State-Level Equity Crowdfunding: The Next Big Thing

4/9/14Follow @joewallin

Just a few weeks ago, Facebook’s surprise $2 billion purchase of virtual reality headset developer Oculus riled up some of the startup’s earliest financial backers, who said they got a raw deal while the founders got rich. 

We’re talking about pre-order backers on Kickstarter here, not investors. But if new equity crowdfunding rules had been in place, those early Oculus supporters might be singing a different tune right now.

Unfortunately, the crowdfunding envisioned by the federal JOBS Act that Congress passed over two years ago is still not a reality. However, thanks to advocates and enthusiasts, state-level equity crowdfunding is popping up all over.

The trend has strong ties to Washington, where in 2013, state Rep. Cyrus Habib introduced what may have been the first state-level equity crowdfunding bill in the nation. As an attorney who specializes in early stage companies, I’ve also been paying attention to this issue for some time—I actually might have written the first blog post advocating state-level equity crowdfunding, complete with a proposed statute, in 2012. 

First, Wisconsin passed a bill. Then Michigan. And now Washington. A half a dozen other states are also considering legislation, providing enough legislative momentum to fuel a dedicated website that tracks the various proposals. (Lawyer Alixe Cormick has also written a really nice summary of the current state of play.)

So why are these laws popping up at the state level?

First and foremost, states are vying to become tech hubs, and legislators want to support startups and entrepreneurial efforts in their backyard. Legislators are carefully tracking where the investment dollars from venture capitalists and angel investors are being deployed, and are trying to attract those funds and businesses that attract those funds.

The preamble to the Washington bill does a nice job of summarizing what state legislators are trying to do:

“The legislature finds that start-up companies play a critical role in creating new jobs and revenues. Crowdfunding, or raising money through small contributions from a large number of investors, allows smaller enterprises to access the capital they need to get new businesses off the ground.

The legislature further finds that the costs of state securities registration often outweigh the benefits to Washington start-ups seeking to make small securities offerings and that the use of crowdfunding for business financing in Washington is significantly restricted by state securities laws.

Helping new businesses access equity crowdfunding within certain boundaries will democratize venture capital and facilitate investment by Washington residents in Washington start-ups while protecting consumers and investors. For these reasons, the legislature intends to provide Washington businesses and investors the opportunity to benefit from equity crowdfunding.”

Second, there is widespread disappointment over the federal law, for which the SEC still has not finalized the rules putting it into practice. Venture capitalist Fred Wilson aptly described the frustration: “Two years later, it’s as hard as ever to raise equity capital and if you aren’t rich (accredited or qualified investor status), you can’t legally participate in the world of startup investing.” 

But even when we finally get federal equity crowdfunding, the federal law is not going to work—it’s too complex and too expensive. There are estimates that to raise $1 million under the federal law, companies are going to have to spend something on the order of $250,000 in intermediary (broker-dealers or registered portals), lawyer, and accounting fees. This simply won’t work for the vast majority of companies. It certainly won’t work for brand-new or naked startups.

Perhaps the federal law’s worst defect is that it forces companies to use third-party intermediaries. The SEC estimates that third-party intermediary fees will cost companies about 8-10 percent of gross offering proceeds. But startups don’t typically use third parties to raise funds, so I’m not sure why Congress wanted to force startups into the arms of intermediaries.

It’s possible that state laws won’t fall into the same trap. Washington’s bill does not require the use of an intermediary or a portal.

Why should you care? If you are a state legislator or a crowdfunding advocate, and you want to know how to make a great state equity crowdfunding law, I would recommend the one we wrote in Washington.

I believe that what we put together here will actually work for startups for several reasons. For one, it won’t be ridiculously expensive—companies will be able to start the crowdfunding process just like they do now in all accredited investor offerings under federal Rule 506. Meaning, with a little lawyer help, they will be able to get out to market to see if they can actually succeed in raising money.

So much of the trouble with various other securities law exemptions is the investment of tens of thousands of dollars in legal and accounting fees before a company even knows if it has a deal it can sell. That’s a big contrast to one of the wonderful attributes of Kickstarter and similar non-equity crowdfunding platforms: the ability to test the market. Are you proposing to build something people will actually buy? If not, it is good to know before you spend a bunch of money building it! 

I believe equity crowdfunding can help transform business climates around the country. I also believe that if we continue to work on our federal legislators, perhaps they can fix the JOBS Act. But in the meantime, we can work on creating state-level equity crowdfunding laws that do the job better.

Here’s my quick checklist of what makes up a great state equity crowdfunding bill:

—Do not require startups to use a third-party intermediary. Allow companies to raise funds the way they raise money right now. Again, right now, founders go it alone. They do it themselves. They don’t hire brokers or finders.

—Do not require audited or reviewed financial statements. Startups won’t have these and won’t be able to afford them; if you require them the bill won’t work for startups.

—Require disclosure that companies can hack through without teams of accountants and lawyers and spending thousands of dollars.

—Do not impose novel or new theories of liability of directors and officers (like the federal bill did).

To prevent fraud, state laws should also require an advance filing and approval with the state regulatory agency, preclude bad actors from participating, and require companies to make ongoing disclosures to both investors and the state regulatory agency.

To make sure that people know the risks, these laws also should make sure that investors sign a statement acknowledging they know they are likely to lose their money. The Washington statute does that, and says the disclosure must be conspicuously presented at the time of sale on its own, separate page.

Will people lose their money? Sure. There are going to be companies that don’t work out. But there are also going to be success stories. It will be great for startups and founders, giving them an avenue to capital that doesn’t exist now. And people want the ability to participate, even in this risky area.

Joe Wallin is a partner at Davis Wright Tremaine in Seattle, focusing on emerging, high growth, and startup companies. He's also the founder and editor of StartupLawBlog.com. Follow @joewallin

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