Finance & Operations

Exploring the Hidden Costs & Delays of Equity Crowdfunding

December 17, 2015

The ability to raise equity capital on the internet has, for many years, been an elusive dream of entrepreneurs — one that has always hovered just beyond the horizon. To be sure, Kickstarter, Indiegogo and other rewards-based crowdfunding sites have been around for a while, but selling stock over the internet has been a very, very long time coming.

Now, there is finally a way to raise real equity capital online with another option coming in 2016. So, with all these new options (at least three just for crowdfunding), it’s important for entrepreneurs to understand in depth each kind and how it works.

Donation / Rewards-Based Crowdfunding

When people think of “crowdfunding” they generally think of sites like the aforementioned Kickstarter and Indiegogo. There is no question that these sites, which collect donations from the public in exchange for modest rewards like product prototypes, have been wildly popular. On the high end, the most successful Kickstarter projects raise millions of dollars, but this is a best case scenario. The average Kickstarter campaign brings in just $7,000 and the vast majority of projects never reach their fundraising goals.

So, what’s the difference between rewards-based crowdfunding and equity crowdfunding? The difference is starkly illustrated by the case of Oculus Rift, which raised $2.4 million on Kickstarter, and was later sold to Facebook for $2 billion. The early funders who made a donation to Oculus Rift through Kickstarter received a VR headset worth maybe a couple of hundred dollars, but no stock or other equity upside, which could have been worth thousands. It’s cases like this that continue to drive both entrepreneurs and early-stage investors to look for a practical way to buy and sell stock online.

Sell, But Verify

Under long-standing SEC rules, companies with stock to sell had a clear choice, either: (1) file for an initial public offering (IPO), with all the time, expense and regulation involved, or (2) do a private placement with no publicity, advertising or solicitation of the general public. The most common form of private placement requires that you sell primarily to “accredited investors” who have an individual income of at least $200,000 per year or $1 million in net worth (excluding the investor’s primary residence). Note that accredited investors are estimated to constitute only 3% of the US population. Let’s call this option, the “traditional private placement.”

In April 2012, President Obama signed the Jumpstart Our Business Startups (JOBS) Act, which promised to liberalize fundraising for startups, by providing new alternatives to the traditional private placement. With respect to online stock offerings, this liberalization was to come in two steps:

First, allowing the use of the Internet to sell stock to the same class of people, i.e., “accredited investors,” but with certain new obligations not required in traditional private placements; and

Second, opening up online stock offerings to a broader group of investors.

Let’s consider the first new crowdfunding option, which has been available since September 2013. If you want to use the internet to reach as many “accredited investors” as you can, that is now permissible, but on the condition that you actively verify each purchaser’s “accredited investor” status. This may not seem like much to ask, but in practice it requires that you spend a considerable amount of time and expense reviewing your investors’ financial information (such as bank accounts, tax returns, etc.) to ensure that they are indeed accredited investors. Or, you can hire someone to do that verification for you. The costs of verification can eat into your net proceeds. Moreover, some of the state’s securities laws may make this type of offering more burdensome in terms of filings and fees than traditional private placements.

Some investment banks or brokers will provide much of the verification and other administrative services for you, but at a cost. The bottom line is that you should not head down this path (namely, start soliciting investors on the internet) unless you know what is required to complete the process and get the money. Once you start openly soliciting investors on the internet, you cannot go back to the traditional private placement without stopping all fundraising activity for a six-month “cooling off” period.

Small Investors Coming Soon…with Baggage

Three and a half years after the JOBS Act became law, the SEC finally adopted rules to permit crowdfunding from investors who are not “accredited,” (i.e., the 97%). This should have been a big win for entrepreneurs. But not so fast. These rules don’t go into effect until May 2016 and come with a number of limitations. On the bright side, you have plenty of time to consider whether this is a capital-raising strategy you want to pursue (if you don’t run out of cash before then).

There are a few things you should understand about these new crowdfunding rules. Yes, you can seek investments from anyone in the US (outside the US, this may not be legal), but a company can only raise $1 million in any 12-month period using this method and there are relatively low limits on how much someone can invest. For example, if an investor’s annual income or net worth is less than $100,000, he or she can only invest in any 12-month period the greater of $2,000 or 5% of the investor’s annual income or net worth (whichever is lower).

As if these limitations aren’t restrictive enough, companies selling securities through these crowdfunding offerings must also:

  • Provide a detailed offering statement filed with the SEC, possibly including audited financials; and
  • File annual reports with the SEC.

Finally, this is not a do-it-yourself undertaking. You must use an SEC-licensed broker-dealer or “funding portal” to conduct these crowdfunding offerings, and the operators of these portals will have their own due diligence and client obligations, not to mention fees.

If you satisfy all these numerous requirements, will you be free to promote your company’s stock however you want to on the internet? Unfortunately, no. The only advertising you can use to promote your crowdfunding is a “just-the-facts” announcement naming the company, its address, the terms of the offering and a broker or portal being used to conduct the offering. That does not leave much room for marketing creativity on the web.

The bottom line is that the new SEC crowdfunding rules coming in 2016 are likely to prove inefficient and burdensome to entrepreneurs and their startups in the long run. Despite the original promise of the JOBS Act and nearly four years of waiting, entrepreneurs are probably still better off raising capital the traditional way by networking privately with high net-worth “angel” investors and venture capital firms.

But, whether or not you choose to raise capital using the new crowdfunding options, be sure to spend some time planning which path you want to follow before launching online to avoid foreclosing options or incurring unexpected costs and/or delays down the road.

Chief Legal Officer

Rufus is OpenView's Chief Legal Officer and a venture lawyer who has spent his career focused on venture capital firms and technology companies. Before joining OpenView in 2015, he launched the Center for Law and Entrepreneurship at Villanova Law School, serving as its initial Director. At the Center, he worked to build a bridge between the Law School and the entrepreneurial and venture communities by creating new courses, internships and a legal clinic.