Can crowdfunding equity holders and angel and VC investors co-exist?


One of the concerns that pop up in the commentary regarding the viability of equity crowdfunding under the proposed Regulation Crowdfunding is an anticipated reluctance on the part of angel investors and VC investors to take any interest in a company that has securities held by individuals who purchased pursuant to the crowdfunding regulation.  Angel investors typically look at who the outstanding investors are, because they want active and committed investors to help an early stage company overcome its growing pains. The consequences of the fear of future rejection by angel or VC investors may create a reluctance on the part of issuers to expose themselves to a situation (having crowdfunding equity holders) that may cause them to be shunned by larger and professional investors down the road.

Another concern stems from the fact that common shares held by a large number of shareholders will be difficult to manage in an angel and VC environment where investors typically have an active or quasi-active mentoring role with an issuer's managers and directors, which would not be the case with crowdfunding equity holders.

Depending on the situation, the disparate degree of influence and control exercised by angels and VC investors could raise issues under state corporate law.  Of course, if all investors hold common shares with one vote per share, simple majority rule could deal with these control issues, but that does not help alleviate any administrative burden under any applicable state corporate law requiring that all shareholders receive adequate notice and opportunity to vote on certain actions requiring a shareholder vote, which translates into delays in the decision-making process and a less nimble company.

There are several potential ways to structure a crowdfunding equity offering to try and neutralize this potential conflict before it arises.

First, the crowdfunding securities offered could be structured similarly to a friends and family round, such as preferred securities with no voting rights. 

If, for whatever reason, an issuer wants to offer common equity securities with voting rights in a crowdfunding offering, then for those types of issuers that have a kind of product or are in the kind of industry that would naturally lead to scaling-up and who, therefore, can anticipate the need to raise larger amounts of capital in the future, it may be possible to issue securities in the crowdfunding round that are a designated class that is redeemable by the issuer, at the option of the issuer, at the time of a subsequent funding round.  In that case, the securities can be redeemed, effectively cashing out the crowdfunding equity holders by using some of the funds raised in the angel or VC round, and the angel or VC investors can start with a clean stock ledger.  This may also, in fact, make the crowdfunding security more attractive to crowdfunding investors because it provides a potential source of liquidity; however, setting the stock redemption value could be the tricky.

These alternatives would depend, of course, on any particular peculiarities regarding voting rights,  an issuer's right to redeem securities, and acceptable differences between classes of securities, as may be prescribed by the state corporation law that applies to the issuer.


DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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