Implications of the Pending Startup Crowdfunding Bill

The U.S. House of Representatives recently passed the Entrepreneur Access to Capital Act (H.R. 2930), which creates an exemption from the registration requirements of the Securities Act of 1933, allowing startups to engage in crowdfunding (i.e. raising capital from a large number of investors over the Internet). Action is still pending in the U.S. Senate. While the actual usefulness of this new exemption will depend largely on how the SEC interprets it in implementing regulations, it’s worth thinking ahead about how such an exemption would actually work (assuming of course that the bill passes). Here are some of my thoughts:

  • The bill may (or may not) reduce the amount of legal fees a company would pay for its seed round. It creates a new type of capital markets participant called an intermediary, which would typically handle the offering for a startup. The intermediary itself would be subject to considerable regulatory oversight and would also carry a large amount of risk of lawsuits brought under the anti-fraud provisions of securities laws. Therefore, the intermediary’s need for legal counsel will be considerable (as will the need for some form of E&O insurance). These costs will be passed along to the startups who use the intermediaries. Ultimately, it remains to be seen whether the intermediaries will be able to obtain economies of scale for these costs, or whether startups will be better off engaging in the offering themselves. And of course, even when a startup does use an intermediary, not hiring legal counsel is a risky move, given that the intermediaries will likely try to shift as much of the legal risk to the startup companies as possible through contract.
  • With numerous shareholders comes the potential for class action securities lawsuits, derivative claims, requests for books and records inspections, and other actions shareholders can take against management. These actions are much rarer when a company is funded through a small number of sophisticated investors.
  • Having numerous shareholders also increases administrative burdens on a company. The company will need to administer shareholder voting, transfers of stock, and communications with investors. For large companies with significant resources, this is not a problem, but for a small startup that raises $1 Million, the administrative costs associated with having many shareholders could start to hurt the company’s bottom line. One possibility is that the intermediaries themselves may step in and provide this service to crowdfunded startups on their electronic platform, permitting them to take advantage of economies of scale.
  • We have no way of gauging how VCs will regard the attractiveness of investing in a company that previously used a crowdfunding offering. Crowdfunding can be used for seed rounds, but eventually, many companies need to turn to VCs or other institutional or sophisticated investors for further funding. Assessing a startup’s capital structure is an essential part of any sophisticated investor’s due diligence. When they find that they’ll be investing in a company that has numerous unsophisticated investors as its existing shareholders, they may balk at going ahead with the transaction.
  • Finally, we have no idea how undertaking a crowdfunding offering will affect the price of a company’s D&O policy. A sophisticated investor will usually want some form of board representation, which means they will also want the company to purchase D&O insurance for their board members (if they haven’t already). D&O insurance providers may regard a company that has used the crowdfunding exemption as a higher risk, and price the premium accordingly.

As you can see, there are some downsides to using crowdfunding as your source of seed capital (as opposed to an angel investor or some other form of accredited investor). If this bill passes, it will be interesting to see how this plays out.

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© 2011 Alexander J. Davie — This article is for general information only. The information presented should not be construed to be formal legal advice nor the formation of a lawyer/client relationship.

About Alexander Davie

Alexander Davie is a corporate and securities attorney based in Nashville, Tennessee. Businesses of many varieties rely on his counsel and judgment throughout all stages of their growth. In particular, fund managers and investment management professionals seek the expertise Alex gained when he served as general counsel to a private investment fund. Alex also has significant experience and enjoys working with companies and entrepreneurial ventures, especially within the technology industry. As a believer in technology's ability to enrich people's lives and allowing people to connect with each other in new ways, he is passionate about helping tech startups achieve success. He is active in Nashville's startup community as a mentor at the Nashville Entrepreneur Center and participates in numerous other events geared towards making Nashville a nationally ranked location for starting a business.

You can read more about Alex here.

Comments

  1. Interesting points, many of which I’d never considered from a legal standpoint (being an engineer by trade and not a lawyer).

    My concern about crowdfunding is more one of market economics than anything else, and it’s based on experience as an engineering design service provider to early-stage technology companies: Basically you can’t get the people whose money is burning too far removed from the people who are burning it. VC’s and angels, aside from being savvy investors have probably been to more than one rodeo; and when a company starts to sputter, they can (and will) step in to help set it to right. And I don’t see how that’s going to happen in a crowdfunded venture.

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