Crowdfunding has been around for several years; however, its use by small businesses as a source of growth capital is becoming increasingly popular. Changes in securities laws since the passage of the JOBS Act have created a spike in interest among not only entrepreneurs, but also individual investors who seek to broaden their portfolios. What does this mean for you and other business owners who may be leaning toward nontraditional funding sources to grow their companies? We get the low-down from attorney Jennifer Post, partner at the LA-based law firm of Raines Feldman LLP, where she specializes in M&A and venture capital financing.
It's tough to negotiate and keep your shareholders happy. It's just the reality of being an entrepreneur.
- Jennifer Post
Jeff: We appreciate having you. Jennifer, the idea of crowd funding, it seems that we really started to hear more about crowd funding from the very beginning at about the time of the financial collapse in 2008. It seems like maybe this was an idea that may have been born slightly ahead of that, but that started to really gain some traction as an option for companies to find a way to finance at least part or maybe even in some cases all of their business when maybe the traditional means of funding their business may have dried up a little bit after that financial collapse that we saw in 2008. Is that correct or has crowdfunding been around for a lot longer than maybe we give it credit for?
Jennifer: I think that's mostly correct but there is a bit of a history to understand in terms of how we got to today's notion of crowd funding. And I think if you look back just a little past 2008, maybe several years before that, with sort of the advent of the Internet being a constant source of communication between companies and the crowd, or between causes and the crowd and they're being sort of this 24-hour news cycle. It became quite popular to raise money online for various humanitarian causes. So the Red Cross and other international relief organizations turned to the Internet as a means to reach people to make donations for crisis-oriented events. That sort of merged forward with this notion that individuals could raise money, that companies could raise money for their projects, that people who wanted to make films could raise money, people who have medical problems could raise money. Websites like Kickstarter and IndieGoGo were founded on the notion that if humanitarian companies could do this why can't individuals. And organized companies do this for the sake of reaching people that have an interest or passion in connecting with those people and getting funds from those people.
IndieGoGo and Kickstarter were set in place really before the recession, but they were an outgrowth of this notion that the Internet was this perfect way to reach people with news and information and have them become involved monetarily with these causes, or with these crises, or what became products, films, and other passion products of individuals and companies. The history here is that the Internet provided a terrific interface for people who needed money, with people who are willing to give money if they could form a connection around the cause, or the passion, or the common interest. That's sort of the long history of how we get to the JOBS Act.
But to your point, certainly the recession brought a lot of typical and customary sources of capital to a halt. Banks stopped lending. Most venture capital fund and private equity funds rolled up shop for a while and weren’t making traditional investments, certainly not at the pace in prior years. There are a lot of failures in technology and other industries. So investors started to hold on to their pocketbooks in a way that we hadn't seen in a long time. At the same time the Internet was out there and companies were raising money. Companies that were producing movies, creating new consumer products, launching restaurants, and also individuals who wanted to forstore foreclosure, or raise money for medical purposes, etc. People were turning to the Internet to raise money and have people participate in their project. However, it was not legal then and it just recently became legal to have these people take the form of investments to make actual equity investments in the company. Until recently IndieGoGo and Kickstarter, I'm picking on them because they're the most popular and widely used platforms were able to take pledge-based donations or pledges or donations.
The history here is that the Internet provided a terrific interface for people who needed money, with people who are willing to give money if they could form a connection around the cause, or the passion, or the common interest.
Jeff: In other words pledge is really from anyone. We're not talking institutional investors here but we're talking about the guy or lady next door, right?
Jennifer: That's right. And that's sort of the beauty and the magic of crowdfunding is that someone who wants to raise money for a movie, or a new consumer product, or open a new restaurant can find some way to appeal to someone who maybe can only donate $10, or $5, or $75, or $100. But over the course of hundreds of donations like that companies can raise substantial amounts of money. But yes, it's true. There was no particular disclosure requirements. People were giving money for the sake of helping companies and for getting back some kind of perk. So these perk-based campaigns for example, if you're raising money to produce a movie, if you pledge $10 maybe you get a hat. If you pledge $50 you get a t-shirt. If you pledge $100 you can come to the movie set. If you pledge $1000 you get a copy of the script signed by all the actors. They were ways to create incentives for people to make pledges. And this was all fine in terms of the securities laws because no one was actually investing, no one was anticipating sharing in the profits of the venture. And conversely the companies didn't have to make any particular representations, and have any particular compliance requirements. The bottom line was the company had to try in good faith to accomplish what they promised the pledgers they were trying to accomplish. Make a movie, produce a product, open a restaurant, and so forth.
Jeff: Let's broaden the base here. Crowdfunding as a source for funds for privately held businesses. You were getting ready to, before I kind of walked on you just a little bit there, Jennifer, for clarification. You were getting ready to talk about some changes that have come about for the purpose of equity investing now as opposed to just kind of a one-off contribution to a company for the purpose of helping it grow or get up off the ground. Things have changed a little bit, is that correct?
Jennifer: Oh yeah, they've changed radically and substantially I would say. The history as I said is sort of humanitarian relief, and then companies and individuals who wanted to get money from the crowd for projects, or new companies, etc. And this was sort of during the recession. And then a movement started amongst people who were hosting the websites, amongst the individuals in the crowd who said, "If we can give money for the purpose of getting a t-shirt or some other gift, why can't we invest money and actually participate in the profits?” Meanwhile, in 2012 the JOBS Act is adopted. The JOBS Act provides many changes to the securities laws. But most importantly it opens up the access point between companies that want to raise money, and people in the crowd who are willing to invest money and take a risk, but who want to participate in the profits. And this is known as equity or securities based crowdfunding.
And so the first generation of that under the JOBS Act was changing a very, very old rule that the FTC and Congress have laid down decades ago that if you're going to have a private offering, if you're going to offer securities privately, if you're a private company and you're going to work with small groups of investors, that offering in fact had to be private and you could not have any public advertising or what's known as general solicitation. So in very traditional venture capital financing, the sort of closed loop capital environments, investors knew emerging companies, emerging companies knew where to go to meet investors, etc. But there were a lot of entrepreneurs who couldn't penetrate that environment. And as we said, in 2008, 2009, 2010, those environments were shut down anyway. The FCC said, "If raising money privately, having existing relationships with investors is not working, we need to open up the capital markets we need to be responsive to what Congress has asked us to do under the JOBS Act." Under the JOBS Act this really sort of ancient rule about no general solicitation, no public advertising, you can only take money from people you already know, that was eliminated. And that was known as the elimination of the ban on general solicitation.
What does that mean? That means that you can go beyond people you know in your direct circles. You can go beyond the traditional sources of capital, and you can open up your offering to the general public by means of advertising by email, on the Internet, and so forth. However, that first stage, that first step of the JOBS Act, which was huge frankly for the securities regulatory commissions at the state level and also obviously for the FCC, you could go to the crowd and you could offer your investment and your company but you could still only take money from high net worth individuals or credited investors. All these years when you were doing private offerings with French capital firms and high net worth individuals, and everybody was sort of in that club of ready investors, they were all credited. And if you were a private company and you had a relationship with an investor and the investor was accredited you could take their funds. And the investor could tell you on their own, they could self-certify as being accredited. There was this ecosystem of companies who could find high net worth individuals who were accredited. The accredited investors could say, "Yes, we're accredited." And the transaction could move forward. Because of the JOBS Act, and because the FCC reacted to the JOBS Act, you could advertise on the Internet. As I said, the ban on general solicitation was gone but you could still only take money from accredited investors. The trick here and what the FCC did was they said, "Okay, you can advertise to the public. You can find accredited investors, but the way you determine whether or not they're accredited is going to be more challenging, it's going to be more difficult.”
If it's private you can self-certify as accredited. If you find investors over the Internet and you want to verify that they're accredited there has to be some third-party substantiation or documentation. People have to submit tax returns or investment statements, or their lawyer, or their accountant or somebody has to write a letter verifying that they're accredited investors. What are credited investors? They're people with over a million dollars of net worth, or they're people with substantially high annual incomes of either $200,000 if they're independent or $300,000 if they're married. Congress said, "Go to the crowd and find these people. Find the accredited investors. The FCC said you can do that but we're going to make it a little harder for you to verify that they are in fact accredited." That was the first part of the JOBS Act. It created a new exemption under Section 506-C Regulation D which is a mouthful. But basically the first stage was to allow companies to reach the crowd but only to reach investors who are otherwise qualified to invest in private companies. That was sort of the first wave of it.
The second wave which just recently was implemented by the FCC is under Title 3 of the JOBS Act which allows companies to go to the crowd, and so to your point, to allow anyone, sophisticated or unsophisticated, wealthy or not wealthy, to invest in private companies. This is a general equity crowdfunding rule. There are some limits but basically it has proverbially opened the floodgates for everybody in the crowd to become an investor in private companies, and for private companies to reach virtually everyone they can via public means to appeal to these people to become equity investors, stakeholders, profit holders in their company. We can talk more about what those regulations entail, but you can see it's been sort of a steady march forward and there have been incremental changes. But given where we were and given where we are now it's quite substantial, the changes.
If you're going to offer securities privately, if you're a private company and you're going to work with small groups of investors, that offering in fact had to be private and you could not have any public advertising or what's known as general solicitation.
Jeff: But from where you sit as an attorney, and really as someone who, I'm sure you're an investor as well and probably have a 401K set-up there through the firm that you're with. But as someone who works a lot with business owners is this a good thing, do you think?
Jennifer: I think it depends on which side of the table you're on. I think the regulations and the FCC mandate to protect investors is really where the regulations were geared to. There's a lot of wording in the adopting release. There's been a lot of wording in legislative history and so forth to protect investors. People in the crowd are going to be seeing these company offerings, is there going to be fraud, and are they going to be taken advantage of, and how do we protect investors? That is the FCC's focus and that is more or less their mandate and understood. But your question is really I think in some ways the more interesting question.
If I represent the company or companies out there trying to raise money, of course they want funds, of course they need capital, of course they have to have money to survive, operate, and grow. However, they really have to ask themselves, and I tell my entrepreneur clients this, "Do you want to have in your company hundreds of shareholders who have never invested in a private company, who don't know what to expect, who could be nervous and demand liquidity at a time when you can't offer it, and who have ultimately voting rights in your company, and who also have quite a buffet of statutory and contractual rights to hold you accountable for what happens inside of your company?" That by itself is not a bad thing, shareholders should have rights. But think about having hundreds of strangers, people you don't know, don't know what their qualifications are, don't know what their level of sophistication is, potentially involved in your company, potentially having to manage them to a process, etc.
I think for entrepreneurs there's a real question of, first of all, could you raise the money. And second of all do you want to have all of these shareholders to manage. Even having a company where the shareholders are sophisticated, or venture capital, or angel investors, or people that have a background of investing in startup companies. It's tough to negotiate and keep your shareholders happy. It's just the reality of being an entrepreneur. I think it's that much more risky when you're dealing with investors you've never met, you have no relationship with, and you don't know what their level of sophistication is. You have to be willing to live in a new environment where you're bringing with you through your corporate life lots and lots of stakeholders who may or may not be a good fit for your company or for the ups and downs that your company is going to experience. A few of the things we don't know, we don't know with very many examples, there might be a few but very many, what happens to companies that are crowdfunded and have 300 or 400 shareholders. Maybe they've raised $750,000 or maybe they've raised a full million that they're permitted to raise under the rules. Will sophisticated, institutional investors invest in a company that already has hundreds of shareholders? Investors are smart, they're savvy, they want to make money, they're looking for exceptional opportunities, but their risk tolerance only goes so far.
And it's very risky to invest in a company where there are hundreds of other shareholders that you don't know, can't control, don't know what they're going to react to, don't know how they're going to behave. So it's another layer of risk for institutional investors as to whether or not they're going to want to co-invest with the crowd. And that's just an unknown right now so unknown if it's going to work. There are some commentators out there saying, "It's going to go the other way. Investors are going to put in the first half a million and then that's going to give the crowd confidence to go in and put a million on top of that. In other words as long as someone with sophistication, knowledge, and experience has invested why wouldn't I?" The thought there is that companies might be able to leverage early rounds of capital through angel investors and other sophisticated investors, and then go out to the crowd to raise money on top of that.
There are a lot of unknowns there. I think it creates some risks which can probably be managed but nonetheless risks new to entrepreneurs and growing companies. When you invite into your capitalization table potentially hundreds of investors who frankly have never done this before. There are some unknowns there.
Jeff: Interesting point, very risky indeed. There are risks with anything that is new and different, and crowdfunding has been around now for a few years and is gaining traction, and it's gaining investors quite honestly from coast to coast. My name is Jeff Allen and we're going to talk more about this idea of crowdfunding. Is this something that you could benefit from with respect to your business and raising capital? We're going to continue our discussion with Jennifer Post from Raines Feldman LLP when Deal Talk continues in a moment.
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Jeff: Welcome back to Deal Talk where we are becoming the Internet's go-to resource to help business owners understand what it takes to sell their company successfully. You can find a wealth of resources along with all Deal Talk episodes and their transcripts simply by visiting morganandwestfield.com. I'm Jeff Allen with my guest Jennifer Post, partner at the law firm Raines Feldman LLP in Los Angeles talking about crowdfunding as a source of funds for your business.
And it doesn't really matter what stage you are in, in terms of business ownership or how old your company is for that matter, how long you've been in business, crowdfunding is something that is relatively new, it's relatively different to consider. But let's say for example that you've got somebody out there, they've already got a Small Business Administration loan. They're working to pay that off. They've been in business for five, ten years and they're looking for a means to raise capital for any variety of needs. Maybe it's to buy additional equipment, supplies, to expand their business, maybe to open up a new shop someplace. Is crowdfunding really something that they should seriously look into, do you think?
Jennifer: I think crowdfunding potentially can work for a lot of different kinds of companies, but I don't know that it's a solution for all companies. I think companies that are likely to succeed in crowdfunding are companies that have some sort of wide appeal to their product or service, sort of a "sexy industry", some sort of brand new technology, something all consumers can relate to. Perhaps it's a film or creative production that has popular talent associated with it, something that appeals to a lot of people in a broad range of cities, lifestyles, etc. in the country. Companies that have some sort of sex appeal to them if you will are probably going to do well in the crowd.
Other types of companies that are going to do well in the crowd I think are companies that are regionally based. For example I'm in Los Angeles. I like restaurants. I'm not going to invest in a company that's starting a new restaurant chain in New York because it's not in my backyard. But I will be motivated to work with companies, or take a stake in companies that are in my neighborhood, in my region, or in my city. I think companies that are looking to build a brand, or don't have a presence or a connection with the local community I think will also do well. And companies that can find a way to use crowdfunding to find the pockets of investors who will understand them I think will also do well. Posting a crowdfunding campaign and expecting to reach millions and millions of people, and hoping that someone out there understands your business may not be the most strategic way to crowdfund. But if you can find specialized crowdfunding portals, or access, or avenues where people can help you develop and cultivate an audience of people who understand your industry, or understand your technology, or understand your brand then you're more likely to find people who will actually invest. If you're a machinery company and you're involved in aviation, all the better for you if you can find a crowdfunding platform that seems to attract people who have worked in industry, people who have worked in manufacturing, people who have worked in the aviation industry.
I think we're going to see a development probably by necessity of crowdfunding portals and intermediaries, consultants, and advisers who will help these portals and these companies cultivate sort of, if you will, the equivalent of a direct marketing campaign to investors who will appreciate the company, their status, their industry, etc. Otherwise we're falling back to who's interesting, who's sexy, who's got wide appeal, or conversely who's in my neighborhood, who's in my community, who's in my state that I'm interested in supporting?
You have to be willing to live in a new environment where you're bringing with you through your corporate life lots and lots of stakeholders who may or may not be a good fit for your company or for the ups and downs that your company is going to experience.
Jeff: What do we not know yet about crowdfunding that you may have a concern about in terms of risks potentially, not just risks to a company for embarking, going down that road. Whether or not you've got a sexy product or not it really depends and it's kind of in the eyes of the beholder. Really, what is there that you are concerned about as an attorney from a legal standpoint that we just don't know yet enough about crowdfunding and its safety as far as a resource for companies that want to go that way?
Jennifer: We've discussed in the first half it’s not only risk for the companies in developing large populations of shareholders that can be a burden from an administrative point of view, it can be a burden from the point of view executing on transactions. And also there's some exposure there frankly to shareholders who don't feel that there's enough liquidity. Or frankly if there's no success, people I think don't really expect to lose money. I just think that that's going to be a new reality for a lot of investors. On the other side of the table for the investors I think there will be a lot of disappointment. I think there will be a lot of complaints filed with the FCC and also with state regulatory commissions, people who feel in hindsight that they didn't get a good deal, that they lost money unnecessarily, or there must have been a problem with the company or the management that wasn't disclosed.
On the investor side I think there's going to be some amount of frustration. What happens with that frustration I think is the big risk. There's been a lot of discussion by commentators and others as to whether or not this is going to be a breeding ground for class action lawsuits. Hundreds and thousands, maybe millions of investors coming together to sue the websites that host these offerings, or the companies that offer securities. There certainly is always a risk of fraud. But I think the biggest risk in the market right now, unfortunately, is that there is this legal track developing for offering securities. The securities offerings to the crowd needs to be conducted on registered Internet sites, or they're known as intermediaries or funding portals. These are websites that register with the FCC, will be regulated by the FCC, are mandated to provide certain types of information to the crowd. However, the Internet's a big place. Lots of people get email, lots of people get spam, lots of people get solicitations from all sorts of websites. I think there could be, at least for some period of time, an unregulated crowdfunding market that could develop. So investors could be fooled in other words into investing in companies that are not offering securities through these regulated crowdfunding portals. That is certainly a risk. It's really hard to know if that's going to happen, but I think that risk is out there because there's a lot of misinformation, misunderstanding, and lack of clarity around how someone in the crowd can invest in a small company. The regulations are still developing. I think that that will be a continuing risk.
The other risk I see for investors, and this happens even in well-funded, well capitalized companies, is that investors want liquidity. If you're a company with a few hundred shareholders, shareholders want to sell their stock. We live in a world where people buy things and then they're not useful anymore and they want to sell them. So people will want to sell their stock to their friends and family. They may just want to get rid of it. People frankly move, they die, they become incapacitated. What happens among the ranks of shareholders in terms of how they want to handle their stock as property is a risk we don't have any answers to. Will there be a secondary market where people start trading in these crowdfunded companies even though they're either not supposed to or the regulations restrict that? Again, another unknown, it's a risk for the shareholders and it's also a risk for the companies.
A lot of unknowns really about how the rules are going to be implemented. Whether they'll be sort of a shadow market. Even if people successfully invest in crowdfunded companies what are they going to do with that stock and how long are they going to be willing to hold on to it before they start taking action which are contrary to the regulations.
Jeff: Because we're running out of time I'd like to go ahead and just break now and tell you that we might have a need to have you back on the program for a follow-up edition of our show just to once again explain maybe even in greater detail some of the key concepts here that we talked about today. And provide us with the an update as news comes down about any changes, further changes in the law and regulations, and legislation concerning crowdfunding. We hope that you'll do that at some point in the future.
Jennifer: Sure, I'd be happy to. These are very complicated regulations. Things are changing rapidly. There's a lot of material to talk about.
That is certainly a risk. It's really hard to know if that's going to happen, but I think that risk is out there because there's a lot of misinformation, misunderstanding, and lack of clarity around how someone in the crowd can invest in a small company.
Jeff: I'd like to find out too also Jennifer how people can get in touch with you if they have any questions about this subject that we're talking about today or if they want to talk to you too about any number of other business related matters concerning their companies, how can they reach you?
Jennifer: I'm a partner at Raines Feldman. We have offices in Beverly Hills and also Orange County. Our website is www.raineslaw.com. There's always the telephone. I'm at 310-440-4100. I'm happy to speak with people about their questions and comments on this or other topics that are important to them.
Jeff: Jennifer Post, again, I thank you so much for participating with us today on Deal Talk and we look forward to having you back on again.
Jennifer: Great, thanks so much for having me.
Jeff: Business law attorney Jennifer Post, partner at Raines Feldman LLP has been my guest today. We hope you enjoyed the discussion.
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