Crowdfunding Part 2: The Pros and The Problems

This post will be the second post on the new concept of crowdfunding. If you haven’t, take some time to read the first installment. Crowdfunding is billed as being a savior of small business and a boost to the power of the everyman entrepreneur by tapping into the power of the internet and the masses to provide funding for their businesses. This post will give an initial idea of the pros of having this legislation and the potential problems that might arise.

So why would we want a crowdfunding measure in place? One of the claimed benefits that is touted by those who support crowdfunding is an increase in the availability of funding for smaller businesses that may not be able to have access to angel investors, venture capital, etc.  From the perspective of some lawyers in the field, companies find it hard to find the money to fund these ventures.  The reason for this is the relatively small pool of investors. For instance, “there is a funding gap between $25,000 and $100,000, and another capital gap between $1.5 million and $4 million.”[1] Crowdfunding would thus be ideal to fill in the first of these gaps in the $25,000 and the $100,000 range. The larger gap, between $1.5 million and $4 million is out of the scope of the current crowdfunding legislation. Bill Payne, an angel investor since 1980, explains that the reason that this gap between $25,000 and $100,000 exists is the types of investors that you are dealing with. Friends and family, who provide a lot of funding for the very early stages of a company’s development, are limited in their means to contribute. Therefore, it is unlikely that a person will be able to obtain more than $25,000 from this group. Angel investors, the next significant level of investor, are reluctant to contribute amounts much below the six-figure range. While government grants can sometimes help fill this gap, they make up barely more than 3% of all of the annual startup funding in the United States.

This is where, it seems, crowdfunding would be the most effective in providing funds. What crowdfunding would effectively do is extend the reach of the friends and family bracket by attracting more people of similar small means who don’t have the funds of an angel investor. Directing people to the company’s crowdfunding page through the use of Facebook, Twitter, LinkedIn, company website, etc. would also provide a better platform to present the idea to the offeror’s extended friends and family network without having to go make a presentation to each one or violating any prohibitions on solicitation.[2] If Stu, from Stu’s Kitchen, had already gone to his parents and uncle or, also likely, they didn’t have enough money to spare to help him out, but he has 1500 Facebook friends, his status update could direct his Facebook friends to the crowdfunding site where they can buy into his company. Doing this, Stu could potentially attract Lindsey, a girl who went to elementary school with him who he may not have thought to contact but who has become a bloody mary connoisseur.

Crowdfunding is certainly not without its criticisms. Even the claim that funds are scarce is under fire. Joshua Zumbrun points out, for instance, that the small companies that are responsible for most of the job growth are not actually short on funds. Bill Payne echoes this sentiment:

“Finally, I have heard many pundits suggest that there is a shortage of capital available for startup companies, because banks and other sources are inactive due to the financial crisis.  The assumption is that crowd funding would increase the number of viable startups and therefore be a great source of job creation in the US.  This argument is flawed.  Banks have almost never funded startup companies.  Banks are sources of working capital and fixed assets for ongoing companies with the cash flow necessary to routinely amortize this debt.  However, the normal sources of startup capital for entrepreneurs (“friends and family” and angel investors) appear to be investing at normal rates.  It is not clear to me that a capital shortage exists for viable startup entrepreneurs.”

The goal of the crowdfunding legislation is to create more jobs by giving businesses that need capital access to it. Claiming that the companies that are actually responsible for job growth are not short on funds runs counter to the purpose of crowdfunding. This point could also be extended to say that crowdfunding would only be throwing money at companies that are not likely to create jobs, thus wasting it.

Criticisms also come specifically against the bill. Those who support the idea of crowdfunding as well as those who oppose it share a common criticism against the bill. The criticism is that the bill that was passed and the subsequent SEC rules will likely make the cost of compliance prohibitive. For example, if Stu’s Sour Pickle Company wanted to raise over $500,000 then they would have to get audited financial statements, which would be based on the type and complexity of the business. This could be a big chunk of the capital that is raised from the crowdfunding offering. Stu’s Sour Pickle Company will also have to annually report to the SEC, prepare private placement memorandums and may find it necessary to obtain D&O insurance to protect the directors and officers. There will also be the cost of using an intermediary. These intermediaries will have their own compliance costs and going through them will likely not be cheap. All of these items add significant expense and while they will not eat up all of the money that is procured, it will be a significant amount and will have a deterring effect. To make matters worse, most of these items must be obtained before the crowdfunding offer is ever presented to people. This means that it will have to be funded by money out of the company’s pocket before it has had a chance to raise the capital that it is looking for. Combine this with the fact that if the company does not meet its funding goal, then none of the money will be obtained and there is a significant risk of founders and companies losing a lot of money on compliance without anything to show for it. This cost and risk associated with the inability to raise more than $1 million will make the cost and risk outweigh the benefits in a lot of cases.

Another criticism with the current method is the funding portals and how they are handled. Some suggest eliminating the funding portal altogether. This would reduce costs significantly on the registering business and reduce the hoops that the companies would have to jump through. Others would prefer that the funding portals not register with the SEC but would require them to provide a medium of communication between the issuers and the shareholders. The cost of an intermediary essentially means that part of what the future shareholder is buying is for someone to give them a button to click and a form to fill out to buy the stock. If these were large IPOs or other multi-million dollar transactions then the cost would be minimal as a percentage of the whole. Given the large percentage that the intermediary will likely take, a company may be wise to avoid them. In addition, not only would the SEC have to regulate the businesses that are making the offerings, they also have to oversee the funding portals. While the SEC could use the funding portals as a way to make sure that the companies comply with some of the filing and paperwork requirements by holding the portal accountable too, this is a benefit to investors, it is not a benefit in a way that can offset the cost and burden to the company.

A related problem to costly intermediaries would be sketchy intermediaries who swindle the unsuspecting public into exhausting their life savings into companies that will likely fail. In a letter to Tim Johnson, the chairman of the Senate Committee on Banking, Housing and Urban Affairs and Richard Shelby, the ranking member of the same committee, Mary Schapiro, the former chairman of the Securities and Exchange Commission expressed that “an important safeguard that could be considered to better protect investors in crowdfunding offerings would be to provide for oversight of the industry professionals that intermediate and facilitate these offerings.”[3] This concern seems to be addressed under the JOBS Act, however. Section 304(a)(1)(C) essentially provides the SEC with the authority to add any requirements that the SEC considers important with regards to the funding portals. The Act also requires intermediaries to take measures to reduce fraud as established by the SEC.[4] Both of these requirements are examples of the extension of the SEC’s authority over the intermediaries with regards to these transactions. The SEC made some early, preliminary rules with regards to the funding portals such as “…a Funding Portal must… Prohibit its directors, officers or partners from having any financial interest in any Issuer using its service.”

While this problem seems to be covered with regards to the funding portals themselves, what about people claiming to be financial advisors calling people and pitching them a piece of the American dream? Here, third-party companies might hire salesmen to set up some sort of crowdfunding portfolio under the banner of diversification. These salesmen might recommend various investment combinations and then charge a fee for setting everything up. At the end of the day, a person may be talked into investing $50,000 in crowdfunding ventures at $1000 or $2000 apiece. This is an unfortunate, though foreseeable way of circumventing the limit of $2,000, 5% of their income or 5% or their net worth as the limit applies only to individual offerings. When all is said and done, a good salesman could talk a person out of most of their net worth, certainly more than 5%. While, in the long run, this may not be that much of a concern as the market might expose these companies as money pits, it may still hit a lot of people really hard before the market has time to adjust.

Another potential problem is the predicted lack of ability to participate in future rounds of funding after a crowdfunding round. The concern here is that the company will not be able to continue to generate funds as most growth companies go through several stages of funding. The company would not be able to do another immediate crowdfunding round within the year past the $1 million mark as that is the cap set by the new rule.[5] The company may also struggle to find venture capital or angel investors, as they may not want to work with so many small, unsophisticated players. This lack of ability to secure future funding could limit the future growth.

Derivative and securities lawsuits could also become an issue with crowdfunded companies if they do not take steps to keep shareholders happy and informed. Owners will need to make sure they are disclosing all of the necessary information to a whole crowd of strangers instead of only a small group of investors. The shift from a single owner or small group of owners to an entire crowd of owners will necessitate a shift in approach for various aspects of business, not just disclosures. For example, the company may employ all of its owners before the crowdfunding round occurs. In this scenario, they may be used to paying out all of their earnings through salary, especially if they have been a C Corporation for a few years. After the crowdfunding round, they will not immediately go out and hire all of their funders so they can continue that practice so they must find a way, especially with the limitations on resale, to start providing those investors with at least a minimal return on their investment. Luckily, if the companies are in that small $25,000 to $100,000 funding range, the potential for derivative claims that are lawyer-driven like at the public level are small as there would not be much money to be made. Also at the smaller level you may have a lot of friends and family members who personally know the entrepreneurs and are more likely to have bought their shares with their charitable intentions outweighing their desire to make money. A properly advised company with a plan to accommodate the shift from a small handful of owners to a larger crowd of owners will likely avoid these issues.

Crowdfunding as it was proposed in the JOBS Act is not perfect and it will be up to the SEC to finely tune the law so that it works well when it is implemented. The SEC has proposed rules that have been commented on but have yet to be finalized. What effect will the SEC rules have on the viability of crowdfunding as a fund-raising tool? Will the SEC rules place too many restrictions in the name of protecting against fraud? To see what the SEC’s proposed rules have done to address these problems you will need to read my next installment on crowdfunding. 

[1] Payne, Bill “The Funding Gap”

[2] There is still a prohibition on solicitation of the actual security that is being offered so that all that can be done is to provide the link to the crowdfunding page where all of the relevant information regarding the security would be presented.

[3] Schapiro Letter March 13, 2012

[4] JOBS Act Title III Section 4A(a)(5)

[5] JOBS Act Title III Section 302(A)

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