AFTERWORD
What the Author Really Thinks of Crowdfunding
Throughout this book I have taken great pains not to editorialize or give my personal views of crowdfunding, its future potential as a means of raising capital for entrepreneurs and small businesses, or the likelihood that crowdfunding will revolutionize the securities industry.
As I stated in Chapter 1, I am an attorney in private practice and not privy to inside information about the federal JOBS Act of 2012, Regulation Crowdfunding, or the lobbying efforts that made equity crowdfunding the law of the land.
Since many readers will want to know my views, however, I thought it prudent to devote a few pages to my—admittedly biased and uninformed—opinion as to how crowdfunding will play out over the next few years.
First, the Bad News
Although Title III of the JOBS Act and Regulation Crowdfunding are excellent attempts at loosening the restrictions that have held back small business capital raising since the Great Depression, they do not go far enough to ensure that crowdfunding will be the revolutionary new financing tool its promoters intended it to be.
There are a number of reasons for this.
The Cost of Crowdfunding
Crowdfunding was intended to give access to start-ups and early-stage companies that are under the radar screen and invisible to traditional venture capitalists, angels, and other professional investors. The way Regulation Crowdfunding is written, however, these are the very entrepreneurs who—with three possible exceptions, which I will discuss in the following pages—will be unable to take full advantage of Title III crowdfunding.
The cost of preparing a written and detailed business plan, together with the legal and accounting fees necessary to convert the plan into an offering statement meeting the requirements of Regulation Crowdfunding, will be prohibitive for many if not most start-up companies. I have joked with friends in the financial world that the JOBS Act should really have been titled the Attorneys’ and Accountants’ Full Employment Act of 2012 because of the extensive professional work that will be required to get even the simplest crowdfunded offering to market. Not that I’m complaining, mind you!
The more established and mature private companies that have the capital and management time to devote to these tasks are precisely the companies that probably are already on investors’ radar screens and can take advantage of more traditional private placement offerings and angel investments. While crowdfunded offerings may provide additional capital, especially if tied to a targeted project to which the proceeds of the offering can be dedicated, it may well be easier and less costly for emerging companies to work a little harder to find traditional sources of capital. After all, as someone once pointed out, “It is always easier to raise the second million dollars than the first hundred thousand.”
Liability of Issuing Companies (and Their Professional Advisers)
As any attorney can tell you, the cost of obtaining malpractice insurance for securities law work is astronomical. Securities law is the obstetrics and gynecology of the legal malpractice world: it requires the most expensive malpractice coverage and faces the highest probability of claims of any legal specialty. Most securities lawyers I know tell me that their insurance premiums for securities law coverage are 50 to 75 percent of their total annual malpractice insurance premiums, often in the range of $5,000 to $10,000 a year (or more if there has been a claim against the attorney).
Why is that? Because when investors get angry, investors sue. And the first people they sue are the lawyers, accountants, and other professionals who made possible what they perceive (often incorrectly) as a fraudulent investment.
Although I have helped put together friends-and-family offerings for my clients for more than thirty-five years, I would hate to be the first attorney to prepare an offering statement under Regulation Crowdfunding. One small mistake and I would be toast.
With crowdfunding, an attorney’s or accountant’s malpractice risk will be even greater than it has been. Most attorney malpractice insurance policies are capped at $1 million per lawsuit, with a maximum cap of $2 million to $3 million per year. When there are only a handful of investors in an offering, they can’t bring a class-action lawsuit for millions of dollars that would exceed the policy limits. With dozens or hundreds of investors in a Regulation Crowdfunding investment, they can, and you can bet there will be plaintiffs’ lawyers aplenty looking to cash in when a crowdfunded company crashes and burns. From a litigation perspective, Title III has the potential to replace mesotheliomia (also known as “asbestos-related injuries”) as the number one moneymaker for plaintiffs’ attorneys.
Funding Portal Liability
Now let’s consider the funding portals authorized by Regulation Crowdfunding. Under Regulation Crowdfunding, these portals assume liability if either or both:
An offering statement they have reviewed and promoted online contains any material misstatement of fact or omission
An investor the portal has certified as an accredited investor turns out not to be so because of misstatements or errors in the documents
As a middleman or facilitator of the crowdfunding process, the funding portal has double the risk and potential legal liability of either the issuing company or the investor(s). If I were advising a funding portal under the current Regulation Crowdfunding, I would advise it to:
Tighten its terms and conditions so they are even more restrictive than Regulation Crowdfunding—for example, by requiring additional backup and support that Regulation Crowdfunding does not currently require (the “investment due diligence” that is commonly performed by investment banks when engaged in an IPO
Require collateral from a company and its founders (such as personal guarantees backed by mortgages on the founders’ homes) for securities-law-related claims before taking on that company as a new crowdfunding client.
Make sure its fees and commissions are high enough to justify taking on the extensive legal risks posed by a Regulation Crowdfunding offering
As I stated in Chapter 11, why would anyone in their right mind want to start and operate a funding portal? Because of the high risk of liability, portals will be extremely capital intensive to set up and extremely labor intensive to operate. How many clerks (some of whom will require at least paralegal if not actual legal training) will a portal need to review offering documents from five different issuers looking to launch their offerings at the same time? How much will the portal have to pay these people for their salaries, employee benefits, payroll taxes, and liability insurance? Will the portal be able to outsource these activities to companies in India or elsewhere in the developing world?
Those additional costs, needless to say, will be reflected in the fees and commissions the portals will unquestionably charge their issuers and investors.
Don’t Get Me Wrong
There will certainly be crowdfunded offerings of securities under Title III and Regulation Crowdfunding —just not as many as crowdfunding’s promoters and cheerleaders think there will be.
As currently drafted, there is a risk that Title III will end up in the same place as the SEC’s Regulation A, which has been around since 1964 but has generated only a handful of successful offerings as compared to those under the SEC’s Regulation D.
Now for the Good News
Before my readers get out their pitchforks and torches and start “doxing” me as a heretic on their social media pages, let me say there is one aspect of the new crowdfunding scheme that is truly groundbreaking and has the potential to revolutionize at least one corner of the securities industry.
That aspect is Title II of the JOBS Act, relating to offerings made by general solicitation and advertising to accredited investors only, which I predict will totally transform the angel investor industry.
Traditionally, angel investors—millionaire-next-door types of individuals who provide capital and advice to start-up and very early-stage companies—are an isolated bunch of loners. Their investments tend to be purely local, to companies based in their home towns or counties. The most social of them belong to an angel club consisting of not more than ten people who meet once a month at a local country club or restaurant.
They are often ignorant of investment opportunities in other states (or countries), especially in industries other than the one they know thoroughly from their years of working in corporate America.
Probably the greatest challenge in the entire venture capital industry is introducing promising new start-up companies to the right angel investors.
One of the goals I and my colleagues had when we put together the MoneyHunt television show in the early 1990s was to create a portal—yes, we actually used that word back then—to help isolated angel investors around the country identify the most promising start-ups, no matter where they were geographically based or what industry they were in.
Title II crowdfunding, which enables websites dedicated to accredited-investor-only offerings to reach out to investors via general solicitation and general advertising methods, has the potential to be precisely that portal, opening up angel investment to scores of start-up and early-stage companies that today don’t even have a clue where to begin looking for such folks.
Even better, Title II crowdfunding will enable these websites to build up a database of qualified accredited-investor angel investors that they can share to find the perfect fit for a particular start-up or entrepreneur.
And for Some Even Better News
There are three situations in which I think an early-stage company should consider an offering under Regulation Crowdfunding as it is currently drafted, even with all its faults and limitations:
The Small Business with a Huge Following
Let’s say you are the owner of a well-known restaurant in your area, a manufacturing or distribution business serving a primarily local or regional market, or a company selling a particular line of antiques, collectibles, or household items on eBay or Amazon. Because your company doesn’t have tons of equipment or other assets, and cash flows vary from quarter to quarter, you are not eligible to obtain a traditional or Small Business Administration-guaranteed loan from a bank. You might qualify for a microloan of up to $50,000, but you need more than that to finance working capital or expand your business. There is, however, something you do have: a large number of customers and other fans in your Outlook contacts, hundreds if not thousands of friends on Facebook, and hundreds if not thousands of followers on Twitter. People love your business, but few of them qualify as “accredited investors.”
If that describes your business, you may be a candidate for Regulation Crowdfunding.
Keep in mind that crowdfunding was originally established as a way for people and businesses to tap into their social media followers in order to raise money for personal or business projects. Let’s face it: it’s highly unlikely that someone surfing Kickstarter or one of the other crowdfunding websites will stumble across a total stranger’s project and decide, on the spur of the moment, to invest in it (unless it’s generating lots of buzz elsewhere in online and off-line media). But if you know the people or company that launched the crowdfunding campaign, or have received notice of the campaign via your Facebook, Twitter, and other social media connections, you might take a look at it, and you might invest a small amount of money.
Success under Regulation Crowdfunding, as in crowdfunding generally, will depend on the quantity and quality of a company’s existing contacts, on social media and elsewhere, who can be leveraged into becoming actual investors.
The Start-Up Looking for Market Validation
A number of commentators on the JOBS Act have pointed out (I think correctly) that many early-stage companies will be fearful of raising money via Regulation Crowdfunding for fear they will alienate the well-heeled accredited investors they will need for future, and much larger, rounds of financing. It is well-known that sophisticated angel investors are reluctant to invest in companies with many friends-and-family shareholders already in place.
I see one possible exception to that argument, though: the company that is looking to validate either its market or its technology and has had difficulty attracting angel and venture capital investors for that reason.
Let’s say, for example, that your company has created a new consumer product. You’ve scrounged up the money to develop a prototype and get a patent on the product, but you’re far short of the capital needed to manufacture the product in large quantities and line up a distribution deal with Walmart and other major retailers.
Here’s what you could do: you could get someone to manufacture one thousand units of the product, and then launch an offering under Regulation Crowdfunding where investors would receive X shares in your company per $100 (or $1,000) of investment plus one of the units of your product. (Again, your presence on social media and ability to network online will be crucial to the success of the offering.)
If your offering sells out, it will demonstrate to later, more sophisticated investors that your product has market potential and deserves to be manufactured in larger quantities. After all, what better market research is there than people who have demonstrated they will buy not only your product but your company as well? It will really help if (1) your crowdfunded offering closes out extremely quickly, showing strong market demand, and (2) some of your investors are players in your industry, for example, executives of distributors or retailers who would carry your product if it were available in sufficient quantities. This would demonstrate to potential investors that the market, distribution, and other factors are there, if only you could manufacture the product in sufficient quantities, buy the necessary equipment, and so forth.
The Upstairs-Downstairs Offering
One thought that occurred to me (and, to be fair, other commentators on the JOBS Act as well) is that an early-stage company might want to launch two offerings simultaneously:
An accredited-investor-only offering of preferred shares under Title II (using general solicitation and advertising) for most of the money needed to grow
A Title III crowdfunded offering of common shares for nonaccredited investors such as friends, family, customers, and other people sourced online who do not qualify as accredited investors
I discussed this two-tiered approach to crowdfunding in Chapter 9. For it to work, you would have to make sure not to include in the general solicitation of the Title II offering an advertisement of the terms of the Regulation Crowdfunding offering, unless that advertisement follows the tombstone format authorized by Regulation Crowdfunding and otherwise complies with the advertising restrictions for a Title III offering. You will need to satisfy yourself (and the SEC) that the purchasers in the Regulation Crowdfunding offering were not solicited by means of the Title II offering, to avoid “integration” of the two offerings under Rule 502(a) of Regulation D. Of course, if the total of the two offerings is less than $1 million, and you do not contemplate a follow-on offering within the next twelve months, the integration question may not matter.
It may well be that Title III crowdfunding will perform best as a plug-in or add-on capital source for a company that is raising capital using more traditional means.
The Longer-Term Picture
Looking at the longer-term picture, crowdfunded investments have a potential to become the norm for private equity investment in early-stage companies. The people who promoted Title III were absolutely right in pointing out to Congress and the SEC that investors today are a lot more savvy and have access to lots more information at their fingertips (literally) than investors in early-twentieth-century America could even imagine, making the investor protections of the federal and state securities laws much less necessary than they were in Franklin D. Roosevelt’s day.
It’s just that I think it will take longer to get there than the current wisdom says it will. Change, especially in an industry so tradition bound and cautious as the securities industry (yes, I am saying that without irony), happens only slowly and incrementally. It will take longer than a few years for the industry, and its regulators, to accept the hypothesis that the crowd knows more collectively than the individuals within it.
Then again, I could be wrong. We’ll see.