As companies wait for the Securities and Exchange Commission to finalize the Jumpstart Our Business Startups Act rules, they may be eager to pounce on equity-based crowdfunding. Once the SEC writes the rules, businesses will be able to raise up to $1 million from non-accredited investors and use general solicitation to secure funding from accredited investors, such as hedge funds and angel groups. But they will have to carefully consider the way they approach crowdfunding, particularly from non-accredited investors.
“I think if you are a company that is looking to do a venture round later and you’re planning on taking advantage of Title III (non-accredited investor) crowdfunding, it is really important that you think about how you structure your transactions,” says Ryan Feit, CEO and co-founder of SeedInvest, an equity-based crowdfunding platform. “If you do raise $100 from 1000 people, that could be a problem later down the line when you raise a Series A,” the first round of venture funding.
“Most of the VCs I’ve spoken with, heard from and been on panels with are going to be very wary of making investments in some new venture that got crowdfunded and now they have to deal with a [capitalization table] that’s full of hundreds of tiny investors who they now have to manage,” says Sean Carr, a lecturer at the University of Virginia Darden School of Business. As part of his research, Carr collects and analyzes data from equity-based crowdfunding platforms outside the United States.
One way companies can address this concern: structure securities that allow venture capitalists to buy out crowdfunded investors at a certain multiple of their investment at a later stage. “We came up with a security that would potentially allow crowdfunded investors to get, say, three times their money back when the company does a Series A,” Feit says. “That alleviates the problem, because it creates a very nice return for investors in the seed stage that are investing through crowdfunding, and it allows venture capitalists to take the existing shareholders out of the capital structure.”
Some investors might not want to cash out during a Series A round of funding. A platform in the Netherlands offers another potential solution, says Carr: pool crowdfunded investors into a collective. “Each of those tiny investors in the venture don’t get an individual vote,” Carr says. “They just get to vote within the collective, and the collective self-appoints someone to be [its] representative, like having a board. As an investor, I get to decide what venture or ventures I want to invest in, but I may not get a full vote on issues that would come before the board as an equity owner. The whole point of that is to minimize complexity for future investors.”
These models would work well for companies that raise funding from non-accredited investors. But they may not be necessary for those that secure financing from accredited investors, who are more sophisticated and invest larger amounts of money. Feit says VC firms will probably be less concerned about how to incorporate this kind of financing, because they already work with angel groups that invest at similar dollar levels.
That said, VC firms or angel groups could also group crowdfunded accredited investors into a sidecar fund. “Instead of having 50 people investing into the company directly, 50 people can invest into a fund, and the fund invests into the company,” Feit says. “With that example, you only have one investor in the capital structure, which alleviates any potential issues with VCs as well.” The SEC only allows companies to create such a fund for accredited investors.
Mature companies may be better off limiting their crowdfunding efforts to accredited investors. Crowdfunding from non-accredited investors is subject to a $1 million limit, so the payoff may not be worth the effort for some firms. “These campaigns are going to take a lot of work,” Carr says. “If it’s a modestly sized business, it would be difficult to actually make it useful. If you could get 10 people in a room and raise 100,000 from each of them, that would be a lot more effective than slaving away on Kickstarter.”
In any case, the future of equity-based crowdfunding is still murky. “The specific ways in which emerging equity-based crowdfunding platforms structure term sheets and structure the governance of these very small investors for future investments will be an important aspects of this,” Carr says. “That will likely be out of the purview of the SEC. The winners in this space — which platforms are going to be successful and actually have viable models — are the ones that are going to carefully consider what equity-based crowdfunding means for further follow-on investments.”
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