Is Crowdfunding Dead On Arrival? A Legal Perspective...

by JD Supra Perspectives

"[Crowdfunding] lays the riskiest investments at the doorstep of those investors that can least afford the risk. And it won’t create jobs except for plaintiff’s lawyers…”- Brian Korn, of counsel at Pepper Hamilton

Is crowdfunding under the JOBS ACT over-regulated and, therefore, ultimately useless (especially for early stage fund raising)? It's a notion that appears to be gaining traction in some circles - and so, for a legal perspective, we turned to lawyers writing on JD Supra.

Is crowdfunding dead on arrival?

Attorney Christian Salaman, partner at Pillsbury Winthrop Shaw Pittman LLP: “Crowdfunding will only be as good as the portals that will be required by the regulatory regime to funnel the opportunities. Winners and losers in the portal game will emerge, and then the winners will dictate its value. The legitimate fear is that these winning intermediaries – and their desire to extract value, or their inability to continue to find winning companies – will sap the strength of the crowd.”

Attorney Brian Korn, of counsel at Pepper Hamilton LLP: “Equity crowdfunding as it emerged from the JOBS Act is the new 'bridge to nowhere.'  It puts big deal procedures and liability on small deals. The expense of complying with crowdfunding, combined with the low issuer maximum that can be raised ($1 million over a trailing 12 month period) will be prohibitive for most issuers.

I would estimate crowdfunding expenses would surpass 15% or 20% on many transactions, compared to the maximum IPO commission allowed by FINRA of about 8%. The JOBS Act produces a number of procedural hurdles that are not economically consistent with small capital raises, and when compared with a Regulation D private placement or even new Regulation A+, only those transactions that cannot be done by any other means will be done through crowdfunding, which potentially will make the crowdfunding issuer universe potentially a world of dregs, cast-offs and Hail Marys. This lays the riskiest investments at the doorstep of those investors that can least afford the risk.  And it won’t create jobs except for plaintiff’s lawyers.”

Attorney Benjamin M. Hron, special counsel at McCarter & English, LLP advocates a more “wait-and-see” approach: “It’s too early to tell because so much depends on the rules the SEC and FINRA impose on companies and portals. While the general parameters set forth in the JOBS Act suggest crowdfunding will be subject to considerable regulation, this doesn’t have to mean crowdfunding won’t be a viable means for companies to raise capital. Initially, transaction costs will likely be high, but as best-practices develop and a supporting ecosystem evolves, costs will decrease – ideally to the point that crowdfunding is a cost-effective option for many companies.”

If crowdfunding is not the best option, what are more effective ways for startups to raise capital?

Christian Salaman again: “Entrepreneurs have been raising capital for centuries without tapping the crowd. It may not be as alluring (or as easy) as harnessing social media, but it still works to pitch friends and family and then graduate to professional investors or lenders when the time is right. And I continue to see the strongest startups financed by adventurers who are willing to risk credit card debt (and even their homes).”

Brian Korn: “The most effective way to raise capital will be to use a Regulation D Rule 506 private placement. An issuer can raise unlimited amounts of capital without preparing a disclosure document or filing anything with the SEC (other than a simple form in some cases). No funding portal or broker dealer is involved and no audited financials are required. The most dangerous aspect of crowdfunding is the potential liability that will result when an issuer does not meet its projections that it may be required to provide investors. This risk is significantly limited in a Rule 506 private placement, as the liability is a weaker “10b-5” standard requiring intent and reliance. With new rules that have not been finalized, issuers will be more free to engage in advertising and other forms of general solicitation, provided they only sell to accredited investors. If the issuer wanted to raise money from non-accredited investors, it still could (from up to 35 investors) under Rule 506, but those investors would have to be provided with a disclosure document.  But this document would not need to be filed with the SEC nor would it have prospectus disclosure liability.

Another way to raise money is under the small offering exception, Regulation A/A+. New Regulation A+ which was created by the JOBS Act will allow investors to raise up to $50 million from all classes of investors, and these shares will not be restricted, unlike Regulation D or crowdfunding. No broker or funding portal is required, although a disclosure document must be prepared and filed with the SEC.  Also, Regulation A offerings are not automatically exempt from state securities law requirements if not sold exclusively to 'qualified purchasers.'”

Which is a larger economic problem: lack of funding for startups or abuse of unsophisticated investors?

Benjamin Hron: “I believe lack of funding is the bigger economic problem, but that won’t help those persons who are defrauded. The JOBS Act’s caps on the amount a person can invest is a good way to limit potential abuse, but this will likely be difficult to police.”

Brian Korn: “These two concerns seem to be at odds [in] the fracas that resulted in the crowdfunding exemption in the JOBS Act. The Senate clearly believes that investor protection should trump business startup fundraising. Crowdfunding as it emerged from the Senate and ultimately in the JOBS Act is likely a red herring, given the onerous cost, procedural and liability requirements. I know some people who believe that if an investment cannot be funded with accredited investors, that it should not be funded. I think that is too harsh a tack, but there has to be some balance between a workable crowdfunding process that still protects investors from fraud and unscrupulous behavior.”

What type of crowdfunding regulatory regime could protect investors while encouraging investment?

"...crowdfunding coming out of the JOBS Act is a private placement on steroids with the same requirements as an IPO – and it may be designed to fail from the start in order to protect investors."

Brian Korn: “Crowdfunding has a laudable purpose and has tremendous potential to harness the world of social media to raise capital from private investors beyond an entrepreneur’s friends and family base. The bill that emerged from the House of Representatives allowed a company to raise up to $10 million and did not require SEC filing, the use of funding portals or broker dealers. I think a regime that scales back the costs of compliance but still protects investors is best. I think Congress should raise the current $1 million offering cap, and move toward the private placement model without prospectus liability, SEC filing or the use of intermediaries. Because retail investors are involved, I believe requiring a disclosure document is appropriate, similar to the same requirement for Regulation D private placements. But crowdfunding coming out of the JOBS Act is a private placement on steroids with the same requirements as an IPO – and it may be designed to fail from the start in order to protect investors.”

Benjamin Hron: “There are many regimes that would protect investors while encouraging investment, but I believe the real question is where should we strike the balance between those two goals. Rewards-based crowdfunding largely relies upon the 'wisdom of the crowd' to ferret out fraudsters. Based on the success of rewards-based crowdfunding sites, and the few reported cases of successful fraud, it would seem this approach is fairly effective. The JOBS Act goes some way towards relaxing the existing regulatory regime for private securities transactions, thus shifting the balance towards encouraging investment; however, there is still a strong emphasis on investor protection. I believe the JOBS Act struck a reasonable balance, but I’m concerned the SEC will move the pendulum back so far towards investor protection that it will negate the potential economic benefits of crowdfunding.”

What else should we know about crowdfunding?

Christian Salaman: “Crowdfunding is a lot less alluring to the entrepreneur than most realize. The sophisticated entrepreneur does not want dozens of cooks in the kitchen. If another option exists at comparable pricing, the investor will avoid all the administrative headaches – legal and non-legal – that come with crowdfunding.”  

Brian Korn: “There is a very active world in 'rewards-based' or 'donation-based' crowdfunding. Kickstarter, Indiego-go and Rockethub are a few hosting sites where entrepreneurs have been able to raise capital using donations that are not 'investments' and therefore are not regulated by the SEC. This is the perfect spot for an entrepreneur who is looking to raise a modest amount and believes his or her idea will resonate with funders who either like the idea or are looking for a 'reward' – usually a product sample or hat or t-shirt, or even the opportunity to pet the company dog.

As 'projects' become 'companies' of course, these entrepreneurs are recognizing the stark realities of equity crowdfunding and finding that it will likely be very tough sledding once the SEC enacts the rules that allow crowdfunding to begin.

Also, venture capital firms have expressed that they expect to take a dim view to companies that raise money through crowdfunding, and that if they invest in these companies, the crowdfunders must be holders of pure common with no investor protection rights and other features common in a VC deal.”

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