Silicon Valley Debates the Do’s and Don’ts of Equity Crowdfunding
Your Facebook friends would love an “Attaboy” from you when they post about their new jobs, or an “Awwww” when they share a puppy picture.
But what will you do when they offer you shares in their startup company?
That expansion of social media is on its way, as soon as securities regulators finish the rules for a new way to float private stock issues—equity crowdfunding.
Congress, by passing the JOBS (Jumpstart Our Business Startups) Act in March, created a number of alternatives to the traditional IPO, or initial public offering, for company financing. One of them will allow entrepreneurs to raise up to a million dollars a year by selling shares in their startups to hundreds or thousands of people they’ll reach through websites and social media networks.
Crowdfunding may be familiar to you in the form of existing websites like Kickstarter and Indiegogo, the online forums where artists or inventors can appeal for financial support from people who like their ideas. In return for their dough, contributors might get a reward like an early copy of a band’s CD, a thank you card or T-shirt.
The success of these platforms—where some fledgling projects have raised more than $1 million—has inspired the next step: selling equity stakes in young companies. Indiegogo CEO Slava Rubin, who wants his San Francisco-based site to become an equity crowdfunding portal, predicts that the Securities and Exchange Commission will clear the path for the new financing route by issuing regulations in the first quarter of 2013.
Larry Kane, a Silicon Valley attorney who works with emerging companies, says the method could help small outfits that haven’t been able to raise capital from the usual sources: friends and family of company founders, angel investors, and venture capital firms.
“Clients and potential clients are routinely asking about crowdfunding, ‘When can I do it?,”’ says Kane, a partner at San Francisco-based Orrick, Herrington & Sutcliffe. He says the method will probably attract entrepreneurs such as consumer-product makers and developers of smartphone apps or edutech projects.
But should they do it? Is it a good idea to post your novel business plan on a public website? What are the risks of taking on thousands of private shareholders?
Kane will lead a panel discussion of these topics at Orrick’s Menlo Park office on Thursday. The event will include representatives of two trade groups, the Crowdfunding Professional Association and the National Crowdfunding Association, that have been weighing in with Congress and the SEC over the language of the JOBS Act and upcoming SEC regulations.
The task for the SEC is to protect investors who buy shares through crowdfunding sites, while supporting the aims of the JOBS Act—to make capital available to small businesses so they can grow and hire employees. Opponents of equity crowdfunding, including some state securities regulators, fear that the financing mechanism will expose thousands of unsophisticated investors to fraudulent stock offerings.
Sherwood Neiss, a co-founder of the Crowdfunding Professional Association, says the concerns of consumer groups and other opponents come from a “very valid place.”
“They’ve experienced the fraud that can take place under the current system,” such as the Bernie Madoff scandal where many investors lost their shirts, Neiss says.
Neiss says the nature of social media itself may mitigate some of the worst hazards. Crowdfunding companies will offer their shares through “pitch pages” on crowdfunding portals, where critics can poke holes in their business plans and ask pointed questions, he says. So far, the SEC has released some preliminary information about the requirements for funding portals. They’ll have to register with the SEC and become members of a national securities association such as the Financial Industry Regulatory Authority (FINRA). They’ll also have to take steps to protect investors’ privacy and to reduce the risk of fraud.
Indiegogo’s Rubin says he couldn’t predict the design of his equity crowdfunding portal, or the timeline for its launch, until the final SEC rules come out.
Will selling shares yield higher capital returns for startups than the current crowdfunding model that offers incentives like T-shirts to contributors? Rubin says that’s also hard to foresee, but will likely depend on each company’s unique circumstances.
“It could be that some people will be excited just to buy $20 (share) units,” he says.
Orrick attorney Kane says startups need to be aware that state securities regulators will be scrutinizing crowdfunded share offerings for false statements, downplayed risks, and other violations of federal or state rules governing stock issues.
“If anybody raises money from anybody else without a lawyer, it’s really foolish,” Kane says.
Many emerging companies are concerned about their eventual chances of attracting venture capital if they already have a collection of private shareholders whose rights would have to be considered in a new financing deal.
Kane says VC’s will look carefully at the ownership structure, but won’t turn their backs on a successful young company.
“Would a VC not invest in Facebook because it had been crowdfunded?” he asks.