Equity Crowdfunding: What Are The Promises & The Pitfalls?

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By Vincent DiForte
| Financing & Securities

When Facebook purchased Oculus VR for $2 billion, much coverage was devoted to the significant returns the company’s venture capital backers realized. But some of Oculus’s earliest “investors”–their 9,522 Kickstarter backers–won’t see any upside at all, let alone a huge payout. Instead, these Kickstarter backers (who contributed over $2.4 million to help launch the virtual reality company) will walk away with only a t-shirt, poster, or other small tokens in recognition for their “donation” to Oculus. In fact, until now, US securities laws did not provide for the kind of crowdfunding regime that would have allowed Oculus to distribute equity in exchange for money raised through Kickstarter.

But crowdfunding rules are now on the horizon. Congress enacted the Jumpstart Our Business Startups (“JOBS”) Act in April 2012 to stimulate job creation by easing securities regulations that restricted small businesses’ ability to raise capital. The Securities Exchange Commission (“SEC”) then took more than a year and a half to promulgate the necessary regulations to implement the equity crowdfunding provisions in Section III of the JOBS Act.

Now, in the midst of the 90-day public comment period offered by the SEC, hundreds of commentators have voiced concerns about the new regulations. Experts, platform managers, investors and other professionals have submitted strong–yet contradictory–positions. The polarized calls for revision reveal the difficulty of easing the onerous restrictions on capital raising by enterpreneurs and small businesses while retaining the ability to adequately protect investors from fraud.

As the SEC continues to review these comments before issuing the final regulations, here is a list of the promises and pitfalls for both investors and entrepreneurs.

entrepreneur-investor

Investors

Promises:

1) Equity crowdfunding allows anyone to invest and become an equity stakeholder in an early-stage company. No longer are these opportunities available only to high net-worth accredited investors or institutions like venture capital firms.

2) Small investors are now presented with the promise of significant returns for investing in the next Google or Facebook. For example, the returns for an early investor in Facebook were 62,000%.

Pitfalls:

1) The amount an individual can invest depends on their level of income and assets. In fact, the SEC’s proposed rules adopted the most expansive limits allowed by the JOBS Act–and thus allow investors of any size to put much of their overall wealth at risk. The rules also provide for more lenient disclosure requirements and rely on crowdfunding sites (called “intermediaries”) to vet fraudulent companies. The combined result: the proposed rules enable unsophisticated investors to allocate a significant portion of their wealth to some of the most risky investments on the market.

2) The proposed rules do not provide individual investors with the ability to negotiate specific terms to protect their investments. Typically, sophisticated investors negotiate complex terms to ensure that they are amply rewarded for early-stage investments and prevent dilution. While obviously less experienced investors might not have the means to negotiate the perfect deal, without negotiating specific terms it might be difficult to ultimately realize significant payouts even if the company turns out to be “next big thing.”

Entrepreneurs

Promises:

1) Equity crowdfunding provides entrepreneurs greater access to a wide-range of investors. This creates more opportunities to move beyond family and friends for startup investment, and alleviates reliance on a small number of venture capital firms or angel investors to fund your business.

2) Access to a wider range of investors enables more diverse business relationships and feedback on a product. It also facilitates marketing and awareness through social media promotions by hundreds, if not thousands, of investors.

Pitfalls:

1) Entrepreneurs are only able to raise $1 million in any 12-month period through crowdfunding. Expenses associated with complying with the SEC’s proposed rules include: producing an offering disclosure document, enlist a funding portal, run background checks and file an annual report. These costs can easily exceed $100,000 and in some instances account for 39% of the money funded. The high cost to raise only a small amount of capital could make crowdfunding impractical for many entrepreneurs.

2) After successfully raising capital through crowdfunding, companies may find themselves with a host of new equity owners who each have statutory and contractual rights. These rights may include voting on certain matters or access to management – each of which could make it difficult for companies to run efficiently.

Amidst all the competing considerations and concerns, one thing is clear: equity crowdfunding is coming soon. The SEC will implement its final regulations later this year and new crowdfunding intermediaries form almost daily in anticipation.

If you are considering equity crowdfunding, consult a Priori lawyer to help maximize the promise and avoid the pitfalls.

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