[authors: David McMahon & Jeevan Subbiah]

In this post, we will deviate from our startup blog series, How to Select New Counsel and Manage Legal Fees, to discuss the recently passed Jumpstart Our Business Startups Act (the “JOBS Act”) and “crowdfunding” that we briefly mentioned in our last blog post. We will outline some key information and issues about the JOBS Act to see if crowdfunding may work for your company.

The JOBS Act Background

The JOBS Act allows “emerging growth companies” (generally companies within five years of their IPO with gross revenue under $1 billion) easier access to raising money, new potential investors and less regulatory paperwork while potentially creating more jobs. Through the crowdfunding provision of the act, startups will be able to raise money by selling equity shares through an online portal (website) registered with the government. This gives everyday “non-accredited” investors the opportunity to invest in startups and receive equity. A major reason for the passing of the JOBS Act was the decline in small company initial public offeringsover the last decade. 

Key Aspects for Startups – Crowdfunding

Startups will now be able to raise money through crowdfunding in public markets. CNN Money noted:

"The new law allows a company to use crowdfunding for seeking actual investors. It can raise up to $1 million this way. To protect investors, those with a net worth of less than $100,000 may now invest 5% of their yearly income or $2,000, whichever is higher. Wealthier types can invest up to 10% of their income.”

Another key aspect is that a privately owned startup can stay private longer. CNN Money states:

"Having 500 investors or raising $5 million previously forced a company to register with the SEC -- a costly endeavor… A company with $10 million in assets will now have to register with the SEC when its number of investors reaches 2,000, including 500 who don't meet the "accredited" wealth requirement. And companies with less than $1 billion in annual revenue can enter a five-year phase-in plan with the SEC.” 

Issues to Consider

Certain provisions of the JOBS Act went into effect when the law was enacted on April 5, 2012, but the crowdfunding exemption still requires the SEC to draft the specific rules and regulations.

Aside from this uncertainty, startups may also want to consider the benefits of crowdfunding against potential regulations, paperwork, legal risks, and legal and accounting fees. You may want to evaluate your comfort level and capacity for investor relations (quarterly reports, financial reporting, business updates, etc.).

In addition, startups may want to consider the benefits of raising money as needed in separate stages to avoid equity dilution and also so the startup can raise money at later stages when it may be valued higher. Additional issues include whether being crowdfunded makes a startup less attractive if they seek venture capital funding in the future and whether a company could or would want to seek crowdfunding after traditional venture or angel funding. 

Security concerns include the legitimacy of the government registered online funding portals that will sell equity shares of companies, the services and disclosures they will provide and the percentage “cut” they will take of the funds raised from equity shares sold.   

Debate Over The JOBS Act

Some people believe that the JOBS Act will bring forth strong job creation since only a very small percentage of startups currently receive angel investing. But others, such as former SEC chief accountant Lynn Turner, voiced concern as noted in a Forbes article:

"The proposed legislation is a dangerous and risky experiment with the U.S. capital markets, and the savings of over 100 million Americans who depend on those markets. The evidence does not support the need for it. In fact, it contradicts it. I do not believe it will add jobs but may certainly result in investor losses.” 

Others see the potential for a new huge market. As noted in Triple Pundit:

"Fred Wilson, co-founder of the venture capital firm Union Square Ventures (which has invested in Twitter, Tumblr, Foursquare, and Zynga), predicts that once it gets up and running, the equity crowdfunding market will reach $300 billion and will be largely driven by families and individuals investing a small percentage of their assets via crowdfunding. As a point of comparison, a study from Crowdsourcing.org reports that about $1.5 billion was raised from 452 crowdfunding platforms in 2011.” 

Tim Rowe, CEO of the Cambridge Innovation Center, noted:

"Americans save about $30 trillion in 401ks, pension funds, IRAs, and so forth.” Redirecting just 1 percent of that to crowd-funded local businesses, would create a pool of money 10 times greater than all the venture capital invested annually and half as big as all outstanding small business loans in the U.S.” 

Regulations, Paperwork & Money

Some experts believe that crowdfunding will enable many small startups access to capital. Others doubt that most startups at an early stage of funding will be able to take advantage of the crowdfunding provisions of the JOBS Act due to the regulations and accompanying legal and accounting fees. An article at CFO.com noted:

"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."

The article also notes that the regulations that could raise costs for a startup, stating:

"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.”

Express Liability & Potential Litigation

There are express liability provisions in the JOBS Act related to crowdfunding that may require legal assistance. CFO.com notes,

"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…"

Is Crowdfunding for You?

As you decide whether or not to participate in crowdfunding, it is prudent to keep your business and financial documents in order and up to date (financial forecast, business plan, business deck, etc.) in case you do use crowdfunding. Continue to refine your sales pitch, especially from a financial perspective, and develop tools such as a video, to tell your company’s story in a creative and effective way. You may also want to keep a list and hierarchy of potential investors to approach and continue to weigh the benefits of crowdfunding against traditional methods of raising capital.

Getting Good Advise is Critical

While the crowdfunding provision of the JOBS Act provides a potential new source of funding for startups, there certainly are regulatory concerns, due diligence requirements and legal risks to take into account. In addition, since the SEC regulations are incomplete, additional rules may come forth related to funding portals and requirements for disclosures and communications with equity holders. A startup may want to discuss these issues with independent counsel as well as the costs and benefits of raising money against the potential legal and accounting fees.

Examples of Crowdfunding Companies

Triple Pundit and CNN Money have detailed some key examples of crowdfunding companies.

On June 27, 2012, The Motley Fool electronically submitted the letter reprinted below to Secretary Elizabeth M. Murphy of the U.S. Securities and Exchange Commission. We hope these proposals will help protect ordinary investors.

Dear Ms. Murphy,

As individual investors, we are concerned that the JOBS Act lowers the bar for the vast majority of companies going public and re-exposes Americans to some of the worst financial abuses in recent memory. We believe it is incumbent on the Commission to mitigate these abuses and protect the integrity of our capital markets.

To this end, please consider the following recommendations that expand on our senate testimony. The first section contains our recommendations associated with Title III of the JOBS Act -- the creation of a crowdfunding market. The second section contains our recommendations related to Title I -- the exclusion of "emerging growth companies" from the prevailing regulatory regime. The third section contains our recommendations associated with Title II of the JOBS Act -- the removal of Regulation D's general solicitation ban for Rule 506 offerings.

I. Title III Recommendations -- Crowdfunding

A. Introduction 
In principle, we're not opposed to crowdfunding. However, the opportunities for misuse and abuse are enormous due to the inherently speculative nature of start-ups, as well as what will certainly be weaker accounting scrutiny and corporate governance.

As the SEC designs the rules governing the crowdfunding market, it will need to focus on investor education; liability and accountability for intermediaries, issuers, and key persons; clear and comprehensible disclosure; and prohibitions on scams.

No matter which figures you look at, the failure rate for start-ups is high. According to Harvard Business School, 30% to 40% of start-ups lose most or all of their money, 70% to 80% fail to meet projected returns on investment, and 90% to 95% fail to meet declared projections.B. Investor education 
As the statute makes clear, brokers and portals must verify that investors understand the risks of investing in crowdfunding.

Kate Mitchell, former managing director of the National Venture Capital Association and head of the IPO Task Force, recently noted that 40% of her venture capital investments lose their money, 40% basically break even, and only 20% make money. Crowdfunding will presumably have a lower success rate than Ms. Mitchell's fund, given that, among other things:

1. crowdfunded companies are far earlier in their development life cycle than venture capital investments,
2. many of the best ideas will already have been poached by venture capital firms,
3. non-professional individual investors may not have the opportunity or expertise to conduct venture-capital-level due diligence, and
4. criminals are obviously aware of No. 3.

Title III charges the Commission with designing a quiz that would be made available by portals or brokers that investors would need to pass before investing in crowdfunded ventures. Among other things, investors would need to demonstrate that they understand the rate of start-up failures and the risks inherent to crowdfunding:

This suggests a different, and more involved process, than simply checking a box ostensibly verifying the reader has reviewed a series of terms and conditions. There should be several multiple-choice questions tailored to testing whether prospective investors understand the nature of crowdfunding risk, the potential for fraud, their legal rights and issuer responsibilities, and the probability of losing the entirety of their investment in speculative, early stage ventures, among other things.

C. Liability and accountability 
If crowdfunding is to succeed as a start-up funding mechanism rather than as a backwater for hucksters and frauds, the Commission will need to ensure that there is sufficient transparency, liability, and accountability such that quality issuers are distinguishable from low-quality issuers.

A few examples:

1. Background checks: Sec. 4A(a) requires brokers and funding portals to obtain a background �check and a securities enforcement regulatory history check. 
   While obtaining these checks is an important step, the information could be even more effective at weeding out scammers if the Commission requires brokers and funding portals to prominently display the results of those checks, insofar as the information discovered bears on the honesty of the individuals checked. (We don't care about speeding tickets.)
2. Crowdfunding history: Quality leadership is vastly more important for the fate of small companies than large ones. What's more, crowdfunding scammers are vastly more likely to repeatedly escape prosecution and regulatory enforcement than those at the small-cap level, given their lower profile and the smaller amounts of money involved. 
   The Commission should therefore also require brokers and portals to perform and disclose checks on the crowdfunding history of officers, directors, and people holding more than 20% of outstanding equity of the offered securities. 
   "History" here means their record of crowdfunded issues and each issue's status: proposed (pending), proposed (dropped), active (with link to most recent financial performance report), and terminated (with final shareholder return). Such a check shouldn't be too expensive, as the crowdfunding intermediary industry will have already collected all the data it needs. 
   This is important for allowing investors to have the material information they need to make informed investing decisions and for weeding out and apprehending repeat scam artists. Brokers and portals could flag suspiciously prolific individuals to potential investors and enforcement officers. It's one thing to seek funding for a variety of ideas -- it's another to raise $300,000 for 20 different ventures and continually "lose" the money.
3. Residency requirement: In order to ensure access to legal recourse and enforcement actions, the Commission may need to require that all issuers' officers, directors, or holders of more than 20% of outstanding stock be residents or citizens of the United States, or of some country where the Commission would be able to easily pursue enforcement actions.

D. Prospectus disclosure 
The Commission should create and mandate a simple, uniform, easy-to-understand yet comprehensive template prospectus that is similar in principle to the mutual fund industry's summary prospectus.

Doing so would streamline the filing process for issuers, most of whom won't be able to afford a team of lawyers. A web-based template filing would also make it easier for portichs to collect and display the key information about each issuer that investors would need to know when screening for and analyzing issuers.

Among other things, the prospectus should disclose: issuer and individual backers' identities including executives, directors, and persons holding more than 20% of outstanding equity; business plan; financial statements (if applicable); proposed valuation; amount being raised; related party transactions; executive, director, and employee compensation; and any payments made for lead generation and solicitation (if applicable).It would also partially alleviate the need for the Commission to create a slew of rules that would otherwise be necessary to contain the potential for scams to proliferate in the fine print. It would clearly be abusive, for instance, for a start-up to raise $1,000,000 in exchange for 0.001% of its shares. In the absence of checks provided by underwriters and financial media, it would be relatively easy to scam investors in the crowdfunding market by hiding such information in the fine print of a 100-page legalistic prospectus.

In short, creating and mandating a fill-in-the-blank prototype (and providing an example of a good prospectus) would streamline the crowdfunding process by ensuring that issuers know what information they need to provide, help portals and brokers comply with their oversight role, protect investors, and save the Commission from having to consider and ban every possible scam that the traditional IPO process would have ordinarily caught.

E. Wanton dilution and other tantalizing scams 
Given the lack of traditional corporate governance enforcement mechanisms, the Commission will need to ban certain abusive practices outright.

Here are three examples, though there will undoubtedly be more:

1. As noted earlier, it would be possible for an issuer to raise up to $1,000,000 in exchange for only a negligible ownership interest. While the statute sets a maximum aggregate issue amount at $1,000,000 per issuer and requires disclosure of valuation, it does not specify a maximum issuer valuation. The Commission will need to set one -- perhaps at something two, five, or 10 times the aggregate issue limit -- and each issuer's proposed valuation should be prominently communicated to potential investors via the prospectus.
2. Similarly, unscrupulous issuers might sell a special class of shares to the crowdfunding public that they eventually dilute in future offerings, leaving insider shares undiluted. Unlike venture capital firms, crowdfunding investors won't have the ability to negotiate protection from potentially abusive dilution. The Commission should therefore implement a rule to protect investors from excessive dilution.
3. Unsavory issuers may seek to pay outsized salaries, bonuses, dividends, or other perks to officers, directors, or outstanding shareholders. Such payments could be an effective and legal means of embezzlement. 
   What's more, due to the limited liquidity of crowdfunded shares, even if a reasonable salary is disclosed in a prospectus, investors will have little recourse if the issuer changes its compensation in later years, say, to the entire equity of the company. 
   In light of the unique features of the crowdfunding market, while we understand that the SEC is traditionally a disclosure-based organization, we believe it should set a maximum aggregate compensation amount for officers, directors, and dividends at some percentage of the issuer's tangible book value.