By 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 offerings over 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