September 26, 2013
Crowdfunding: Death by Expense?
Here is an excerpt of some interesting observations from Nancy Fallon-Houle.:
The legal cost and accounting cost of the following items can easily cause death by expense of crowdfunding:
1. Disclosure Document and Due Diligence Cost
2. Accounting Cost of Financial Statements and shareholders’ equity statements, so that investors understand what percentage they are buying and for how much. Even if the financials are not audited or reviewed, even if “compiled” standard, accountants compiling the financials require special certifications for public offerings, and therefore at higher costs.
3. Portal Costs – How do the Portals get paid? Assuming some cost to the Issuer, out of the raise, or in advance?
4. Portal Legal Fee Cost – Legal Negotiations between Issuer and Portal – What liability shifting from Portal to Issuer will occur in the Portal Agreement? Issuer’s counsel called on scene to protect Issuer from liability, or alternatively add a liability risk disclosure to the Disclosure Document. Will Portal’s counsel start with an underwriting agreement and edit? (If so, this process will keep Issuer’s counsel busy, and on their toes.) Very costly process either way, especially as we collectively “figure this out”. Even after “standard” provisions settle in, the Portal Agreement would likely be a negotiated agreement, which adds Portal’s law firm costs to the mix. Who pays those? Negotiating process between Issuer’s counsel and Portal’s counsel will add cost to an already “too large budget, for the size of the deal”. Add an interesting phenomenon if the Portal does not have counsel?
5. Legal Fee Cost of Subscription Agreements, with many permutations. With complexity comes cost. Though these costs will settle down eventually.
6. Legal Fee Cost, Consultant’s Cost, or Issuer’s In-House Compliance Cost, of Monitoring Investor Compliance with the Investor Thresholds – Various percentage calculations and income or net worth calculations, and investment limits based on both, will require due diligence on the investor. Issuer must maintain calculations on each investor and its threshold. The “per investor” cost of legal fees goes up.
7. Legal Fee Cost, or Issuer’s In-House Compliance Cost, of Reporting Notice to the SEC – Crowdfunding notice will likely be a pre-offer notice, which typically includes substantial detail in reporting, if not inclusion of the disclosure document.
8. Social Media Cost – Legal Fee cost of managing/reviewing/editing communications of Issuer/clients over social media.
Crowdfunding: A Preview of State Discontent?
And Kim Lisa Taylor of Trowbridge & Taylor notes: This “Notice of Intent to Issue Cease and Desist Order” illustrates the Ohio Division of Securities’ opinion about crowdfunding. Despite the fact that SoMoLend jumped the gun, Ohio appears to have carefully crafted this Notice to illustrate their issues with crowdfunding in general. This Notice could be the first of many if other states share their sentiments.
There are currently a number of companies online purporting to offer crowdfunding opportunities (not just the donation type), who apparently don’t understand that it’s not yet legal or that they will have to be an approved portal to offer them when (if ever) it becomes legal. The public’s confusion appears to stem from the mass media’s misuse of the term “crowdfunding” to describe everything from crowd-sourcing (for non-profit purposes) to advertising for accredited investors under new Rule 506(c).
When I tell people it’s not yet legal, they don’t believe me, citing the numerous websites and articles that talk about it as if it is. My law partner and I I teach hundreds of real estate investors how to syndicate every year. This misinformation problem seems to be prevalent in the real estate investing industry – and I hear that many “guru” types are teaching crowdfunding to wannabe group sponsors as if it’s legal. I also have a column in the September/October issue of “Personal Real Estate Investor Magazine.”
Crowdfunding: Will It Really Help Startups in the Long Run?
And here is some interesting commentary from Caroline Schroder of Sulgrave LLC (here is Caroline’s blog):
Say startups raise small sums of $100K-$400k through crowdfunding. What are they left with then? Is the result consonant with the rationale for the Act, creating jobs? Will such startups be real businesses? Can they go forward as is? Or do they then have to raise real sums? Could they? Will the commercial lender look at them? The VC? Will such startups be able to do real rounds or even go IPO? Would they have to go through an expensive restructuring to become a real contender?
As a strategic matter, startups that go after such small sums – $100K-$500k – usually think that they need only a small cash infusion to get into production, to get the first contract, to build a prototype and file a patent application, or to sit and code in an incubator, but how often is this need realistic? Usually they end up being seriously undercapitalized, if they succeed at all, because they misunderstand burn rate. They mistake their real costs and their real needs because they defer the critical financial questions. Marketing, ramp up, and scale up seem much farther away than they actually are. Sometimes reality is too complex to understand or too scary to think about. Such startups usually end up going back to the trough many times.
Too many startups have been down this path. It’s the classic story in angel, friend, and family funding. Sometimes the startups are the next instant hit, the designer cupcake or disruptive gadget, but more often, the startups run through the first $300k and then they are back trying to raise the next $300k, if, in fact, they don’t just disappear. Their “deal lawyer” rarely sees them again or they become the habitual client, in the door every two years or so. Years on, they seem to be largely in the business of raising small sums. And if one looks at their real business model, one sees that the world has moved on and the market opportunity or the technology window has gone; someone else has already done it or built something better.
Crowdfunding is a source of ready cash but I’m not sure it has much to do with creating jobs or growing real companies. Vanity funding may have its place, but it doesn’t make economies run – which was the point if the JOBS Act.
You may not be familiar with the ‘mandate’ under the America Invents Act, under which patent lawyers are asked to provide free legal assistance to startups and inventors as part of the ABA Model Rule 6.1 obligation to provide “at least” 50 hours of pro bono work a year. That is quite an obligation when all lawyers in this high liability field are pressured to discount heavily and to accept conflict-ridden sweat equity.
Here’s a note from the US Patent Office: “The America Invents Act specifically called on the United States Patent Office and practitioners alike to establish a pro bono program to assist financially under-resourced independent inventors and small businesses. The USPTO is working with different regions across the country by educating both IP law associations and non-profits on how these pro bono programs work and how to successfully implement them in new regions. Efforts are now well underway with volunteers endeavoring to achieve the goals of ABA Model Rule 6.1 to provide at least 50 hours of pro bono legal services per year.”
– Broc Romanek