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Founders: The Strengths and Dangers of Investment Crowdfunding

on May 13 2016
Founder & CEO @ Wefunder

On May 16th, the law changes: startups can raise up to $1 million per year from their friends and supporters, who can invest as little as $100 each. (Before, companies could sell products on Kickstarter, but not stock).

This is part of the “Regulation Crowdfunding” portion of the JOBS Act, a bill passed by Congress in 2012, which is just now being fully implemented four years later (the government moves slow!).

This new federal law gives founders another lever they can use to get funded. Capital no longer has to be constrained by the traditional gatekeepers in suits — the risk-adverse bankers or the out-of-touch venture capitalists investing in the next hot “app” like a herd of cattle. In a way, this law brings back how companies were funded 80+ years ago: by their friends, neighbors, and local communities. Not some conglomerate bank headquartered on Wall Street that treats you like a FICO score.

However, as exciting as the potential of Investment Crowdfunding is to allocate capital to more deserving businesses more fairly, this is serious business: securities regulations are complex, and doing it “wrong” can hobble and possibly destroy your business.

So let’s take a clear-eyed look at the opportunities and dangers of using Regulation Crowdfunding. If you decide to do it, make sure you do it “safely” so that it won’t negatively impact your company down the road.

Strengths: Why Investment Crowdfunding?

For a small business trying to open on Main Street, there might be no other good option — Banks don’t take much risk anymore. However, let’s assume a few “angel investors” or venture capitalists are knocking around your door, and you have other options to raise funding. Why crowdfund also?

  • Pressure investors to close the deal. Professional investors often “wait and see”. The longer they wait, the less risk they take. They may make it seem like their check is just around the corner, but can be hard to close. When in this situation, the solution is to make them fear missing out.There are plenty of cases where the venture capitalists acted only after a Kickstarter campaign took off; investment crowdfunding works on the same principle for non-sexy hardware.
  • Marketing & Press. Great crowdfunding campaigns kill two birds with one stone: funding and lots of press exposure.
  • An Army of Investor-Evangelists. Top-tier venture capitalists like a16z offer tremendous strategic value that the crowd doesn’t provide. However, the crowd offers a different kind of value: evangelism. Crowdfunded companies have a “street army” of hundreds of shareholders who feel like they personally played a small part in starting the business. An investor is different than a customer; they literally feel ‘invested’ in the long term.

The Dangers… and How to Guard Against Them

The Regulation Crowdfunding law isn’t perfect, and while the SEC did a great job overall in drafting the final rules, they messed up in two key areas. Congress is in the process of fixing it with the Fix Crowdfunding Act.

However, until Congress acts, founders who crowdfund must take two safety precautions above all else:

  • Never accept more than 480 unaccredited equity investors. The SEC didn’t exempt crowdfunded securities from 12(g) of the Exchange Reporting Act. In English this means if you have more than 500 shareholders who are not wealthy, your business could be forced to report much like a public company. This is insanely expensive. There’s an easy solution: never accept more than 480 unaccredited shareholders.  Or, if you do, allow the securities to be re-purchased.
  • Use a security that can be repurchased, has no voting rights, and can be amended by a trusted lead investor appointed by the company. The SEC outlawed the “single-purpose funds” that accredited investors use to invest in startups on sites like AngelList or Wefunder. As a result, a company that uses Regulation Crowdfunding has to accept direct shareholders directly on their “cap table”. The standard convertible notes, SAFE’s, or stock agreements typically used with accredited investors should not be used. Instead, either have your lawyer draft a custom agreement, or use the Wefunder Crowdfunding SAFE for free.

If a company crowdfunds without these protections, it could endanger (and certainly slow down) their follow-on financing when they raise a Series A financing from venture capitalists. No one wants to be in a position where they have to chase down 480 signatures to raise a round of funding or get acquired (and God forbid if you have to be a public reporting company).

However, with these protections, in the very worst case scenario, a venture capitalist firm ideologically opposed to a “messy cap table” (even though there are no voting rights) can simply repurchase the crowdfunded securities during the deal. With this power, do you think a venture capitalist would have honestly walked away from Oculus if they raised with equity crowdfunding instead of with pre-sales on Kickstarter?

Other Issues with Equity Crowdfunding

While the two issues above are the most serious, there are other issues that a company needs to be aware of — the Wefunder Founder Legal Primer has a good overview. Here, I’ll deal with the issues relating to cost and time.

  • Annual Reports. Once a year, financials must be released to your investors. Thankfully, they are self-certified by the CEO, not reviewed or audited by a CPA (which would be expensive). Reporting may be terminated if there are less than 300 shareholders after 1 year in some cases, or if the securities are re-purchased. Most importantly, not complying with the reporting requirements is not a condition of the exemption. If you fail to report, you may not use Regulation Crowdfunding again until you do so (but you can always raise unlimited funding from accredited investors with Regulation D).
  • First-Time Financials: No audits, but CPA reviews. Audited financials are never required for first time crowdfunded raises. Less than ideal, for raises between $100k to $1 million, a CPA must review your financials. Many CPA’s will quote close to $5000. However, funding portals may have special deals — on Wefunder, a partner CPA charges $1000.
  • Time. It can take a few days to collect the SEC-required disclosures. Busy founders should choose a funding portal that will do most of the work for them, and then send the founders a draft of all the disclosures (a “Form C”) and fundraising profile to review for accuracy.
  • Platform cost. By law, a business must use a funding portal to raise capital. Many people expect funding portals to charge upwards of $10,000 and 10% of the round. However, you should use choose a portal that is not a parasite. 

The Bottom Line: Choose the Right Funding Portal and Lawyer

Founders can fundraise with an equity crowdfunding campaign safely without negatively impacting their follow-on financing… but only if they choose an experienced funding portal and law firm. In summary, until Congress passes the Fix Crowdfund Act, choose a funding portal that:

  • Caps shareholders at more more than 480.
  • Works with custom, crowdfunding-specific securities like the Wefunder Crowdfunding SAFE that can be repurchased and limits voting rights of minor shareholders.
  • Has a track record of working with other successful companies (you want to be on a web site listed alongside other great companies).
  • Doesn’t charge you an obscene amount of money.
  • Does most of the work so you can focus on growing your company.
With these precautions, a founder can have the best of both worlds: allowing their friends, supporters, and neighbors the right to invest in them, while ensuring that — if their company is successful — their follow-on financing options from future professional investors won’t be limited.