Category: Entrepreneurs

Technology Platform for Crowdfunding

On By crowdfundattnyIn Crowdfunding, Entrepreneurs, Form D, Regulation D offerings, SEC, Technology PlatformsLeave a comment

A company raising money through Crowdfunding will face certain logistical challenges:

  • How to keep track of prospective investors
  • How to automate the due diligence process
  • How to execute documents electronically and securely
  • How to communicate with investors
  • How to securely handle the transfer of funds
  • How to satisfy the new SEC requirements regarding accredited investors
  • How to prepare and file the newly-expanded Form D with the SEC

These challenges have always been present in Regulation D offerings, but with a dozen investors, or two dozen, or three dozen, they were merely a manageable nuisance. In a Crowdfunding offering with 150 investors they could be overwhelming.

SeedInvest, a startup with offices in Manhattan, offers a technology platform that claims to do all these things and more. A company seeking to raise money through Crowdfunding, or a brokerage firm seeking to raise money for its clients, or an angel group seeking to manage multiple investments, would in effect “rent” the SeedInvest platform as an alternative to spending the time and money to build its own.

Today, thousands of entrepreneurs – perhaps some of them reading this blog – are planning to jump into the Crowdfunding space. One entrepreneur might be building a portal for biotech companies in the Northeast – a place where investors could find and invest in the best the research centers in the Northeast have to offer. Another might be doing the same for Manhattan commercial real estate, believing there must be many accredited investors around the country who would like to own a piece of New York. And on and on, in every industry and every region.

By using SeedInvest’s platform, or a similar platform offered by a competitor, the entrepreneur overcomes some of the most significant technological and logistical barriers to entry. In effect, the entrepreneur can focus on the business of attracting quality companies and investors while outsourcing the technological back office.

Crowdfunding is already creating new opportunities for entrepreneurs in many industries. SeedInvest is one example; there will be many, many more.

Questions? Let me know.

Will Crowdfunding Hurt My Company Later On?

On By crowdfundattnyIn Crowdfunding, Entrepreneurs, JOBS ActLeave a comment

With bona fide JOBS Act Crowdfunding about to launch, many entrepreneurs wonder whether raising money through Crowdfunding will hurt their company in the future.

The simple answer: not if you do it the right way.

A company raises money for its current needs, naturally. But no matter where the money is coming from, Crowdfunding or otherwise, the company must have one eye on the future to ensure that nothing it does today will keep it from raising more money tomorrow.

Here are a few tips to avoid problems in the future:

  • The Crowdfunding investors should not have the right to veto later rounds of financing.
  • The Crowdfunding investors should not be able to control the company’s Board of Directors.
  • The Crowdfunding investors should have very limited liquidity rights, if any.
  • The company should be able to grant later investors economic and management rights – for example, a preferred return on sale – that are superior to the rights of the Crowdfunding investors.

These things and much more can be accomplished with the right legal structure for the company and the Crowdfunded investment. In fact, if Crowdfunding is done correctly, it should not interfere with subsequent rounds of investment at all.

Questions? Let me know.

SEC Finalizes “General Solicitation” Regulations: Full Steam Ahead

On By crowdfundattnyIn Crowdfunding, Crowdfunding Portals, Entrepreneurs, FundersClub, General Solicitation, Investing, Investor, JOBS Act, Kickstarter, Rule 506, SEC, Securities Exchange CommissionLeave a comment

Since President Obama signed the JOBS Act into law on April 5, 2012, we have been waiting for the SEC to finalize the rules on Crowdfunding.

At long last the SEC has done just that, at least with respect to one of the two components of Crowdfunding. Sometime in mid-September, company will be allowed to use “general solicitation” in certain “Rule 506 offerings.” The rules governing the other component of Crowdfunding, where small issuers will be allowed to raise money through Internet portals from small, unsophisticated investors, will have to wait for later in the year.

Even so, these new regulations mark the largest change to the securities laws in almost 80 years. Companies will now be allowed to raise money from accredited investors (in the case of individuals, those with over $1 million of net worth or incomes over $200,000 per year) through social media, print materials, email, and other means. Not only will companies have greater access to the capital they need, but the new rules are likely to significantly disrupt the money-raising industry, displacing brokers, lawyers, and other middlemen just as the Internet has displaced so many middlemen before them.

Now the technical rules.

The rules allow general solicitation and general advertising where:

  • All purchasers are accredited investors; and
  • The company takes reasonable steps to verify that the purchasers are accredited investors; and
  • All of the requirements in Rule 501, Rule 502(a), and 502(d) are satisfied.

Whether the company has taken “reasonable steps” will be determined on a case-by-case basis. Among the relevant factors:

  • The type of accredited investor that the purchaser claims to be (e.g., the CEO of a Fortune 100 company or a store clerk).
  • The amount and type of information that the issuer has about the purchaser.
  • The nature of the offering, including the manner of the solicitation.

When the regulations were proposed last August, many people complained about the absence of hard-and-fast rules and the resulting ambiguity. The final rules take a large step in the direction of certainty by providing that a company will be considered to have taken reasonable steps to verify that a natural person is an accredited investor if it does any of the following:

  • If basing the decision on the purchaser’s net income:
    • Reviews W-2s, 1099s, or other IRS documents that report the person’s income for the past two years; and
    • Obtains a written representation that the person reasonably expects to reach the income level required to qualify as an accredited investor in the current year.
    • If basing the decision on the purchaser’s net worth:
      • Reviews one or more types of documents dated within the past three months, including bank statements, brokerage statements, tax assessments, and a report from one of the national consumer reporting agencies concerning liabilities; and obtains a written representation that the person has disclosed all liabilities necessary to make a net worth determination; or
      • Obtains a written representation from certain third parties, including registered broker-dealers or investment advisors, that they have taken reasonable steps to verify the person’s accredited investor status within the past three months and have determined that the person is an accredited investor; or
      • Permits existing security-holders who had acquired issuer securities in a previous Rule 506 offering and had qualified as accredited investors at that time to certify his or her accredited investor status at the time of the sale.

These steps are neither exclusive nor mandatory. The final rules also discuss other factors and procedures.

In addition to taking reasonable steps to verify that purchasers are accredited, the company must also have a reasonable belief that they are accredited. This has always been part of Rule 506 and was not changed by the JOBS Act.

NOTE:  These new rules offer enormous opportunities for entrepreneurs seeking to raise money for their existing businesses or start new businesses. Please contact us if you would like to discuss your idea.

Questions? Let me know.

SEC: FundersClub, AngelList Not Required To Register As Broker-Dealers

On By crowdfundattnyIn AngelList, Crowdfunding, Crowdfunding Portals, Entrepreneurs, FundersClub, Investing, Investor, LLCs, SECLeave a comment

Through “no-action letters” dated March 26, 2013, the Securities and Exchange Commission has just ruled neither FundersClub nor AngelList, both nationally-recognized equity-based Crowdfunding portals, is required to register as a broker dealer under Federal securities law.

But portals are structured as investment advisory services and are registered as investment advisors. When a company is funded by investors, the portals do not receive cash compensation, as a broker would typically receive, but instead receive compensation more customary for a fund advisor: an interest in the future profits of the company – a “carried interest.” The form of the compensation seemed to be the principal factor that convinced the SEC to rule favorably.

Other equity-based portals might register as broker-dealers to avoid the issue altogether. Because both of these coordinated decisions could have gone the other way, however, the larger lesson may be that the SEC is taking a relatively hands-off approach to the rapidly-evolving Crowdfunding industry. If you are a portal or company waiting anxiously for the SEC regulations later this year, that is good news.

Questions? Let me know.

The Gold Rush – Part II

On By crowdfundattnyIn Crowdfunding, Crowdfunding Gold Rush, Crowdfunding Portals, Entrepreneurs, Investing, JOBS Act, KickstarterLeave a comment

Many young companies fail for lack of capital. With Crowdfunding making much more capital available, it seems plausible that more young companies will succeed. Even so, the nature of capitalism is that many will fail and investors will lose their money. And unfortunately, with so much money flowing through new channels, the nature of human beings is that Crowdfunding will attract its share of the outright unscrupulous.

You can never protect yourself completely, but here a few tips to reduce the risk.

If you are an Investor:

  • Use common sense. If something seems too good to be true it probably is.
  • A company financed by Crowdfunding is no more likely to be successful than a company financed the old-fashioned way.
  • One of the great things about Crowdfunding is that you get to see a lot of companies. It follows that you can afford to be picky.
  • By all means, register at more than one portal.
  • Don’t invest in a company just because others are investing.
  • Often, it makes sense to invest in industries you already know something about.
  • Make sure you are satisfied with the due diligence.
  • Figure out how much money the business must earn for your investment to be worthwhile, i.e., to earn a profit commensurate with your risk. Do you understand how the business will make that much money? If not, you probably shouldn’t invest.

If you are a Portal:

  • You are going to be swamped with companies looking to raise money. Your greatest risk is that a company you sponsor turns out to be a fraud. Beware:  con men are very good at what they do.
  • Develop strong contracts with companies and investors, making clear exactly what everyone can expect, and what they can’t.
  • Do not allow your portal to infringe upon the rights of third parties.
  • Comply with all laws and in particular the securities laws. When – not if – investors lose money, the chances are very high that you will be sued.
  • Buy insurance.

If you are a Company:

  • You are now using OPM – Other People’s Money. Your expenditure of every nickel may be scrutinized by a plaintiff’s lawyer with the benefit of 20/20 hindsight. Have strong accounting systems in place.
  • Develop strong contracts vis-a-vis investors.
  • Disclose everything about your company up front, especially all the bad news, and otherwise comply with Federal and State securities laws. Your greatest risk, by far, is that you fail to comply with these laws.
  • Make sure your portal is reputable and complies with the law also. If the portal doesn’t comply, you are going to be sued.
  • Try to raise enough money the first time around.
  • Make sure your corporate structure allows you flexibility in the future, including the flexibility to raise more money.
  • Buy insurance.

Questions? Let me know.

The Gold Rush – Part I

On By crowdfundattnyIn Crowdfunding, Crowdfunding Gold Rush, Crowdfunding Portals, Entrepreneurs, Investing, JOBS Act, Kickstarter, SECLeave a comment

A man and woman created a Crowdfunding campaign for their newborn. A company raised $2 million in one day. The SEC regulations to launch “real” Crowdfunding per the JOBS Act might be far off, but the Crowdfunding gold rush is already well underway.

The excitement – the discovery of an enormous vein of money flowing into a brand-new channel – holds many opportunities. If you are an entrepreneur looking for funding there have never been more places to look. No longer beholden to a broker or a wealthy aunt or a lawyer with a big Rolodex, every entrepreneur now has ready access to the biggest Rolodex in the world: the Internet.

Seizing their own opportunity, Crowdfunding portals are springing up like Western mining towns with names that can become nationally-recognized overnight. Circle Up, SeedInvest, and Funders Club are among the equity-based portals while Kickstarter and Indiego remain the leaders in donation- or rewards-based projects, at least for the time being. New portals are being formed and coming online all the time as eager prospectors look for their share of the gold.

Others are poised to benefit as well:

There is an enormous and growing need for someone to perform meaningful due diligence on all the new companies, beyond the information that might be posted online. The new structures and relationships will require new insurance products, some of which are already being developed. If it hasn’t happened already, someone is going to offer to represent Crowdfunding investors on the Boards of Directors of far-flung companies. Every company funded by the Crowd will need an investor relations platform.

With so few barriers to entry, the opportunity to stake a claim in the Crowdfunding gold rush is practically unlimited today.

Bear in mind, all this is happening before true JOBS Act Crowdfunding springs to life, probably by late summer. When that happens, companies will be able to legally raise money from large numbers of non-affluent, unsophisticated investors for the first time in 80 years, uncovering the largest vein of capital yet.

One thing seems certain. With all the gold and all the gunslingers, some things will go wrong and some people will get hurt. In our next post, we’ll offer some pointers so you’re not one of them.

Questions? Let me know.

How Much Of My Company Should I Give Away?

On By crowdfundattnyIn Crowdfunding, Entrepreneurs, Investing, JOBS ActLeave a comment

Entrepreneurs and investors alike are often puzzled by this basic question: How much of the company should the investor get?

One approach is through financial analysis and calculations. If you like numbers you will definitely find this approach satisfying.

Suppose you’re raising $500,000. To calculate how much your investor should receive:

  • Step 1: Look at your business plan and see how much annual EBITDA (earnings) your business will be generating in five years from now. Let’s say $800,000 per year.
  • Step 2: Look at the market and see at what multiples companies in your industry sell for. Say the right multiple is 8x earnings.
  • Step 3: Look at the market and see what annual returns investors expect to receive for a company like yours. Say the required rate of return is 30% per year.
  • Step 4: Based on Step 2, your company can be sold at the end of Year 5 for $6,400,000 (eight times $800,000).
  • Step 5: Based on Step 3, your investor will expect to receive $1,856,465 at the end of Year 5 ($500,000 compounded at 30% per year for five years).
  • Step 6: This means your investor should own about 29% of your company ($1,856,465 divided by $6,400,000).

Very elegant and simple.

But also very inexact. At virtually every step, you’re really making educated guesses: how much you will be earning five years (an eternity) from now, the right sales multiple, the return your investor expects to receive. Change any of the inputs and you can get a very different output.

That’s why in the real world the investor’s ownership percentage is more often the subject of negotiation. The investor wants X, the entrepreneur wants Y, and you try to reach a compromise, depending who has more negotiating power.

The process doesn’t have to involve just horse-trading. For example, if the investor wants 30% because she thinks the company will be worth $5 million in Year 5 and the entrepreneur is willing to give up only 20% because he thinks the company will be worth $7.5 million, there’s an obvious compromise: the investor gets 30% up front, but the entrepreneur can “claw back” part or all of the extra 10% if the company turns out to worth more than $5 million.

In practice, determining how much stock the investor receives is a function of both art and science, although probably more of the former than the latter.

Questions? Let me know.

Is My Portal Legal?

On By crowdfundattnyIn Crowdfunding Portals, Entrepreneurs, General Solicitation, JOBS Act, Kickstarter, Rule 506, SECLeave a comment

As Crowdfunding gains traction, Crowdfunding portals are springing up and marketing themselves aggressively to entrepreneurs and prospective investors.

No, I take that back. Websites are springing up and marketing themselves aggressively to entrepreneurs and prospective investors, but technically there aren’t any “Crowdfunding portals” yet. Crowdfunding portals are a creature of the JOBS Act, and the JOBS Act hasn’t yet come into effect because the Securities and Exchange Commission (SEC) hasn’t yet issued regulations.

If the websites springing up today are not really Crowdfunding portals, then what are they? Are they legal? That matters a lot for entrepreneurs.

Background

The JOBS Act created two kinds of Crowdfunding:

  1. Using one kind of Crowdfunding, companies can raise up to $1 million from in unlimited number of investors through Internet “portals” that would be registered with the SEC and licensed by FINRA.
  2. Using the other kind, companies can use “general solicitation” to raise an unlimited amount of money from “accredited investors” by following Rule 506 issued by the SEC under Regulation D.

But neither kind of Crowdfunding is available yet.

Today, we see websites that combine the concept of a “portal” with a traditional private offering of securities. At these sites, accredited investors sign up to review companies, and companies sign up to raise money from investors. If everything goes right you end up with a happy entrepreneur and a legal Rule 506 offering.

What Could Go Wrong?

By definition, these Internet sites are not Crowdfunding portals and what they do is not JOBS Act Crowdfunding. For the sites to be legal they must satisfy the securities law rules as they existed before the JOBS Act. And it turns out that it’s not easy to mesh the very fast, very public world of the Internet with the rules in place long before the Internet was a twinkle in Al Gore’s eye.

These are a few of the tough issues these sites face:

  • Until the SEC issues Crowdfunding regulations, companies are not allowed to use “general solicitation” to attract investors. But if you visit some of these sites – public to anyone with Internet access – you see the companies listed.
  • If a portal isn’t careful, it might end up with one or more unaccredited investors, disqualifying the whole offering.
  • The sites generally don’t work for free – they are paid by the companies that raise money. In general, only a licensed broker can receive compensation in connection with the sale of securities.
  • Some sites provide “due diligence” on companies, offering to help investors to separate the good from the bad. That kind of service generally requires a license as an investment advisor.
  • State securities regulators can be even more aggressive than the SEC. If an offering violates Federal law then it probably violates state law, too.

Some sites seem more aggressive legally than others. Entrepreneurs should pay attention.

Why Does It Matter to the Entrepreneur?

If a website raises money improperly, the website can find itself in hot water. The operators of the website may be fined, banned from the securities industry (thus missing out on Crowdfunding when the SEC finally issues regulations), even go to jail.

But it’s no picnic for the entrepreneur and his or her company, either. If the portal does something wrong it likely means the company engaged in an unregistered, and therefore illegal, public offering of securities. The entrepreneur can also be fined, banned from the securities industry, or even go to jail. Moreover, the entrepreneur could be forced to give all the money back to the investors.

Conclusion

Raising money has always been hard. The internet and the JOBS Act are making it easier, but in the Wild West version of Crowdfunding we live in today, entrepreneurs have to be picky about their portals.

Questions? Let me know.