The recently enacted Jumpstart Our Business Startups Act (“JOBS Act”) includes crowdfunding provisions that are of great interest to early stage companies. Implementing regulations have yet to be adopted and will be based on input from several federal agencies with varying roles (from enforcement to consumer protection). As is the case with most dynamic and emerging areas, the legal implications are many. This article discusses some of those legal implications for incubators whose tenants are considering crowdfunding to raise early stage funds. Incubators can play an important role while minimizing legal risks by equipping entrepreneurs with education and information they will need to perform their own due diligence and make informed decisions.
Essentially, crowdfunding allows a larger number of individuals to make relatively small equity investments in early stage companies. The income and net worth parameters have been relaxed for this lower-level funding option. Crowdfunding has been around for some time and gained traction as a grassroots fundraising option for charities, political causes and microloan programs. A number of internet crowdfunding portals use a similar model to raise funds for commercial projects. Even though the projects are commercial in nature, currently the return on investment (“ROI”) prospects for donors is limited and not at all equity-based. Donors might, for example, receive a promise for discounted pricing upon commercialization of the technology or be provided with research updates or logoed items (t-shirts or water bottles) for their financial support but no securities are exchanged. The JOBS Act radically changes the ROI expectations by permitting these
same projects to issue stock in exchange for financial investments from individuals who meet very relaxed income and net worth parameters. The statutory disclosure requirements are quite limited and it remains to be seen whether the implementing regulations (currently set for a December 2012 release) will require a greater level of disclosure by fundraisers.
Currently, the crowdfunding model incorporates two important concepts. First, the crowdfunding internet portals serve primarily as intermediaries facilitating the exchange of information, and the financial transactions are handled by an outside party. For example, micro-loan portals typically serve as an information resource for “investors” while the financial transactions underlying the micro-loan project (initial funding, payments and interest) are handled by a third party financial institution. Second, social networking is an essential element of most successful crowdfunding campaigns. Since projects are typically connected with funding through an internet portal, the success of fundraisers is often very much dependent on leveraging the social media network of the company’s principals and other individuals who are committed to the project.
These two concepts are likely to carry over when the JOBS Act crowdfunding provisions become effective as an investment vehicle.
All three major players in crowdfunding transactions under the JOBS Act (entrepreneurs, investors and portals) will likely look to incubators early on for several reasons. First, the incubators have access to both pipeline ideas as well as a network of potential investors already interested in the work. This is an ideal start for a crowdfunding project. Second, incubators have access to industry data on fundraising that will become important to both entrepreneurs and investors when deciding when to seek crowdfunding and how to structure those deals. Third, the incubator’s endorsement of a particular investment deal or crowdfunding portal would likely be an important consideration. The legal implications for incubators addressing these
issues are worth reviewing.
Entrepreneurs are no doubt excited about the prospects of a new early stage funding option. Incubators are already equipped to provide companies with information they will need to make informed decisions at every stage of the funding process. One important decision for entrepreneurs (perhaps most important) is made at the initial crossroad in deciding whether or not to pursue crowdfunding as an option at all. This will require an analysis of short-term as well as long-term goals. If the entrepreneur chooses to move forward with crowdfunding when other options were available (such as boot-strapping, nonequity crowdfunding, friends-and-family, etc.), decisions made as to valuation, structure and equity divested could effect or preclude later institutional investment. Entrepreneurs that choose to move forward will also need the tools to make an
informed decision on which crowdfunding intermediary to use. In this context and in fairly short order, incubators will be faced with requests for advice from companies as well as requests from intermediaries for endorsements, introductions and access to pipelines. There are obvious legal implications for an incubator that proceeds without caution in providing advice or endorsements rather than educating entrepreneurs with a goal of informed decision-making.
Alumni and community partners of the incubator may seek special access to information on investment opportunities. The incubator director may be asked to walk a fine line between donor relations and maintaining the confidentiality (and confidence) of its entrepreneurial tenants. Investors may also turn to incubators for information on intermediary portals or due diligence service providers. Each crowdfunding portal will have its own business model, track record and affiliation with a financial institution handling the investment exchange. Incubators asked to provide a recommendation, even on an informal basis, should consider responding cautiously to avoid an endorsement that could be a source of potential legal liability.
Intermediary portals will be looking for deal flow as well as potential investors. Incubators (particularly those that are university-based) will be top of mind as an access point for portals to satisfy both of their pipeline needs. Sponsorships and donations to affiliated universities by portals seeking access should be carefully considered to ensure that the appearance of impropriety is not violated and prohibitions against referral fees are not compromised.
Cautious consideration should also be given to any of the following opportunities that will undoubtedly be presented to incubators in the next few months:
1. whether to provide portals or investors with introductions to pipeline companies;
2. whether to provide portals or entrepreneurs with introductions to alumni network for crowdfunding purposes;
3. whether to provide portals or entrepreneurs with e-mail addresses for alumni or donor networks;
4. whether to permit a portal to be a sponsor of the incubator or an incubator program;
5. whether to contact alumni or donor networks on behalf of a tenant, directly or indirectly, for crowdfunding purposes; or
6. whether to provide potential investors with information on a tenant.
There will undoubtedly be legal implications that are worth an incubator’s consideration in the event entrepreneurs or investors rely on the advice or endorsement of an incubator in this new financing arena. As equity-based crowdfunding is tested and rolled out, incubators that focus on education and information resources (rather than guidance and recommendations) will be better positioned to weather the storms that will surely arise.
If you have any questions, please contact Kelly Mooney Lester, Partner, at (518) 472-1224 Ext. 1230 or email@example.com.
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