Crowdfunding is not what it’s cracked up to be

The Capital Raising Online While Deterring Fraud and Unethical Non-Disclosure Act, or “CROWDFUND Act” established a securities law exemption (codified at Section 4(a)(6) of the Securities Act) allowing startups to raise funds under conditions that would have previously been considered a general solicitation. Since going into effect in 2016, over $1 billion has been invested in U.S. small businesses from their communities and stakeholders.  

The Requirements of Section 4(a)(6): 

  • An issuer can raise up to $5 million during any 12-month period from what the brokerage industry might call “retail” investors.  An investor can invest the greater of $2,500 or 5% of his annual income or net worth, if the investor’s annual income or net worth is less than $124,000. Where the investor has both an annual income and net worth of at least $124,000, the investor can invest 10% of the greater of the investor’s annual income or net worth. 
  • Crowdfunding transactions must be conducted through a registered broker-dealer or a “funding portal.”   Additionally, all offerings must be conducted exclusively over the internet. 
  • Startups will have to provide certain information to participating investors.  All startups relying on Section 4(a)(6) will have to provide basic information about the offering, the company, and its officers, directors and major stockholders.  Startups will also have to provide financial information, depending on the target offering size.  For rounds up to $124,000, the company will only need to provide tax returns, if any, and financial statements certified by the chief executive officer.  For rounds between $124,000 and $618,000, the financials must be reviewed by an independent certified public accountant.  For rounds above $618,000 and where it is the issuer’s first-time crowdfunding, the financials must be reviewed by an independent public accountant. If it’s not the first-time crowdfunding, the financials must be audited by an independent public accountant.

Implications of the Crowdfunding Exemption: 

  • Many investors at the upper end of the income/asset ranges will be “accredited,” and therefore eligible to participate in less restrictive Rule 506 offerings. However, for retail investors, even if the process of closing with individual investors can be fully-automated, the ongoing cost of dealing with potentially hundreds of minor investors may pose unique challenges.  The burden of managing relationships with that many stockholders is typically reserved for significantly larger and more mature companies. 
  • Typically, crowdfunding platform fees range from 5-12%. By contrast, offerings limited to “accredited investors” under Rule 506 of Regulation D do not need to be transacted through an intermediary.
  • The information requirements of Section 4(a)(6) may seem fairly relaxed, but it still requires time, effort, and significant cost outlay to prepare the information and financial statements required to be disclosed. This is in contrast with Rule 506 offerings, where there is no information delivery requirement for offerings limited to “accredited investors.”

Bottom line: 

Crowdfunding is an option worth considering for startups that do not have access to more traditional sources of angel or venture capital financing. However, given the difficulties of managing a diffuse stockholder base, the cost of fundraising through intermediaries, and the disclosure burden imposed by the Act, offerings to accredited investors under Rule 506 of Regulation D may still be the best option for sophisticated startups. 

How to Prepare for an Equity Financing

We have covered in past FTTWs how to value your startup and how much capital to raise. Once your startup decides to pursue equity financing, you should start to prepare for the investor due diligence process. On the business side, you will need to prepare a business plan and should take steps such as obtaining management references, interviews and background reviews, customer/user references, technical/product reviews, financial statements and business model reviews.

What Every Startup Needs to Know

On Wednesday, June 26th, Perkins Coie’s Palo Alto office hosted the startupPerColator event, “What Every Startup Needs to Know.” Lowell Ness, a Perkins Coie partner in the Emerging Companies & Venture Capital (ECVC) practice, moderated a panel which included Herb Stephens of NueHealth, Thomas Huot of VantagePoint Capital, Jennifer Jones of Jennifer Jones and Partners, Yuri Rabinovich of Start-up Monthly, and Olga Rodstein of Shutterfly.