The concept of pooling resources to launch businesses, build buildings and support causes is nothing new. It’s been around for centuries, and in the last three years “crowdfunding” has become part of American pop culture thanks to sites like Kickstarter and Indiegogo, which have produced some of the most noteworthy successes and failures.
It’s important to distinguish between crowdfunding as the SEC defines it and crowdfunding as pop culture defines it. The latter includes reward- and gift-based fundraising, where backers donate money or receive rewards, such as T-shirts, personalized thank-yous and first-run editions of the product. They get no ownership stake in the companies.
What Title III Does for Crowdfunding
The SEC doesn’t care about gift- and reward-based crowdfunding. Its concern lies with equity-based investments where investors receive ownership stakes in exchange for capital. SEC 506 (b) and (c) rules say only accredited investors may buy these securities from issuers directly or through licensed broker-dealer firms, and the JOBS Act would slightly relax those rules to allow non-accredited investors to buy smaller shares of companies without going through accreditation.
Equity-based crowdfunding has its limitations and possibilities, and two Arizona attorneys who have long histories in the state’s startup ecosystem share their thoughts on what the proposed rules for crowdfunding will do for startups and firms looking to raise capital.
Tom Curzon, an attorney with Osborn Maledon, has been involved in the startup and venture capital scene in Arizona since the mid 1980s. He serves as outside general counsel to growth and startup companies, helping them navigate their life cycles from founding, through financing (angel, venture, strategic) to their exits. He is a long time board member and former Chairman of Invest Southwest, a nonprofit organization that connects investors with startups.
Michael Hool is managing partner of Hool Law Group and has been involved with the Venture Capital Conference (now Invest Southwest and Venture Madness) since its inception. He organized and has served on the boards of two active angel investor groups and is active in representing emerging companies and forming funds for investors. He is a founder and past board member of Invest Southwest.
Will Title III Help Startups?
Historically, businesses have not been able to reach out to large numbers of people to sell securities without going through licensed brokers. The SEC has opened Title III of the Jobs Act for public comment until February, then Hool says it could take three to nine months to finalize its crowdfunding rules. Meanwhile, existing non-equity crowdfunding platforms such as Fundable.com have their developers at the ready to add equity-based crowdfunding as soon as the SEC greenlights Title III.
Curzon says even though pop culture has embraced crowdfunding, and it’s been relatively successful and disruptive to the existing angel and venture models, he is skeptical that the nonaccredited investor portion of crowdfunding will lead to the creation of a large number of startup companies.
“It’s an unfolding flower with a lot to learn,” he says.
Hool agrees that crowdfunding needs a lot of work, but he says the JOBS Act will see an increase in startups. “They’ll still be highly regulated,” Hool says, “and they are not solutions for average companies looking to raise money on their own.”
Will Crowdfunding Attract More Investors?
Curzon says he doubts that a large number of nonaccredited investors will want to invest in high-risk startups, and he is concerned about what will happen when these unsophisticated investors realize their money will likely be tied up for a very long time – five to 10 years, or even longer.
“Equity-based crowdfunding is still for sophisticated investors who understand what it means to be investing in high-risk (usually technology) ventures,” he says. “That kind of crowdfunding for equity is working and is going to continue to work reasonably well.”
Hool predicts there will be a lot of interest, especially initially, and that failure rates will be big.
“I think they (small investors) are going to lose a lot of money, frankly,” he says. He adds that 30 percent of first-round venture capital fundings fail, and those investors do heavy due diligence before backing a startup. Will the small investor do the same? Not likely. Angel investors say it takes about three times before investors earn their money back. These non-accreditors will lose five to 10 times in the beginning before they start seeing returns on their investments.
Will Small Investors Deter VCs and Angels?
How the VC community will view these crowdfunded companies remains to be seen. Curzon points out that larger, accredited venture capital funds might shy away from these startups if they come with 1,000 small, unsophisticated shareholders. “Most private companies would not be well served by having a large shareholder base of unsophisticated shareholders,” he says. “They may not understand risks or they may want to sell shares and not understand why they can’t.”
On the other hand, Hool says VCs want to make money. “If there is a very cool company that has huge explosive growth potential that was funded at startup by using crowdfunding, the VCs are still going to want to make money.” He says VCs and angels will learn to play with these non-accredited, unsophisticated investors. Today, they would not entertain the thought of a company with 1,000 investors coming to them for money. That will change as counsel for investors suggest new structures to isolate classes of investors who purchased crowdfunded securities.
“The lawyers will work it out,” he says. “We’ll make it manageable for later-stage investors.” He adds that when angel investors entered the marketplace, VCs met them with resistance. Now they work very well together.