESTMENT.” You did say that in your offering documents, right? If you didn’t, you have not only violated Regulation Crowdfunding but set yourself up for a whole world of hurt.
Of course, if you still have your investors’ money, you can always get out of trouble by announcing your company’s failure, publicly taking responsibility, apologizing for the failure, and giving your investors’ their money back. They won’t be happy, but they aren’t likely to sue over a small or inconsequential monetary loss.
In the real world, of course, you won’t realize your company has failed until after your investors’ money has all been spent. Here is what you need to do, with the understanding that no amount of explanation, groveling, or falling on your sword will prevent righteously angry investors from seeking redress in a court of law.
First, prepare an email announcement of your company’s failure and send it to all of your investors. The announcement should contain the following information:
The date on which your company will cease business
An explanation, in reasonable detail, of the reasons behind your company’s failure
A statement, in plain English, that while you “regret” having to break this bad news to investors, the circumstances behind your company’s failure were not known or “reasonably foreseeable” by you or your management team at the time of your Title III crowdfunded offering
A statement that you have explored alternative means of staying in business but have found no viable way to continue your operations
A detailed accounting of how your investors’ money was spent, down to the very last penny (the investors will need to see that you did not use any of their investment money to pay personal expenses or bills that were unrelated to the company’s business plan; ideally, if you can, you should also say that none of the investors’ money was used for salaries or other management compensation to the company founders)
A statement that investors will be entitled to share in any proceeds of your company’s liquidation and the sale of your company’s assets, if anything is left after payment of the company’s debt (remember that debt always has to be paid off in full before you and your fellow shareholders get anything; if you have shares of preferred stock outstanding, those will have to be paid off in full as well)
A statement that investors should “consult with their tax advisers” to determine if any portion of their investment can be deducted for federal income tax purposes as “worthless investments”
Can Your Investors Write Off Your Company Failure on Their Taxes? After reading that last bullet point, some of you are probably thinking, “Hey, wait a minute—you mean my investors can write off their investments in my company on their taxes? Whew—you had me worried there for a minute. Why didn’t you tell me before that I can walk away from my company and not get sued by angry investors who will be only too happy to have tax deductions?”
Not so fast.
Whenever the IRS allows you to write off something on your taxes, there’s always a heap of conditions.
In order for your investors to write off their investments as total losses, the shares they purchased may have to qualify as Section 1244 stock. Section 1244 of the Internal Revenue Code allows losses from the sale of shares of small, domestic corporations (sadly, LLC membership interests do not qualify for Section 1244 treatment) to be deducted as ordinary losses instead of as capital losses up to a maximum of $50,000 for individual tax returns or $100,000 for joint returns.
To qualify for Section 1244 treatment, the corporation, the stock, and the shareholders must meet certain requirements. The corporation’s aggregate capital must not have exceeded $1 million when the stock was issued, and the corporation must not derive more than 50 percent of its income from passive investments. The shareholder must have paid for the stock and not received it as compensation, and only individual shareholders who purchase the stock directly from the company qualify for the special tax treatment. This is a simplified overview of section 1244 rules; because the rules are complex, companies looking to hedge their bets against failure in a crowdfunded offering are advised to consult a tax professional for assistance.
Even if your shares do not qualify for Section 1244 treatment, investors may be able to deduct their losses under Section 165 of the Internal Revenue Code, but their deductions will be capital losses, which in general are not as valuable as the ordinary losses they would receive had your shares qualified for Section 1244 treatment.
Once you have released your announcement and have dealt with the inevitable barrage of shareholder emails, it is time to consult with your attorney and wind down your company. You will need to follow the procedures in your state corporation or LLC statute for dissolving your company, winding up its affairs, selling its assets, paying off your company debts, and distributing the balance to your shareholders. You will also need to file Form C-TR on EDGAR, terminating your obligation to continue filing periodic reports with the SEC.
When the Revolution Has Begun
You wake up one bright, shiny morning, open your front door to get your newspaper, and there on your front lawn are a crowd of people waving pitchforks and torches, preparing vats of tar and feathers, and tying a hangman’s noose around the branch of your favorite oak tree.
It’s your crowd, and they are not happy.
Shareholder revolts rarely happen out of the blue, and you will rarely be surprised by them. When investors are unhappy, they let you know in no uncertain terms well before they consider taking legal or other action against you and your cofounders. The best time to deal with an investor revolt is well before it happens, by proper communication using the methods described in this chapter.
There are two types of shareholder revolt. In the first, they post negative comments and reviews about your company, its products, services, and management on social media and elsewhere. A member of your management team (the same person who is responsible for investor relations) should be monitoring Yelp.com and other review-oriented websites for mentions of your company (you should be doing this anyway, using tools such as Google Alerts to inform you of online posting of any kind affecting your company). The minute you see a negative or critical posting from one of your crowdfunded investors, someone on your management team should immediately contact that investor and do everything possible to set matters right.
If you sense that a handful of investors have launched a smear campaign against your company online, it may be best to deal with them as a group: invite them to a conference call or other online meeting to discuss their grievances and see if there’s a way to resolve them without dramatically changing the direction of the company.
In extreme cases, you may have to amend your charter documents (the articles of incorporation if you are a corporation, the operating agreement if you are an LLC) to give your crowdfunded class of investors the right to appoint one or more members to your company’s board of directors (board of managers for LLCs). By doing so you ensure that they will have a seat at the table with the right to oversee, comment on, and otherwise influence your management decisions. That may calm your crowd down, but there are disadvantages:
Because your company now has an outside director, you will have to call formal directors’ meetings complying with your state corporation or LLC laws.
Your outside directors may insist that you purchase insurance covering them against any liability they may incur by acting as directors.
Venture capitalists and other professional investors who may invest in your company in future years will want to appoint directors of their own and may not want to share the table with directors they perceive as less experienced in that role.
The second type of investor revolt involves legal action, which may take two forms: a class-action lawsuit or a proxy fight.
In a class-action lawsuit, your investors would pool their resources to hire an attorney to sue your company. Investors would be invited to participate in the class, and those participating in the class would share in any settlement. The class-action lawsuit would take one of two forms: a direct action (shareholders sue for violation of their rights as shareholders) or a derivative action (shareholders sue third parties on behalf of the corporation based on your management team’s failure to take appropriate action in the corporation’s best interests).
In a proxy fight, your investors would pick several of their members to run for office as directors of your corporation and present their dissident slate to compete with your management team for approval at your company’s next annual meeting of shareholders (discussed in Chapter 7). If a majority of your company’s shareholders approve the dissident slate offered by your crowd, then you and your cofounders have been voted out of office and will have to quit the company you founded (although you would continue to hold your shares in a company that’s now being run by your adversaries). Of course, if you and your management team hold the majority of the corporation’s shares (highly recommended), then there will be little chance of a proxy fight. If you and your cofounders have given up so much of your company that you own less than 50 percent of your company’s shares, then all bets are off, as a mere handful of investors with small holdings of securities may be the swing votes that determine the future course of your company.
If it appears your shareholders are getting ready to take legal action of any kind against your company, you may have no choice but to file for bankruptcy under the federal Bankruptcy Code. By doing so, you will freeze any legal action your shareholders may be contemplating against your company and give yourself the opportunity to work out differences with your shareholders under the supervision of a bankruptcy court, in the hopes of gaining a favorable settlement that will allow you to emerge from bankruptcy.
Bankruptcy proceedings are extremely expensive and time consuming and will probably kill off any hope your company may have of generating investment in the future, as bankruptcy proceedings would have to be disclosed in any future offering of securities.