The following guest post is by Tom Murphy, a partner at the law firmMcDermott Will and Emery and who has represented the issuers or underwriters in more than 30 IPOs. He has also represented Fortune 500 companies in connection with multibillion-dollar acquisitions.
Crowdfunding is a trendy and cool buzzword. “Crowd” sounds sociable and “funding” is, of course, always good. But equity crowdfunding as contemplated by rules proposed by the SEC in late October is not promising.
Because it sounds good, the term “crowdfunding” is applied, sometimes confusingly, to vastly different funding models, including “donation funding,” (e.g. Kickstarter), in which no investment is involved and “backers” expect no return; “advertised” private offerings, which have only been legal since September and allow the general solicitation of investors directly by private companies seeking funding, known as “issuers”, or through intermediary sites like CircleUp, provided all investors are “accredited” (meaning wealthy); and “real” equity crowdfunding contemplated by the JOBS Act, which I describe here. This last model would allow non-public issuers to sell securities to anyone, regardless of their sophistication, net worth, or income, and no matter how risky, albeit in limited amounts and with many restrictions.
While the first two models work, the restrictions and requirements in the JOBS Act and the SEC’s proposalare too substantial, for this model to work efficiently in the real world. All three sets of crowdfunding players – the issuers, investors, and portals (websites that connect the other two) are likely to be disappointed.
For issuers the first problem is that, unlike private offerings, advertised or not, in which confidentiality can be generally maintained, crowdfunded enterprises will be public companies “light.” They will not be subject to all the voluminous and costly rules applicable to publicly traded companies, but several parallel unpleasantries will nonetheless apply.
For one thing, crowdfunded companies will be required make publicly available their financial statements (or, tax returns), comprehensive offering documents and specific disclosures of the risks involved, by filing with the SEC. This sensitive information will be accessible to competitors, suppliers, customers, employees and everyone else, at a time before the issuer even knows if the offering will succeed.
There will also be ongoing requirements to provide updated information publicly. This “open book” life has always been a major reason to forego or delay a public offering and should have a similar effect on those considering equity crowdfunding once they fully understand it.
A related risk, exclusive to equity crowdfunding, will be the uniquely public nature of the offering process itself. To allow the “wisdom of the crowd” (if such exits) to be tapped, portals will be required to facilitate investor commentary and communication. Anyone, even those with ulterior motives, may provide “advice” to potential investors, right on the portal website.
Crowdfunding will likely be quite expensive for the amounts raised. Offerings are limited to $1 million annually and even that drops to $500,000 if the company’s financial statements are not audited, and $100,000 if they’re not reviewed. Financial statement preparation and auditing can be expensive, especially when auditor reports will be used to sell securities.
Other expenses will include legal fees to prepare offering documents designed to achieve the delicate balance between making the investment attractive while still being sufficiently candid and cautionary to avoid liability for inaccurate or misleading statements. This is what we securities lawyers do for a living and it’s expensive to do it right.
Crowdfunded companies will have large numbers of shareholders – likely upwards of 1,000 – to whom they and their directors and officers are accountable and owe fiduciary duties. Many of those investors will be unsophisticated and unforgiving if things don’t go well. This means spending significant time and resources on investor relations, and in some cases outright “handholding,” or risking an unhappy and perhaps litigious shareholder base.
Picking the right portal will also be important. Each offering must occur through only one portal of an SEC-registered broker dealer or a “crowdfunding portal.” Neither the portal nor the issuer will be allowed to advertise a specific offering or give one offering prominence over others on the site. So issuers will not be allowed to use multiple sites or other means to increase their exposure. Only advertising of the portal itself will be allowed.
Portals will be required to register with the SEC and with either a securities exchange or FINRA. They will have expensive regulatory requirements, including reporting, record keeping, and regulatory inspections as well as specific diligence obligations regarding the issuer, like conducting background checks on its principals and confirming that it can maintain adequate records.
There will be specific portal requirements for the operation of the sites, such as holding investor funds, allowing cancellation of orders, providing investor education, and facilitating communication among investors.
Crowdfunding portals will also be prohibited from investing in their issuers or engaging in trading, advisory, or custody activities and thus will have limited income sources beyond their share of offering proceeds. Perhaps even more troubling, the SEC release accompanying the proposed rules indicates that portals will likely be subject to the same securities law liability as issuers. For all these reasons issuers can expect portals to charge a substantial percentage of the small amounts raised to compensate them for their costs and risks.
Finally, this market is not likely to be promising for investors. Some argue that equity crowdfunding will help level the playing field by allowing small investors access to the private equity market previously reserved for the wealthy and connected. But this won’t be that market.
For all the reasons already noted, and because of other advantages they can offer, issuers will likely search hard for professional investors before taking the crowdfunding route. Those that crowdfund are likely, by definition, to have exhausted all other options and been rejected by those who invest money for a living.
Crowdfunding investments will be extremely illiquid. Not only do the proposed rules require investors to hold them for a year, no trading market is likely. The amounts will be too small to justify the requisite interest. And even if an investor gets lucky and stumbles onto a good crowdfunded investment, it will not likely have the kind of structural provisions that professional investors use to protect their investments in the future, like restrictions on insider compensation and dealings and protection against dilution.
I’d like to be wrong; another viable funding alternative for entrepreneurs would be a good thing. But I don’t believe this will be it and no entrepreneur who needs funding should be counting on the SEC rules as the fix.
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