Crowdfunding

Five Common Misperceptions About Regulation Crowdfunding

Ryan Flynn | June 7, 2016

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Regulation Crowdfunding has been the law of the land for a few weeks now. But if you’re still unsure whether it can help your business, you’re surely not alone. The rules surrounding this new exemption are complex, in part because it allows companies to market their securities to the general public. As such, there is a lot of uncertainty and misinformation surrounding the new law, also known as Title III of the JOBS Act, that can scare entrepreneurs away.

There are important restrictions that come with Regulation Crowdfunding that need to be carefully considered alongside other alternatives. However, for many small businesses, it provides a potentially valuable new opportunity to raise capital in a way that engages customers and builds deeper relationships with investors.

Here are five common misperceptions about Regulation Crowdfunding that every entrepreneur should understand.

For the first time, non-accredited investors are allowed to invest in private companies.

While this makes for a nice headline, it’s not actually the case that non-accredited investors (meaning the general public) have been precluded from investing in private companies until Regulation Crowdfunding. There are existing securities exemptions that support investment from non-accredited investors, notably Regulation D, Rule 504 which has been in place since the 1980s. This federal statute essentially leaves the rules up to the states, resulting in different limits regarding the number of investors and how much they can invest as well as disclosure requirements for each state.

Managing 50 different sets of laws can be a prohibitive feature of this approach, however using a broker-dealer platform like Localstake helps issuers more easily understand the requirements and manage the execution of an offering relying on Reg D Rule 504. Since 2013, Localstake has helped 18 issuers raise over $3.5 million in capital using Rule 504. More than half of those investors were non-accredited.

There are other options. Over the past several years a growing number of states have implemented “intrastate crowdfunding” exemptions that more or less mimic Regulation Crowdfunding, but limit investment activity to the state level.  By January 2016, 30 states had implemented intrastate crowdfunding exemptions. All support non-accredited investment and permit general solicitation (advertising) of the offering. Each state has its own rules, however most are fairly similar in scope. The caps on how much people can invest are a bit more restrictive than Reg D 504 and offer a bit more flexibility than Regulation Crowdfunding when it comes to disclosure requirements.

So while the new Regulation Crowdfunding exemption creates another tool for companies who want to reach out to the public, including customers and other supporters who may not fit the definition of accredited investor, there are other ways to accomplish that goal.

Regulation Crowdfunding involves increased disclosure, compliance and filing requirements

Fair enough. But the fact is, with any securities offering, there are critical disclosure and filing requirements that must be followed (whether statutorily driven or simply because best practices call for it).  Regardless of the regulatory approach, any small business pursuing investment capital should engage intermediaries or advisors to provide advice and execution support to ensure the offering is conducted in an appropriate manner.

The reality is, Regulation Crowdfunding does not sign a business up for a lifetime of SEC reporting

A careful look at Regulation Crowdfunding and other non-accredited alternatives reveals important nuances to consider. For example, a primary factor to consider with the Regulation Crowdfunding exemption is the pre-offering disclosure requirements and interfacing with the SEC.  If you’re raising more than $100,000, you’ll need the services of a certified public accountant.  Most intrastate crowdfunding exemptions also require some pre-offering disclosure. A detailed look at alternative offering exemptions can be found here.

The ongoing reporting burden created by Regulation Crowdfunding is an important consideration for businesses considering this route. The fact is when looking to raise outside capital of any kind, under any regulatory framework, a business should be taking the mindset that a level of transparency and ongoing communication with all stakeholders is part of the deal. Taking this part of the capital raise seriously requires actual work to be done, which is why it’s important for businesses to have an investor relations strategy in place before going into the process and utilize tools to help make communication and report creation more efficient.

However, the reality of Regulation Crowdfunding is that it does not sign a business up for a lifetime of SEC reporting. Here are the instances where annual SEC reporting requirements terminate:

  • When an issuer has filed 1 report and has fewer than 300 investors
  • When an issuer has filed at least 3 reports and has total assets not exceeding $10m
  • The issuer has repurchased or repaid all outstanding securities or debt obligations
  • The issuer files as a public company, dissolves or liquidates

It’s our view that the majority of issuers who use Regulation Crowdfunding will fall under the scenarios described in points 1 and 3. This creates an endpoint to the annual SEC reporting requirement. Further, the reporting requirements under the Regulation Crowdfunding are not onerous to the point of creating meaningful extra work for businesses that take investor management and communication seriously.

A large number of small-dollar investors will mess up your cap table

This point is heard a lot, especially from experienced angel and venture investors. These professional investors are likely speaking from experience, having dealt with a nightmare investor or ownership management situation (suggesting that this specific problem is not created by the regulatory approach being used).

Ryan Flynn of Localstake
Ryan Flynn of Localstake

More accurately, the “dirty cap table” problem is likely borne out of mismatched expectations among businesses and investors. What are the growth goals of the business at the outset of the capital raise? What is the economic and legal structure of a private placement offering that fits those goals? Is there an organized process and set of documents that outlines the structure being used? Is voting and governance covered and easily executed going forward? What happens when the company falls short of its goals? Exceeds them? What happens in a restructure scenario? What tools and processes can be used to efficiently report and communicate with all stakeholders? When considering raising capital, these questions are more important for the issuer to answer than what securities exemption ought to be used.

So rather than obsess over a future cap table, ask yourself first: what kinds of investors do I want involved in my businesses, and how am I going to manage the relationship going forward?

Future investors would be turned off by a company that had previously used Reg Crowdfunding

If the business is not pursuing a venture growth trajectory requiring several rounds of complex financing—which is to say a majority of small businesses—the current and future cap table is rarely even considered (aside from routine reporting).  If the business is raising debt capital, the cap table and related equity considerations are not part of the conversation. Most times, businesses that fall outside the prototypical venture approach never raise equity capital more than once or twice, making future equity investors a moot point. In the past, these types of non-venture companies more typically have relied on bank capital to achieve their growth goals.

With Regulation Crowdfunding (and other marketplace-enabled approaches) these Main Street businesses can now potentially turn to individuals relevant to them for a more affinity-driven and aligned source of capital to replace (or supplement) traditional bank financing.  They can use these platforms to provide cost-effective guidance in the capital raising process. Again, all that said, having the right structure up front and the means to work through any issues in pursuing future financing options is key. If your company is planning to raise capital from traditional equity sources in the future, any equity structure used in a Reg Crowdfunding raise needs to consider that and factor in a buyout or other restructuring mechanisms upfront.

Small businesses/entrepreneurs don’t fully understand the consequences of Reg Crowdfunding

Probably true. However, most startups and small businesses may not fully appreciate the consequences of raising outside private capital of any kind using any type of regulatory approach. Forget about complex regulatory frameworks, many businesses don’t fully understand the difference between debt and equity, or tax reporting requirements for their investors or how to structure basic economic terms of an offering. And for good reason: this is a complex topic, and they’re busy running their businesses. That’s why it’s critical to use advisors and platforms to help evaluate all options available to the business and execute the basic mechanics of an offering.

So then, what types of companies are the best fit for Regulation Crowdfunding? It might be easier to answer that by first looking at the companies that are not a fit. Companies with large capital needs that are planning a high growth, venture capital trajectory are probably best served by looking to other regulatory frameworks for their capital raises. In most of these cases, the dollar limit and other requirements of Reg Crowdfunding outweigh the primary benefit (general solicitation).

On the other hand, small Main Street businesses that have already built a community of customers and advocates might be able to leverage those existing relationships as a source of capital through Regulation Crowdfunding. General solicitation would allow the business to incorporate the marketing of the offering into the marketing it is already doing through social media and other more public channels. For these types of companies, a revenue-share or similar debt structure can be a simple, manageable structure to accomplish the goal of raising value-added capital that encourages investors to evangelize for the business and become frequent customers.

Ultimately, it’s important to first understand a business’ specific situation and goals, and then fit a regulatory approach to that context. At Localstake, we help companies sort through the options and structure an offering that best serves their needs and goals.

Related: Localstake Boosts Community Investments in the Midwest

Ryan Flynn is a cofounder of Localstake, a full service broker-dealer and crowdfunding platform that helps small businesses structure their securities offerings and connect with investors.

 

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Disclosure: Localstake does not provide legal or tax advice. The information provided here is summary in nature and is not meant to cover a full analysis of securities laws. No information contained herein should be construed as advisory or to recommend a particular method of capital raising.

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