What should a startup do to prepare for crowdfunding?

If you are thinking about using the crowd to fund your startup, you might want to think carefully about why, how and when.  Until SEC does finally promulgate the JOBS act regulations, it is mostly illegal.  Even when the final rules will be publicized, it still may not be very desirable to do so, depending on the type of business you are in and what kind of funding you are looking for.

Current status of crowdfunding

There are actually three different potential equity offerings that intersect with the online and crowdfunding world. First is a series of offerings that are made to accredited investors, such as some Missouri Venture Forum members. This is presently legal and goes under Regulation D, Rule 506 of securities laws. There are several equity-based crowdfunding sites such as AngelList, Bolstr, EarlyShares.com, Navocate.com, ReturnOnChage.com, RoyaltyClouds.com, InitialCrowdOffering.com and CircleUp, among others. The ventures can’t publically advertise for investors and the offerings have to be carefully prepared, much as an offline private placement offering is done now.

The JOBS act added two other situations, one which has proposed regulations that haven’t yet been adopted, called Title 2, and one which is still at the starting gate with nothing yet proposed, called Title 3. The former is just for accredited investors but the ventures can advertise for prospects, while the latter is for anyone who wants to buy in, with the specific circumstances still under discussion. Regardless of which way you go, your venture will probably be limited to raising one million dollars annually within any crowdfunding rounds. Given that one popular game raised that much in a day last year on Kickstarter, this could be a big possibility and a limitation. There will also be minimum and maximum equity amounts limits. These issues are still being worked out by the SEC.

One local venture that isn’t waiting for the SEC is Passer.by, which began operations earlier this year. Todd Metheny is their CEO and he said they started Passer.by “with the specific goal of providing an equity-based crowdfunding platform for indie films and allow a new breed of investors to have some say in what movies are made. If hundreds of people are interested enough in a film concept to invest, theoretically that movie has a much higher chance of finding an audience.” He calls this “social proof” and it is a powerful concept for his business. Right now they aren’t doing any equity funding, of course. They have gotten donors to back three different films, so they are starting slowly. Metheny is waiting to see how the SEC regs play out. “One of the big issues is whether the regs require audited financials. That is one of the potential deal killer provisions. It doesn’t really make sense to force a company with no financial history to provide audited financials, and the cost would be a significant risk for a new company anyway.”

Passer.by isn’t the only St. Louis-based crowdfunding startup: Former Center for Emerging Technologies COO Bill Simon’s Propelfund.com has also begun operations and is accepting ventures. They also plan on offering equity funding when approved by the SEC.

Outside of the US, there are numerous other sites such as the Dutch site Symbid.com that are used as a mechanism for raising equity or debt funding of business ventures. These countries have more permissive securities laws, and well, you can take your chances with that.

Next steps to take

So before the SEC acts, make sure you thoroughly understand the JOBS act and how it is written, and what it means for your startup. “You might be making a statement that inadvertently is fraudulent under one of the federal securities laws,” says Sara Hanks, the CEO for Crowdcheck.com, a startup due diligence firm for crowdfunding investors and companies looking for them.  “You don’t want to be overstating or overpromising something.” You might want to hire a lawyer, or use one of CrowdCheck’s services, or find other professional advice.

Should startups mix and match the crowd with traditional VC funding? The experts urge plenty of caution here. “With a larger number of investors comes greater investor relations management responsibilities,” says Metheny, who has a lot of questions about how things will work, especially for Title 3 deals. “What will the regs require in terms of updating the investors? Managing half a dozen investors is difficult–what about managing 500? How do you balance creating a system that provides adequate protection for investors but isn’t too onerous to be worth the trouble for startups?”

One possible mix-and-match scenario is to use the crowd for this social proof and pre-sell or pre-market a given product or service, to test the market, promote a startup’s efforts, and get the buzz going. Clearly, even some established companies are doing this already, such as the funding of a Veronica Mars movie to expand its popular TV franchise. Certainly, a major Hollywood studio doesn’t need the monies it raised from the crowd, but it helped get the project moving forward.

Another perspective comes from Bill Frezza, a venture partner in Adams Capital Management. Adams has $800 million under management, and Frezza thinks that startups shouldn’t mix funds from the crowd with the professionals. “If a startup does the initial angel round from the crowd and then does a subsequent round from VCs or sell any stock afterwards, you start getting more complex capital structures. And then liquidity becomes tough if things come apart with the company, if they have a down round or have to restructure. It could end up that the crowd-based investors get screwed and class action lawsuits will certainly happen.”

Metheny thinks it all comes down to how the JOBS regulations are written. “There could be some poor outcomes, but bad regulations have been written before, or you could have unintended consequences.”

Frezza says, “When you buy a security from a public company, it is a well-defined thing. From a venture financed company, it can be a Turkish bazaar, with very complex provisions that will make your head spin. We have enough problems with companies founded with doctors and dentists, but this could be even worse. It could be real easy to see your crowd-based ownership disappear entirely, because every new financing action can reshuffle the equity deck.”

Tim McFadden, a partner with Armstrong Teasdale LLP, recommends that startups interested in crowdfunding should get acquainted with the JOBS Act statute and what disclosures you may be required to make.  Prepare those in advance with help from your legal and accounting counsel so when SEC finally clarifies the crowdfunding rules, you have all documents in place and can act quickly.

(This originally appeared in the newsletter of the Missouri Venture Forum.)

One thought on “What should a startup do to prepare for crowdfunding?

  1. Pingback: The Growing Need for #Biotech Crowdfunding « Catalyzing Illinois

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