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.

The Cashflow Hustle Podcast: Crowdfunding Techniques to Level Up Your Business

CFH47_Mark Roderick.png

CLICK HERE TO LISTEN

Mark Roderick appeared on the Cashflow Hustle Podcast with Justin Grimes, where he discussed Crowdfunding Techniques to Level Up Your Business.

In this Episode, You’ll Learn About:

1. The Crowdfunding and its flavors
2. The deductions in Crowdfunding
3. The role of SEC
4. Blockchain technology in Crowdfunding
5. The Investor portals
6. Tokenized security in Crowdfunding

Questions? Let me know.

Title II Needs Company

Statue of Lib CF_Purchased

Title II Crowdfunding is great, and it’s booming. For the first time in history entrepreneurs have access to every accredited investor in the world, and every accredited investor in the world has access to deals once reserved for the very wealthy. New Crowdfunding portals – I call them “stores” – are opening all the time, serving more and wider markets. The stores are growing in sophistication and attracting a growing number of customers, i.e., investors. Register with Fundrise and you can invest in 3 World Trade Center!

But as long as Crowdfunding remains limited to Title II, it’s not going to achieve its potential. And that’s not only, not even primarily, because allowing non-accredited investors to participate would deepen the pool of available capital.

It’s not primarily about capital, but about the Crowdfunding ecosystem. Accredited investors represent a small fraction of Americans. Open the ecosystem to another 100 million potential investors and everything changes. Awareness changes. New ideas are borne and flourish. New businesses are created that wouldn’t have been created otherwise. New experts come into the field, new business models are tested. Behavior and expectations change.

I’m sure there are better and more sophisticated ways to describe what happens when more people join an ecosystem. Maybe things like “network effects” and “information feedback loops.”

Whatever it’s called, we need non-accredited investors in the market for Crowdfunding to achieve its potential. To get non-accredited investors into the market we need the SEC to issue final regulations under Title III and Title IV, and for that to happen it looks as if we’re going to need urging from the Legislative branch.

If you have a moment and the inclination, please click on the link below to find the names and email addresses of your Congressman and Senators, and drop them an email. I’ve included a sample form but of course feel free to create your own.

Title II has been lonely for too long!

Find My Congressman and Senators

Sample Email

Questions? Contact Mark Roderick.

C Corp vs. LLC: What’s the Right Choice?

Ryan Feit, the CEO of SeedInvest, just published a great piece in Inc. Magazine about the pressure some entrepreneurs feel from venture funds to convert from a limited liability company to a C corporation. Ryan points out that the tax cost associated with a C corporation often makes the LLC the better choice.

It’s a question I’m asked all the time. And like Ryan, I normally come out on the side of the LLC for Crowdfunding companies, at least so far.

To flesh out the issue, I’ve written an online pamphlet describing the main characteristics I’m thinking about when I recommend LLC or C corporation. If you want to understand why corporate lawyers seem so isolated at social gatherings, take a look.

Choosing the Right Legal Entity Flyer

Questions? Contact Mark Roderick.

SEC SUBCOMMITTEE REPORTS ON ACCREDITED INVESTOR DEFINITION

The Dodd-Frank Act instructs the SEC to evaluate the definition of “accredited investor” and, if it sees fit, to modify the definition “as the Commission may deem appropriate for the protection of investors, in the public interest, and in light of the economy.”

As regular readers of this blog know, I’ve been optimistic that the SEC would not take this opportunity to kill Title II Crowdfunding and every other kind of Rule 506(c) private placement (which includes most angel investing as well) by creating an onerous new definition. The report issued recently by a SEC subcommittee, while surprising in some respects, doesn’t dent my optimism.

The subcommittee report makes two important, though obvious, points:

  • The Committee does not believe that the current definition as it pertains to natural persons effectively serves this function in all instances.
  • The current definition’s financial thresholds serve as an imperfect proxy for sophistication, access to information, and ability to withstand losses.

The existing definition is imperfect, yes. The question is, what to do about it?

Although the report does not provide a clear answer to that question, the good news, from my perspective, is that the report does not suggest merely indexing the current thresholds ($200,000 of income, $1 million of net worth) to inflation, which would disqualify most accredited investors and send the private placement market into a tailspin. Instead, the report seeks a standard that will address both financial sophistication and the ability to withstand loss.

The report suggests two specific measures of financial sophistication: the series 7 securities license and the Chartered Financial Analyst designation. Following the lead of the United Kingdom, the report also suggests that those with proven investment experience – for example, a member of an angel investing group – might qualify. Finally, the report suggests, as others have before, that the SEC could develop an examination for the purpose of qualifying investors.

Declining a suggestion from several quarters, the report does not include lawyers or accountants as investors who should be deemed to have financial sophistication.

The reports veers a little off track, in my opinion, when it speculates that, in conjunction with changing the definition of accredited investor, the SEC could limit the amount invested by each investor – following the 10% limit of Regulation A+, for example. That kind of limitation would be new to Rule 506 offerings.

In my Model State Crowdfunding law, I use a definition of accredited investors that includes lawyers, accountants, and anyone with the license from FINRA, as long as the lawyer, accountant, or license-holder has income of at least $75,000. Recognizing the imperfection of any definition, I think that strikes about the right balance. Bolt on an SEC-administered examination option and we’re right there with the subcommittee report.

All in all, it’s good to see the SEC, once again, thinking through the issues carefully. We can see the light at the end of the tunnel.

Questions? Contact Mark Roderick at Flaster/Greenberg PC.

CFGE CROWDFUND BANKING AND LENDING SUMMIT IN SAN FRANCISCO

Roderick CFGE

Since Labor Day, I’ve spoken at half a dozen events: for entrepreneurs, for intellectual property lawyers, for finance professionals, for digital marketing groups. This week I’ll be speaking at one of the premier Crowdfunding events in country, the CFGE Crowdfund Banking and Lending Summit on the 16th and 17th in San Francisco.

The conference features some of the leaders in the industry, including:

  • Richard Swart, Director of Research for Innovation in Entrepreneur and Social Finance, Colman Fung Institute for Engineering Leadership at UC Berkeley.
  • Ron Suber, the President of Prosper.
  • Jason Fritton, the Founder and CEO of Patch of Land.
  • Tom Lockard, the Vice President for Real Estate Investment and Institutional Sales of Fundrise.
  • Nikul Patel, the Chief Lending Officer of LendingTree.
  • Jesse Clem, the Co-Founder of LOQUIDITY, LLC.
  • Joy Schoffler, the CEO of Leverage PR.

Whether you’re new to Crowdfunding or an industry veteran, I’d strongly suggest you attend. I’m always amazed how much more there is to learn.

To register, click here. Make sure to use my promo code and receive a 25% discount! Promo code: Roderick

And while you’re there, please stop by and say hello. Crowdfunding and skiing – those are my two favorite topics.

THE iFUNDING MOBILE APP: AN INTERVIEW WITH SOHIN SHAH

Sohin at desk croppedSohin Shah is the COO and co-founder of iFunding, and created iFunding’s mobile app, the first in the Crowdfunding market. Sohin also created Valuation App, which allows finance professionals to analyze businesses and start-ups. His prior experience is at New York investment banks and he holds a Masters in Finance & Risk Engineering from NYU.

Q:        Before getting to the iFunding mobile app, what’s your sense of technology innovation in real estate overall?

A:        Impressive but uneven. There is a lot of technology for the consumer looking for a home or apartment – the Zillow/Trulia merger is an example of scale in that segment. Also, developers looking to purchase properties wholesale have sites like Auction.com, and larger institutions are increasing their data and automation for deal assessment through services like Compstak and Reonomy. But there’s been surprisingly little innovation available to the individual investor who wants to participate in real estate projects and profits.

Q:        What can an individual investor do with your mobile app?

A:        Anything she could do on our website, from browse opportunities to review documents to actually invest. We can also send an alert to your app to let you know when deals are available.

Q:        Can I switch back and forth from mobile to website?

A:        Absolutely. We made it as seamless as possible going both ways.

Q:        I have to ask you: was the mobile app really necessary? Do your investors log in from mobile devices? Or is this a gimmick?

A:        You would be amazed. Already, about 25% of the visits to ifunding.co come from mobile devices, roughly two-thirds of these from smart phones and one-third from tablets. We realized our customers want to get information and make investments when it is convenient to them, from the couch to the hair stylist.

Q:        But are people really moving tens of thousands of dollars into investments via smartphone?

A:        Yes, definitely. Although we don’t have hard data, those completing the entire investment process by mobile device have probably invested with us before. They know what they want and are looking to roll their money into the next deal before someone else fills that slot. Keep in mind that some of our deals fund with a day or hours, so mobile access at any time is valuable to top investors.

Q:        Why do you think people might be skeptical investing significant dollars by phone?

A:        Sometimes people have a tendency to underestimate the individual investor and what they become comfortable with. Think about banking by phone, or sending funds by PayPal. What we’re learning in Crowdfunding is that individuals really do want the power to control their own destinies. Our mobile app is just one more tool helping them do that.

Q:        Can you use the app to just browse properties and learn about investing?

A:        You sure can. Many people do. We provide a lot of educational content and try to help investors make smart decisions. When you’re traveling or have idle time, instead of playing a game on your phone, why not learn more about real estate and empower yourself financially?

Q:        Did you build the app yourselves?

A:        Yes, our technology team built it. I had the experience of building Valuation App and we had all the industry knowledge in house, so that made sense for us to design and program it.

Q:        Is the mobile app secure? As secure as your website?

A:        Yes, definitely. In fact, no user information is stored on the mobile device – you could drop your phone in Grand Central Station and have no worry about compromised information. All information is on our secure servers and downloaded to the mobile device through an encrypted connection only when you use the app, then erased when you quit.

Q:        Do you plan to add more functionality in the future?

A:        We update the app several times a month based mainly on customer suggestions. The future will see more eye-catching features, though you can imagine we haven’t planned an “Apple Watch” version just yet.

Q:        So what’s it called and where can I get it?

A:        It’s called “iFunding – Real Estate Investing through Crowdfunding.” It’s available on iOS and Android devices. You can download it for free at bitly.com/ifundappios and bitly.com/ifundappandroid.

THE NEXT BIG THING IN CROWDFUNDING: POOLED ASSETS

September 23rd marks the first anniversary of Title II Crowdfunding. The number of portals has grown exponentially but most or all portals continue to offer investments in single deals, e.g., an apartment building in Austin. Before long, I believe the market will shift to investments in pools of assets. Rather than the single apartment building in Austin, a portal will list a pool of 20 apartment buildings in the Southwest.

Accredited or not, very few individual investors have the knowledge or experience to invest in individual deals. And based on the stock market, most individual investors don’t want to. Individuals have historically preferred mutual funds over individual stocks; a mutual fund is just a form of pooled assets.

An investor can create his own pool, investing $5,000 in each of 20 apartment buildings rather than $100,000 in a single property. On Prosper or Lending Club, I bet most investors participate in multiple loans.

But that doesn’t give consumers quite what they want. What they want is a fund manager, someone who will choose the 20 apartment buildings and also decide when to sell them. A stock market investor who wanted to creat her own pool could buy 20 individual stocks, but instead she buys a mutual fund.

Do Crowdfunding investors view the portals themselves as mutual funds? Maybe investors expect Fundrise, Patch of Land, Wealth Migrate, or iFunding to play the role of the mutual fund manager, selecting only deals worthy of investment. On the advice of counsel, every portal tries hard to disclaim that legal responsibility, but maybe investors ignore the disclaimers, looking for a “brand” for investing.

I certainly expect portals to start offering asset pools. I’ll go out on a limb and say the first portal offering curated pools will have a great competitive advantage, and I’ll go further and say that Crowdfunding won’t reach its potential until pooled asset investments are widely available.

Pooling assets makes things a bit more complicated and a bit more expensive: more legal rules come into play; you have to think harder about giving investors liquidity; and, most important, you have to pay someone to make investment decisions and take the legal risk. But that’s where the market is headed.

Questions? Contact Mark Roderick at Flaster/Greenberg PC.

TITLE III AND THE EVOLUTION OF BUSINESS LAW

I’m not optimistic about Title III for the usual reason:  I think the cost of complying with the statute will prove too high. I’ve even proposed my own fix to the statute. But there are plenty of smart people who think otherwise, including Ron Miller of StartEngine, and ultimately opinions don’t matter. The market will decide whether Title III can work in its current form.

The SEC proposed regulations last October 23rd and the comment period ended long ago. Rather than wait for the statute to improve, I’m ready for the SEC to consider the comments, make changes to the proposed rules as it sees fit, finalize the regulations, and let the market do its job.

Whatever the defects of current Title III, and there are many, chances are they will be fixed over time. Time after time, almost from the beginning of time, the legal system has responded to the needs of the business community. Examples:

 

  • Hundreds of years ago, governments created corporations in direct response to the need of traders and investors to limit liability on foreign adventures.
  • With the advent of income taxes in the 20th century, business people had to choose between the limited liability of a corporation and the pass-thru tax treatment of a general partnership. But not for long. Soon legislatures created limited partnerships and S corporations, providing the best of both worlds.
  • When defects were discovered in limited partnerships and S corporation – for example, the risk that limited partners could face unlimited liability – legislators fixed them and fixed them until, lo and behold, Wyoming created an even better entity, the limited liability company we all know and use today (which, in turn, has already been improved).
  • Private placements have always been legal, regulated by the SEC through no-action letters and other guidance. But the private placement market needed clear rules. Hence, Regulation D in 1982. And now Title II of the JOBS Act has improved Regulation D by adding Rule 506(c).
  • Since I have been practicing law (less than a century) the corporate laws of most jurisdictions, including Delaware, have improved dramatically, as state legislatures respond to the needs of businesses large and small.

There are two things you never want to see being made:  sausage and law. But over time, commercial laws do change, usually for the better. If Wyoming can invent limited liability companies, surely we and our Federal government can improve Title III as the need becomes apparent.

So with malice toward none, with charity toward all, let’s stop debating whether Title III can work and let the market figure it out.

Questions? Contact Mark Roderick at Flaster/Greenberg PC.

CROWDFUNDING AND THE LIFE SCIENCES: AN EVENING WITH THE EXPERTS

Last night I had the honor of moderating an all-star panel hosted by Pharmaceutical Consulting Consortium International (PCCI) in Philadelphia, focused on Crowdfunding in the life science space.

Our panelists:

  • Don Skerrett, the President of PCCI and a serial entrepreneur, who spoke from the perspective of an early-stage life science CEO
  • Barbara Schilberg, an experienced life science investor, the CEO of BioAdvance, a leading life science fund that has invested in almost 60 companies – leading to $1.7 billion of additional financing – and a senior executive in four active life science businesses
  • Darrick Mix, a shareholder at Duane Morris and an expert in Federal and State securities laws
  • Samuel Wertheimer, the Chief Investment Officer at Poliwogg, a Title II portal devoted to the health care industry and one of the most exciting and innovative portals of any kind in the world

Among the issues discussed:

  • The advantages and disadvantages of Crowdfunding from the perspective of a life science company
  • The nuts-and-bolts mechanics of Crowdfunding
  • The role of portals
  • The due diligence process for life science companies
  • The legal liability of life science companies and portals
  • The effect of Crowdfunding on the life science market specifically and the capital formation industry generally

The panel agreed that while Crowdfunding in the real estate market is very active, with more than 100 real estate portals already in operation, Crowdfunding in the life science market is at a very early stage. How the market will develop, how much capital it will provide to life science companies, how existing capital sources like BioAdvance will coordinate with new capital sources like Poliwogg, whether the life science market will divide into sectors as the real estate market is doing – these questions are all unanswered. But the panel also agreed that Crowdfunding holds great opportunities for the life science sector even if the details have yet to be worked out.

Thanks to those who attended, to PCCI for making the event possible, and especially to our excellent panelists for making the event so informative and worthwhile.

Questions? Contact Mark Roderick.