Regulation Crowdfunding: It’s Happening Now
The drumroll leading up to equity crowdfunding under the JOBS Act must have been deafening, because the revolution of crowdfunding that is happening right now is going nearly unnoticed by startups that may benefit from it. Equity crowdfunding (a.k.a. regulation crowdfunding) under Title III of the JOBS Act became available for use as far back as May, 2016, yet few startups seem to be taking advantage of it.
For those who do not know what regulation crowdfunding is, it is the financing of businesses through the issuance of securities (stock, bonds, notes, etc.) on a registered crowdfunding portal to purchasers who are not necessarily considered accredited or sophisticated investors. That means that your average investor (one with average experience and wealth) has the ability to purchase securities in a company through an online platform without that company having to register with the SEC, or go through the cumbersome and expensive Reg A exemption process. This is a huge departure from traditional securities laws, and creates an enormous opportunity for small businesses and investors alike. Understand that this is still a highly regulated transaction (please review the SEC’s Small Entity Compliance Guide for more information), but it is far less cumbersome and much more inclusive than the pre-JOBS Act scheme. It gives members of the general public the opportunity to become investors in private businesses, and contemplates that their investment will likely be made through the internet. That is a pretty dramatic facelift for legislation that was developed in the 1930s. The question is, could this opportunity be for you?
The purpose of this article is not to go through the requirements of Title III, which the SEC did a very nice job of summarizing. This article discusses what’s out there, and what some entrepreneurs in more “entrepreneur friendly” ecosystems have been doing under this new scheme. Taking a look at the crowdfunding platforms (portals) that are facilitating these transactions is the first step. Let’s examine at least one equity crowdfunding campaign and platform that has found some success to date.
The Funding Platform
Whether you are investing or trying to raise capital, the first thing you’ll need to know is where to find a registered crowdfunding portal to facilitate the transaction. Well, fortunately the “registration” of that portal is done through the same site that handles registered investment advisors (stock brokers). Crowdfunding portals registered with the SEC can be found on the Financial Industry Regulatory Authority’s (FINRA) webpage here. As of the date of this writing, there are only 21 crowdfunding portals registered in the United States, though I imagine that number will increase soon. There are no funding portals, as of right now, headquartered here in North Carolina. Can you use an out-of-state funding platform if you are a North Carolina based business? Absolutely. (But isn’t it telling that one of the largest banking states in the country doesn’t have a single registered funding portal?)
For this writing, I’ll focus on a single crowdfunding platform to illustrate this new crowdfunding opportunity. Because of its name recognition and openness with respect to campaign information available to passive users, I’m going to focus on Indiegogo’s Equity Crowdfunding Platform. Let’s take a look at one of the platform’s successfully funded campaigns: BeatStars.
The Campaign
BeatStars, “a platform that enables music producers and recording artists to collaborate, share, sell, and distribute” musical content, was seeking to raise between $50,000 and $1,000,000. They opened their campaign in mid-November 2016, and it closed January 17th, 2017. In that time period, they were able to raise $183,596 from 470 investors. The minimum investment amount was $100. In exchange for investment in their company through the crowdfunding platform, the investor became the owner of securities in BeatStars (further explained below). In addition to those securities, investors who exceeded certain investment thresholds get t-shirts, access to BeatStar’s service, hats, and other incentives consistent with more traditional crowdfunding campaigns. Nothing in this paragraph probably stands out to you as extraordinary, but before the middle of last year the sale of securities in BeatStars to non-affluent investors through an online crowdfunding portal would have been ILLEGAL without a cost prohibitive Reg A filing. To make the powers-that-be feel comfortable with this new scheme, BeatStars had to follow certain formalities.
Disclosures
Regulation crowdfunding requires the company seeking to raise funds through crowdfunding platforms to disclose certain pieces of information about their business to potential investors. The means by which they make these disclosures is the filing of the Form C with the SEC, which they must also make available to potential investors through the funding portal. I would not recommend that one try to fill out this form without the assistance of an attorney. It would, however, be well worth your time to review a Form C filing for a successfully funded regulation crowdfunding campaign. If you review the Form C filing for BeatStars, you’ll see the relatively detailed disclosures that are required, such as (not an exclusive listing):
· Target offering, campaign period, how the proceeds will be used, etc.
· Terms of the offering (type of security, price, etc.)
· Employee/officer information
· Risk of Investment
· Business Model
· Ownership (cap table)
· Financials
· Accounting information
As you have probably noticed, BeatStar’s Form C is a 93 page document (when you include attached exhibits), so understand that you are not going to be able to participate in a regulation crowdfunding campaign without giving a detailed forensic analysis of your business. If you are an investor, you are going to want to review the disclosures very carefully, as they will likely give you the best idea of the company specific risk you are taking on by investing.
Purchase Agreement
If you have ever purchased publicly traded securities (stocks, bonds, etc.), it would appear to be a relatively simple, “paper-light” transaction on your end. The average investor does not look at the source documents that outline the legal terms of that transaction, though they should have access to them. Additionally, most investors buy pretty run-of-the-mill securities (stocks and bonds), or purchase positions in investment vehicles that own run-of-the-mill securities (mutual funds, exchange traded funds, wrap accounts, etc.). Startups on crowdfunding platforms are not likely to sell the type of securities you would be able to purchase in your investment account. As an investor, or business owner, you are going to want to get familiar with convertible notes, convertible preferred stock, simple agreements for future equity (SAFE), and other more esoteric securities that startups sometimes issue.
As was mentioned above, investors in BeatStars obtained securities for their investment, which would have been an otherwise illegal transaction as between non-affluent investors and small businesses prior to the JOBS Act. A document called a “purchase agreement” memorializes the purchase of/investment in those securities. In taking a look at the purchase agreement from BeatStars, you can see that they are issuing a SAFE. A SAFE will give the investor the ability to obtain, at some point in the future, some form of stock (common or preferred) or cash. That point in the future will be triggered by an “event,” which is detailed in Section 1 of the SAFE agreement. Purchasers of SAFE agreements are generally given the right to purchase stock that will be issued in a later equity financing with more favorable terms than the party purchasing that stock in that later equity financing. Those more favorable terms are mechanized through a “discount” or a “valuation cap” or both. For more information about valuation caps and discounts, take a look at this primer on SAFE agreements from Y Combinator.
It should be noted that this SAFE is a security like a stock or a bond, but owning it is not like owning a stock that you purchase on the open market. There is no secondary market for this security, and there are restrictions with respect to an investor’s ability to transfer securities issued through these funding portals. In other words, investors in these startups are unlikely to see a return on their investment for years, if at all.
The Bottom Line
If you are a business, raising funds through regulation crowdfunding is going to be expensive. As you can tell from the disclosures and the purchase agreement, BeatStars paid quite a bit of money to attorneys, accountants, and the platform ($13 thousand to the platform alone). All-in-all, BeatStars probably paid about $20 thousand dollars to raise their $183 thousand (based on their estimate in their Form C). Will the cost of capital come down as competition increases? Hopefully. Is there something to be said for the ancillary advertising benefit you get from this form of democratized financing? For sure. But, for now, crowdfunding is still probably not going to benefit every startup seeking capital.
If you are an investor, investing in small businesses through crowdfunding platforms is still incredibly risky. More often than not, startups fold. This observation is applicable to all startups, even those on crowdfunding platforms. The platforms and regulatory agencies do not analyze the viability of these businesses that raise money through crowdfunding platforms, and one should not assume that just because the investments are somewhat regulated, that they are more likely to yield positive results.
That said, the prospects are exciting. Access to democratized capital for small businesses could change the way people view small businesses. It will connect the business to their consumer in a way that it never could before, by making them a part-owner in the locally owned business they patronize. The secondary benefits of what this type of financing can breed are limitless. Will there be challenges? Unquestionably, yes. Fortunately, entrepreneurs love problems—problems that need to be solved are opportunities for innovation and wealth.