There's so much hype surrounding crowdfunding and for good reason. Stories like the one of Ouya, a game console developer that raised $950,000 in just 8 hours on Kickstarter capture our imaginations. In 2012 alone, over 2 million people pledged approximately $319 million on Kickstarter while global crowdfunding is predicted to grow to $6 billion in 2013.
So far so good. But existing crowdfunding models are based on donation and reward based models where backers donate money to projects with no prospect of enjoying the upside of a successfully funded crowdfunding project. That's where equity-based crowdfunding comes in. Rather than donate money in a crowdfunded business, backers, or more precisely, investors, invest money in the business and in return receive shares or other similar equity interests in the business with the prospect of sharing in the upside. It sounds simple but raising money from investors in this way requires compliance with the securities laws which until the enactment of the JOBS Act last April were ill-equipped to accommodate this kind of money-raising.
With the passing of the JOBS Act, equity-based crowdfunding will become legal once the SEC issues its crowdfunding rules (which we are still waiting for) to fill in the gaps left by Congress. Nevertheless, regardless of the make-up of the SEC's rules, equity-based crowdfunding under its current formulation in the JOBS Act, is not a viable model. Here's five reasons why:
1. There are limits on the amounts that can be raised
What if a crowdfunding offering were to enjoy the kind of success that Ouya experienced? After raising almost $1 million in its first 8 days, Ouya went on to raise a further $7.5 million in less than a month. Under the JOBS Act however, companies conducting equity-based crowdfunding are limited to raising just $1 million in a twelve-month period. This may sound like a lot of money to a mom and pop type business but if you are like Ouya that requires large expenditures on R&D or are otherwise capital intensive, $1 million will not go very far.
2. How do you manage 100s or 1000s of investors?
Crowdfunding is premised on large numbers of investors investing small amounts of money. Managing 100s or even 1000s of investors is going to present real challenges for equity-based crowdfunded companies. Corporate formalities such as holding shareholder meetings and maintaining up-to-date shareholder records have the potential to become administrative nightmares. And how does one handle the $100 investors who think that their stake in the company entitles them to weekly update calls with the CEO? Is it realistic to expect a startup to dedicate disproportionate amounts of time to investor relations when time could be better spent building the business?
3. Costs of compliance will be disproportionately high
Unlike donation-based crowdfunding, certain legal requirements must be met in order to comply with the rules that govern equity-based crowdfunding. The underlying rationale of the equity-based crowdfunding rules is the prevention of fraud. To that end, among other things, companies will be required to prepare disclosure documents detailing the terms of the offering, the risks involved and information about the company and management. In addition, companies will have to provide financial statements that in some cases will need to be audited. The time and cost of hiring professionals to prepare these documents is likely to be in the thousands or even tens of thousands of dollars not to mention other costs such as fees of the crowdfunding platform that will host the offering.
4 Crowdfunding will create significant legal exposure for companies and their management
If a company undertakes the task of drafting the disclosure documents themselves to save on costs, the likely byproduct of which is sloppy drafting, then there is an increased risk of getting sued for having misled investors. This risk is compounded threefold. First, by the JOBS Act itself that makes available an investor-friendly remedy against a company and its management for material misstatements and omissions. Second, by virtue of the fact that less sophisticated investors have less capacity to lose money and therefore a greater incentive to sue or at least threaten to sue. And third, statistically 25% of startups will fail within the first year resulting in a greater likelihood of disgruntled investors.
5. Who will want to invest in a company that has been crowdfunded?
Raising capital for a company is usually not a one-off event. Once the crowdfunding option has been exhausted and a company seeks traditional means of raising capital, will sophisticated investors such as VCs and angel investors really want to put their money into a crowdfunded company that is burdened with the types of problems discussed above?
In short, donation-based crowdfunding works in part because the access created by online crowdfunding platforms such as Kickstarter to large pools of potential backers is unimpeded from both a technological and legal standpoint. However standing in between a company and large pools of potential investors in equity-based crowdfunding are burdensome regulatory requirements which while having the noble aim of protecting investors from fraud ultimately will have the effect of impeding access to capital. If Ouya were to have launched an equity-based crowdfunding money raise, its doubtful that we'd be seeing their first delivery of consoles this March.
The information in this article is of a general nature and should not be relied upon as legal advice.
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