What Startup Entrepreneurs Need to Know About Crowdfunding Before They Raise Money

 Most of the attention has been focused on how crowdfunding will be a great source of seed capital, but it may turn out to be a better fit for more mature companies looking for growth capital...

- Ben Hron, McCarter & English

What's the one thing entrepreneurs need to know about crowdfunding before they raise money? For a JD Supra Perspective, that’s the question we put to experts writing on this matter. Here’s what we heard back.

Know the Difference

First is a reminder from attorneys David Lavan and Mary Newman of Dinsmore & Shohl to know the difference between types of crowdfunding. Obviously an essential first step:

"There’s a big difference between the crowdfunding that isn’t tied to a security offering and crowdfunding a securities offering. The former is what captures most of the headlines for raising, in some cases, millions of dollars for small ventures. This type of crowdfunding, for the most part, works for entertainment-related products like video games or movies. For companies that offer a security as part of their crowdfunding efforts, the proposed SEC rules would apply, and the prospect becomes much more daunting and expensive.  There are disclosure requirements, a cap on the amount that can be raised, and a cap on what individuals can invest, among other limitations. Before jumping in, it is important to know which path you want to take and whether it is the best fit for your business."

Take the Long View on Your Company's Needs

Ben Hron, special counsel at law firm McCarter & English, offers three points that share a common theme: while most people see crowdfunding as a way to raise early money, you should always start with a long view of your company's needs and, among other considerations, think through what crowdfundung might to do to limit or help you in the future. To wit:

"Entrepreneurs need to think carefully about the lifetime capital needs of their company before crowdfunding. At least until the crowdfunding industry matures, many angels and VCs will be very hesitant to invest in a company that has crowdfunded, so raising seed capital through crowdfunding may preclude raising money from angels or VCs later.

Entrepreneurs need to consider the long-term cost of complying with the crowdfunding rules, not just the up-front cost.  Among other things, the ongoing reporting requirements obligate a company that raises over $500K through crowdfunding to file audited financials with the SEC every year thereafter, which could be very costly.

 Most of the attention has been focused on how crowdfunding will be a great source of seed capital, but it may turn out to be a better fit for more mature companies looking for growth capital. A company that already has its financials audited annually may be able to tap its existing network of customer, vendors, etc. to raise capital through crowdfunding without incurring much additional expense."

Consider Crowdfunding in Tandem with a Reg D Offering

If you are going to take on the expense and responsibility that comes with this type of capital raising, keep in mind that crowdfunding can be used in tandem with traditional Reg D offerings. Richard A. Lyons, business practice partner at law firm Wendel, Rosen, Black & Dean explains:

"The SEC’s proposed crowdfunding rules contain many restrictions. For example, only $1,000,000 can be raised in any 12-month period through crowdfunding, and individual investments are limited to 5% or 10% of an investor’s income or net worth with an overall limit of $100,000 per investor. There are no such financial restrictions in an 'accredited investor' Reg D offering. However, unlike crowdfunding, a Reg D offering cannot be advertised over a public investment portal. So long as a company does not use its crowdfunding offering to attract investors into the Reg D offering, the company can conduct a Reg D offering at the same time that it crowd funds.  This allows the investment materials prepared at some expense for crowdfunding to do 'double duty' as materials for the Reg D offering, allowing the company to amortize the cost over two offerings instead of one while at the same time increasing its opportunities for a successful capital raise."

Understand the Restrictions as You 'Mobilize the Crowd'

Finally, Matt Triplett of law firm Womble Carlyle's corporate and securities group echoes the theme of Restrictions and reminds us that it's an essential first step to understand your constraints even before you try to reach your ideal investors. That is to say:

"A key factor behind a successful crowdfunding offering will be the issuer’s ability to mobilize the “crowd.”  Issuers and their counsel will need to understand the restrictions on advertising and public communications and be able to work within these constructs to reach their intended audience.  Designing an effective and compliant strategy beforehand could be a determinate factor in the issuer’s ability to mobilize investors."

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[Image credit: AlleyWatch]