Crowdfunding Update: Suggestions for Navigating the Capital Raising Process
As just about any seasoned or new entrepreneur will tell you, raising capital is one of the most challenging tasks of growing a start-up.
Raising capital is hard for many reasons. Startups are risky! Entrepreneurs have to pitch dozens if not hundreds of prospective investors, and maybe, just maybe, you’ll entice one or more to invest in your venture. That’s one of the reasons that crowdfunding has gained popularity among startups.
However, because of the different risks associated with startups and investing in general, there are complex state and federal laws that regulate capital raising activities—including crowdfunding.
Securing legal counsel with expertise in corporate finance and advising startup companies is key for getting it right and avoiding the many costly pitfalls of doing it wrong.
Before we get into some tips for navigating, here’s a high-level look at the capital raising landscape.
A (very) Brief Overview of the Capital Raising Regulatory Environment.
Federal securities laws related to raising capital were established with the Securities Act of 1933. The Act:
- requires that investors receive financial and other significant information concerning securities being offered for public sale; and,
- prohibits deceit, misrepresentations, and other fraud in the sale of securities.
Sounds pretty straightforward, right? Au contraire! In our view and experience, it is anything but.
The Exchange Act of 1934 created the Securities and Exchange Commission (SEC) to regulate the securities industry.
Together these two acts, plus three more Acts in the forties and fifties, Sarbanes-Oxley, Dodd-Frank, and most recently the Jumpstart Our Business Startups (JOBS) Act, determine how public and private securities are created and sold in the U.S.
The JOBS Act is intended to reduce the barriers to capital formation for startups. Among other provisions, the JOBS Act created the possibility for:
- companies to engage in equity crowdfunding,
- broadening the definition of “qualified investors” to include non-accredited investors in certain circumstances, and
- changing the restrictions on general solicitation (e.g. public advertising) of unregistered securities.
Perhaps no other provision in the JOBS Act has generated more interest (and excitement, uncertainty, confusion…) than equity crowdfunding.
Equity crowdfunding currently cannot be done under federal law.
There are proposed federal rules, but they have not yet been enacted. This brief, JOBS Act Quick Start 2014 update,” provides a technical overview of these proposed rules, which include limitations on financing—the amount that accredited and non-accredited investors are permitted to invest—as well as reporting requirements, and numerous other important details.
In the meantime, there has been and continues to be activity among the states to create intrastate crowdfunding provisions. So far, about 14 states have recently adopted crowdfunding provisions, but Ohio has not yet done so.
A very recent development relative to the JOBS Act referred to as Reg A+, which updates and expands Regulation A, an existing exemption from registration for smaller issuers of securities.
Reg A+ provides for two tiers of offerings: Tier 1, for offerings of securities of up to $20 million in a 12-month period, and Tier 2, for offerings of securities of up to $50 million in a 12-month period.
Each puts caps on how much of the offering can be sales by insiders (security-holders that are affiliates of the company selling the securities).
Both Tiers are subject to certain basic requirements while Tier 2 offerings are also subject to additional disclosure and ongoing reporting requirements, such as a requirement to provide audited financial statements, file annual, semiannual and current event reports, and limit the amount of securities non-accredited investors can purchase.
Understand how the capital sources in your region prefer to invest, an example.
Consider Rev1 Ventures as an example. A typical Rev1 Ventures financing falls under Rule 506(b) of Regulation D of the Securities Act of 1933.
This exemption enables companies to raise an unlimited amount of money; however, the company cannot use general solicitation or advertising to market the securities.
To avoid being construed as a general solicitation, the company must have a substantive relationship with the prospective investor at the time the offer to invest is made to the prospective investor.
The company can raise funds from an unlimited number of accredited investors. While it is possible to also have a limited number of other purchasers that are non-accredited investors under this exemption, this entails additional requirements, costs, and other considerations.
Under 506(b), companies decide what information to give to investors, so long as it does not violate the anti-fraud prohibitions of the federal securities laws.
It is possible under another exemption (Rule 506(c)) to raise funds through a general solicitation and advertise the offering. However, among other requirements, this requires the company to take “reasonable steps to verify that its investors are accredited investors, which could include reviewing documentation, such as W-2s, tax returns, bank and brokerage statements, credit reports and the like.”
Not surprisingly, we have yet to meet an angel investor excited to provide such private and sensitive personal financial information in connection with making an investment in a startup company.
Fundraising is complicated, proceed with caution!
Here at Rev1, we are not attorneys and we do not give legal or accounting advice.
But, we are in the business of helping entrepreneurs mitigate risk.
Over the years, we’ve seen a number of well-intended, but ill- or unadvised entrepreneurs make huge missteps around raising capital by taking actions that were difficult, costly, and not the least of which distracting to undo or otherwise correct.
With the recent and pending changes relative to the JOBS Act, the complexity of fundraising is increasing, with a plethora of considerations involved. We always advise entrepreneurs to obtain the advice of counsel in connection with any fundraising activity. Leave the DIY to home improvement projects, not financing your startup!
Research and seek expert advice.
Here are some tips.
1. Understand the regulatory environment.
The rules regarding raising capital for a startup exist within a complex state and federal regulatory framework.
Become familiar with the SEC’s terminology, regulations, and rules. That will help you when you engage in a dialogue with counsel on the options, trade-offs, and costs of different approaches to raising private capital.
2. Get legal counsel early.
Identifying and retaining an attorney to advise you on financing alternatives and considerations is well worth the investment in light of the high costs of doing it wrong and having to fix it later.
The changes that came with the JOBS Act are the most wide ranging that have occurred in many years. Entrepreneurs are wise to choose an expert attorney with experience advising startups on financing transactions.
3. Exercise caution when pitching your startup in public forums.
Avoid making a general solicitation (i.e. announcing that your startup is raising capital) unless you have sought the advice of counsel, and fully understand the risks and considerations of engaging in a general solicitation.
Communicating that you are raising capital to small or large audiences, whether or not they are accredited investors, can be construed as a general solicitation. For example, announcing fundraising plans in a newsletter, on the company web site, on social media, in a press release, or in an interview could be construed as a general solicitation.
With a general solicitation, the entrepreneur opens the company up to additional disclosure requirements and other considerations that may have high associated legal costs.
4. Understand how your preferred sources of capital usually invest and why they invest in that manner.
Institutional venture capital and seed investment funds (such as Rev1 Ventures) have preferred and, in most cases, required approaches to how financings are structured.
Work with counsel to understand considerations and preferences of institutional investors, so as not to unintentionally preclude, or at the very least make more difficult, attracting such investors to your company.
5. Pay attention to fundraising implications for your cap table.
If you do find success (under the guidance of counsel of course!) in raising funds from a relatively large number of accredited investors, you now have the responsibility to keep those investors informed on developments at the company.
Managing a larger number of investors is more complicated and potentially more cumbersome than managing a smaller group of investors. For example, you will likely need to obtain investor consent for strategic and financing decisions relative to the business (depending on how the investment is structured).
Perhaps most importantly, prospective new investors (especially angels and venture capitalists) also may be concerned if the company’s cap table is large. Investors like to know with whom they are investing.
Make decisions today with the future in mind.
Raising capital for your startup is important and can be daunting. Doing it in compliance with securities laws and in a manner conducive to your long-term fundraising goals is critical. It is well worth it to take proper care when strategizing on the optimal approach to identify, attract, and close on funding for your venture.
Awareness of the numerous considerations and regulatory environment, and seeking appropriate counsel, are important first steps in the fundraising process.
The information presented is not legal advice, is not to be acted on as such, may not be current and is subject to change without notice. Rev1 Ventures strongly encourages entrepreneurs to seek appropriate legal counsel in connection with planning and undertaking fundraising activities.