How many companies have stayed away from Crowdfunding and the capital it can provide based on a fallacy? Way too many,

THE BIG PROBLEM FOR CROWDFUNDING THAT REALLY ISN’T A PROBLEM

Ask 10 entrepreneurs why they haven’t used Crowdfunding. Three will answer they haven’t heard of it while seven will say “Crowdfunding will screw up my cap table.” Once and for all, let’s lay that fallacy to rest.

We’ll start by noting that many companies have raised money from Crowdfunding and gone on to later rounds of funding, including public offerings. That proves that what passes for common knowledge in some circles can’t actually be true. But let’s drill down a bit more.

What is it about Crowdfunding that could screw up a cap table?

It couldn’t be the number of investors. Public companies with hundreds of thousands of shareholders have no problem managing their cap tables or raising more capital when they need it. Beyond that, technology has made keeping track of investors pretty simple. You can send 1099s to 2,000 shareholders as easily as you can send them to 20, while Excel spreadsheets have 1,048,576 rows. Cap table management tools like Carta make the process even easier.

Don’t want to manage the cap table yourself? Fund managers like Assure Fund Management will handle it for you.

If having lots of investors doesn’t screw up a cap table, what does?

The answer is that a cap table is screwed up by the terms of the securities issued to investors. For example:

  • A company issues 52% of its voting stock to early investors.
  • A company issues stock to early investors with an agreement giving the investors veto rights over a sale of the company.
  • A company issues stock giving early investors a “put” after five years.

In those circumstances and many others, the rights given to early investors inhibit or even preclude the company from raising money in the future. Who’s going to invest in a company where the founder no longer has voting control?

But for purposes of this post, the important observation is that none of those examples depends on the number of rows in your Excel spreadsheet or how the money was raised. If the first round of funding came from just 10 friends and family members who together received 52% of the voting stock, that company has a screwed up cap table and will have a hard time raising more money. By contrast, the company that raised money from 1,000 strangers in Title III by issuing non-voting stock does not have a screwed up cap table and can raise money from anyone in the future, no problem.

To avoid screwing up your cap table, don’t worry about the number of investors and certainly don’t avoid Crowdfunding. Instead, focus on what matters:  the kinds of securities you issue and the rights you give investors. 

Where did the fallacy come from? The venture capital and organized angel investor folks, i.e., the same folks who predicted a few billion dollars ago that Rule 506(c) would never work because accredited investors wouldn’t submit to verification. Considering themselves indispensable middlemen, these folks view Crowdfunding as a threat. (I’ve always thought they should use Crowdfunding as a tool instead of fighting the tide, but that’s a different blog post.)

The fallacy has proven very hard to shoot down, perhaps because of the outsized influence venture capital and organized angel investor folks enjoy in the capital formation industry. In fact, it’s proven so hard to shoot down that the soon-to-be-released SEC rules allowing SPVs in Title III were written in response. If we’re smart about the kinds of securities we issue we don’t need an SPV, while if we issue the wrong kind of security then an SPV doesn’t help. The new SEC rules were written solely for the sake of perception, “solving” a problem that didn’t really exist.

Similarly, the perception that Crowdfunding screws up your cap table led one of the largest Title III platforms, WeFunder, to create an even more convoluted “solution.” WeFunder has investors appoint a transfer agent to hold their securities. Under 17 CFR §240.12g5-1, this means that all the securities are “held of record” by one person for purposes of section 12(g) of the Exchange Act. Based on the section 12(g) definition WeFunder then claims that a round of financing on its platform leaves the issuer with “a single entry on your cap table.” That’s a creative claim, given that the term “cap table” has no legal meaning and if an issuer is an LLC and raises money from 600 investors there are going to be 600 K-1s.  But the point is that WeFunder goes to this trouble and the attendant costs over a problem of perception, not reality.

How many companies have stayed away from Crowdfunding and the capital it can provide based on a fallacy? Way too many, that’s for sure.