Is It Getting Crowded In Here? Crowdfunding Capital For Startups

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Once the law is implemented, it generally accomplishes the goal of making it easier for small companies to raise capital from an unlimited population of average persons who might otherwise never learn about the investment opportunity or qualify to make the investment. By Jennifer A. Post, Esq. (Founder, Post Law Group, PC)

One of the cornerstones of private capital raising in the U.S. is that it must be, by definition, private. That means the process of raising capital for small companies cannot include any sort of “general solicitation” of investors such as advertising or Internet postings. However, startup companies and lawmakers — including President Obama — are finally of the mind that raising capital via the Internet is inevitable. Its time has come. And, while the benefits of easier access to investors and their money may seem obvious to small companies, there are some downsides to consider.

By way of background, when selling securities, companies must follow the federal and state securities rules and regulations. In general those regulations require that companies either register stock for sale with the SEC (a long and expensive process) or sell to small groups of “accredited investors” (meaning, very high net worth individuals and well capitalized entities). In connection with private stock offerings, companies are usually required to prepare detailed business plans and financial statements for review by investors.

The regulations are designed to protect investors. As a result, federal and state regulations make it very hard for private companies to find pools of willing capital since small companies must direct their capital raising efforts to a limited population of investors, bear the burden of preparing costly business plans, forecasts, and financial statements — and all the while operate a startup venture on a shoe string.

To counter some of these burdens and limitations, President Obama has signed the Jumpstart Our Business Startups Act (known as the Jobs Act). The law will allow average investors (meaning anyone that can part with some cash) to safely invest in emerging companies via the Internet; however, it proposes annual limitations on individual investment amounts (ranging from $2,000 to $10,000 per year or up to 10% of annual income for persons earning over $100,000 per year). In a one-year period, a company could raise up to $1,000,000 without having to register stock with the SEC.

The law requires that companies use websites that are designed as capital raising portals (with the idea that these websites will act as “brokers” that will provide safeguards for investors). It will also raise the number of shareholders that a private company may have before it comes within the SEC’s mandatory public reporting system.

The law generally accomplishes the goal of making it easier for small companies to raise capital from an unlimited population of average persons who might otherwise never learn about the investment opportunity or qualify to make the investment. Mission accomplished, once the law is implemented.

We can assume that once the law is implemented, there will be a rush of companies seeking investment capital on the Internet (beyond those already doing so under the guise of “pre-selling” products, or taking donations that might later be converted to actual capital investments). In turn, there will be a steady flow of small investments by a multitude of investors. A quick look at the math would show that a company looking to raise $1,000,000 might rapidly end up with 100 shareholders or more, each investing a few thousand dollars. While this seems like a great result — more exposure of ideas, more influx of much needed capital, and more companies being funded—it may have unexpected consequences for small companies. So, is it mission accomplished, or not?

Of course companies need capital to succeed. Growth is good — for promoting ideas, opening new markets, creating jobs, etc. However, small companies and first-time entrepreneurs need to consider this fact: shareholders stay in your company for the duration. Like annoying relatives, they never go home. Moreover, management has to share information about the company’s progress and financial operations, plans, and decisions with dozens, even hundreds of people the company otherwise has no relationship with and gets no further value from.

Stated differently, young companies that crowdsource capital will be straddled with large numbers of shareholders to answer to. Shareholders who may be unsophisticated, demanding, nosy, and who likely cannot offer additional capital when the company needs it. In addition, the company will have no choice but to abide by and protect the voting and approval rights of its shareholders. No matter how difficult or distracting it may be to manage such shareholders, management cannot abandon its fiduciary and statutory duties to them. In essence, management will be working for years to bring a healthy return on investment to groups of shareholders that may prove to be a liability as the company matures.

That may sound harsh, but those problems highlight the benefits of having smaller numbers of wealthier professional investors in your company. Such people are connected to sources of capital, and they may be able to share valuable experiences, contacts, and insights. Furthermore, they are prepared to ride out the ups and downs of tiny companies that are still developing products and market acceptance.

Professional investors are more comfortable investing in companies where the shareholders share a common vision of the company’s growth and where they can wait out the risks. As such, companies that crowdsource capital from inexperienced and unknown investors risk alienating seasoned private investors who may decline to fund companies stuck with scores of unsophisticated shareholders — no matter how enticing the market opportunity may be.

While relaxing the securities regulations to allow crowdsourcing capital on the Internet is generally a great idea, it may create problems down the line for companies that accept investments from large groups of inexperienced and unsophisticated shareholders, as it ultimately creates management headaches and makes the company less attractive to professional investors. Having a multitude of crowdsourced investors may leave entrepreneurs asking themselves: Is it getting crowded in here?

This post was originally posted at Post Law Group.

About the guest blogger: Jennifer Post is Founder of Post Law Group, PC. She is a corporate and securities attorney based in Los Angeles, California. Her firm works with entrepreneurs, startup companies and investors in private securities offerings, venture capital financings, secured lending and M&A transactions. Her practice represents US and foreign companies and investors. She takes a proactive role as outside general counsel to her emerging growth clients offering both legal and business strategy advice.