When an entrepreneur and an investor sit across a physical table from one another they can make any deal they want. But with Crowdfunding, the company and the pool of possible investors will not be sitting across the table from one another – to the contrary, they will be scattered in the cloud with effectively no way to communicate. The only deal will be the deal the company puts on the table: an investor will either take it or leave it. What deal should companies put on the table, and what deal should Crowdfunded investors accept?
The terms of a “typical” Crowdfunded investment are sure to evolve over time, but we can already make some educated guesses and recommendations.
Human nature and the market being what they are, we can assume that the terms of a Crowdfunded deal won’t be too much different from any other deal. These are typical deal terms in today’s market, and how they might be adapted to the Crowdfunded world:
- Preference on Liquidation: Unless you are dealing with “friends and family,” investors always get their money back on sale or liquidation before the founders get anything. If the investors put in $500,000 and the company is sold for $500,000 or less, that means the founders get nothing, no matter how much time and money they invested themselves. As a starting place, investors in the Crowdfunded world should expect the same deal, and companies should be prepared to offer it.
- Right to Convert: If the value of the company goes up, the investors have the right to convert their investment to regular common stock, thereby sharing in the upside. Because sharing in the upside is the whole premise of investing, Crowdfunded investors should have this right unless the deal is for a loan rather than equity.
- Return on Investment: The investors in a private company typically expect at least a small annual return on their investment, even if they are buying stock. In today’s market a cumulative dividend of 5% per year for Crowdfunded investors would not be unreasonable.
- Right to Information: Institutional investors like hedge funds or venture capital funds typically demand an enormous amount of very detailed financial information from the company, down to weekly or even daily sales and expenses. That volume of information would probably have little value to Crowdfunded investors, first because no single investor has a large economic stake or the power to act on the information, and second because many Crowdfunded investors will be unsophisticated financially.
- Veto Rights: Sophisticated investors often enjoy veto rights over a variety of corporate actions, such as selling the company or issuing more stock. In a Crowdfunded deal, where the investors cannot practically speak with a unified voice and are unsophisticated themselves, veto rights are probably of limited use to the investors and are extremely dangerous for the company. To take one example, the company must be able to raise more capital (i.e., sell more stock) without requiring the vote of 300 Crowdfunded investors. Giving investors a veto right could amount to corporate suicide.
- Insider Compensation: Having issued stock to investors, what’s to stop the company’s founders from taking all the profits for themselves as compensation and bonuses? Institutional investors deal with this directly: any change to the compensation of the founders requires investor consent. Because Crowdfunded investors are unsophisticated it makes no sense to require their consent, but some kind of protection is required.
- Management Rights: The investors have a say in management, often through representation on the Board of Directors. Crowdfunded investors should probably have some management rights – perhaps the right to elect one Board member. Beyond that it will be practically impossible for the crowd to have a meaningful voice in company management.
- Preemptive Rights: Investors often have the right to buy new shares issued by the company. There is no reason Crowdfunded investors cannot have this right.
- Tag-Along Rights: If a founder sells some of his stock – in effect, cashes out – an institutional investor will typically have the right to participate in the sale. Again, Crowdfunded investors should have the same right.
- Anti-Dilution Rights: Suppose the sells stock to the Crowdfunded investors for $5 per share and later sells stock to someone else for $4 per share. The shares purchased by the Crowdfunded investors have effectively been “diluted.” Some kind of anti-dilution protection, probably “weighted average” rather than “full ratchet,” will be appropriate.
- Liquidity Rights: Investors do not want to hold the company’s stock forever; they want to cash out. Institutional investors often have the right to force a sale of the company, force a public offering of its stock, or force the company to buy their stock back for its then-current value (i.e., a “put”). My own view is that Crowdfunded investors should not necessarily have this right – but we’ll see what the market says.
(CAVEAT: When the SEC issues Crowdfunding regulations, it might dictate some or all of the deal terms. Based on the rules the SEC has proposed for Rule 506 Crowdfunding, however, the regulations are likely to take a relatively light-handed approach.)
The bottom line: when structuring a Crowdfunded deal we should distinguish between economic rights and management rights. Almost without exception, the Crowdfunded investor hopes to have invested in the next Google or Apple – that is, he or she is looking for an economic return. In contrast, very few Crowdfunded investors will expect to manage the company. If we give investors the economic deal they expected they will probably be satisfied, even if they enjoy fewer management rights than sophisticated or institutional investors expect.
Theoretically every company can offer a different deal. Far more likely, we believe, is that the market will settle on a standard deal for Crowdfunding, making it easier for investors to choose.
Questions? Let me know.