The Burdens of Crowdfunding

Companies raising equity capital via crowdsourcing platforms will need deeper pockets and more finance savvy than commonly believed.

What kinds of start-up and early-stage ventures will sell shares in their companies over the Internet?

They probably won’t be the average pitch on Kickstarter, a self-styled “funding platform for creative projects”: the musician trying to fund his idea for a concept album, for instance, or the app developer who has a notion of building a walking guide to Dublin. Then there’s the entrepreneur trying to raise money to manufacture vertical “windowfarms” — a plastic planter that grows vegetables without soil.

Because of the reporting and regulatory hurdles, crowdfunding as it’s specified in the Jumpstart Our Business Startups (JOBS) Act may be too complex and onerous — and not very cost-effective — for any of these early-stage ideas.

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Originally, the ability to raise capital from a bunch of individuals through social media without having to register with the Securities and Exchange Commission sounded like a great opportunity for Mom-and-Pop shops or someone starting a business out of his garage. But many entrepreneurs may lack the financial acumen and robust business plans they’ll need to comply with the JOBS Act and possible further regulations from the SEC, say experts. And they also may not have the cash to hire the accountants and lawyers they will need to navigate the law.

Instead, the companies able to jump into crowdfunding, at the outset, will be more mature firms, says Nicole Denny, a CPA in the audit practice at Kaufman, Rossin, an independent accounting firm.

“They’ll be firms that have the experience of searching for sources of capital the past year or two,” Denny says. “They may be too small to attract angel investors and venture capitalists. But they will be big and experienced enough to have a solid understanding of what they offer and what makes them proprietary, as well as an understanding of their costing,” she says. “They will also be able to show, based on prior financial information, performance metrics, and forecasts, that they are heading in the right direction.”

To be sure, crowdfunding can be thought of as just an expanded version of the “friends and family” financing that many start-ups pursue. But “people may not always think about how the securities laws apply to friends and family rounds,” says David Lynn, partner and co-chair of the public companies and securities practice at Morrison Foerster.

“With the JOBS Act, the mind set will have to change because you’re doing it through the Internet with hundreds or even possibly thousands of people as potential investors,” says Lynn. For companies offering a securities interest in their venture, “there’ll be a lot more rigor because you have to provide financial statements and [other] disclosures,” he says. “It’s not like picking up nickels on the sidewalk.”

Here are some of the cost and compliance questions that entrepreneurs trying to issue equity securities via online platforms will face:

Capital-raising target versus cost. Determining the amount of capital the company wants to raise from investors may not be easy. That’s because the regulatory requirements are a sliding scale based on funding size. For up to $100,000 in capital, the company has to submit financial statements signed by the directors, as well as a tax return; between $100,000 and $500,000, the financials must be reviewed by a CPA; and for between $500,000 and $1 million, the financials must be audited.

The cost in time and money incurred for a reviewed financial statement or an audit will have to be analyzed. For a company thinking about raising slightly more than $100,000, it may make sense to raise less money to avoid needing financials reviewed, says Denny.

“If you have to spend $20,000 for a review, is it worth it to instead take $90,000?” she asks. Crowdfunding platforms will also charge fees to list securities, though how they can charge has yet to be determined. “Nowhere in any capital market can you list a security and not have to pay somebody something for it,” Denny says.

Disclosure liabilities. Financial statements and disclosure requirements can mean liability for the owners. As with any other private or public offering, the issuer has to perform due-diligence examinations to ensure there are no material misstatements or omissions in its investor disclosures. Shareholders could sue for fraud, of course. But the JOBS statute also lets an investor who can prove that there was a material misstatement or omission sue for his money back, says Lynn. So if an issuer tries to raise money via crowdfunding, it will probably need to get a lawyer involved, he says, “and that’s not ever cheap.”

Uncertainty around final rules. There’s plenty of conjecture about the additional restraints the SEC will impose on issuers and crowdfunding platforms. The agency is collecting comments on the law, and new rules will probably be in place by January 2013. One sticky area that could affect issuers indirectly is the securities rules for funding portals, which could throw a spanner into the works of some crowdfunding business models.

For example, platforms will not be able to perform any of the functions a broker-dealer can, such as handling the money or the securities. “All that has to happen away from the funding portal itself,” Lynn says. “My initial view is it would be difficult for [platforms] to operate effectively because of the restrictions.”

On the issuer side, while the SEC’s mission is to promote capital formation, it also has a duty to protect investors, notes Lynn. The possibility of entities scamming investors via these platforms has been a major point of opposition to parts of the JOBS Act. “The SEC is probably worried about that and could very well layer on more regulation,” says Lynn, such as requiring financial statements from issuers even after funding is complete. “If the company has to file and provide disclosure after the crowdfunding, which the statute contemplates,” he says, “it could make crowdfunding potentially cost prohibitive.”