Thursday, Virginia joined 19 other States which have enacted Crowdfunding legislation, allowing businesses to raise funding by selling shares through public advertising - or 'general solicitation' as it is known to us securities-lawyer-types. What is never mentioned in the press releases and reporting are the many limitations and requirements on these state-level Crowdfunding exemptions, which make them much less useful for the types of technology startups I tend to work with. This is a run-down of some of those limitations as a way of cautioning startups to consider other alternatives before using this new law.
Background: Securities Law, Fundraising & The Federal/State Mashup
As most of you know, Crowdfunding in various forms is already alive and well. Companies have raised millions on platforms like Kickstarter and IndieGoGo to fund new projects. But, in the U.S., securities laws make it generally illegal for companies to use these public sites to raise money for the sale of shares, convertible notes or other securities. In other words, you can promise products, sell services and accept donations to raise money through public advertising but, unless you've done an IPO, you can't sell stock that way.*
It has been this way since the 1930s when the securities laws we know and love were passed. The laws included a general ban on selling shares publicly unless a company went through the IPO process first. Then, in 2012, came the Jumpstart Our Business Startups Act (JOBS Act), in which Congress ordered the Securities Exchange Commission (SEC) to enact rules creating a new Crowdfunding exemption to the general ban. So that was in 2012. "Where are the new rules?" you're asking. "Surely the SEC has written these by now! I can't wait to start selling shares online!"
Unfortunately, due to its institutional fear of allowing companies to sell stock to unprepared, unsophisticated types (the SEC was created in the 1930s as a result of rampant fraud in selling shares of fraudulent and fictional companies to the unsuspecting public), the SEC is taking its sweet time in getting these rules finalized and into effect.
So here come the States.
One thing you need to know is that there are two overlapping layers of securities laws in the U.S. - the federal level and the state level (also called "blue sky laws"). When you sell shares in the U.S., you have to comply with both levels of securities laws. If you sell shares in multiple states, as is often the case, you will need to comply with the federal securities laws and the blue sky laws of each state involved. The federal level has become much more important since 1996 when Congress passed a law that sort of overrides a lot of state regulation for certain types of securities offerings (a specific exemption upon which I rely heavily in the vast majority of tech company fundraising I work on).
The Intrastate Exemption
BUT, at the federal level, there is one small exemption in which the SEC said to the States, "Hey States, for certain small offerings completely within your borders, you guys get to control the rules." That federal exemption is known as the Intrastate Exemption. In securities law class in law school, I remember being told by my favorite professor: "Do not use this exemption, it is dangerous." And in 18 years of helping tech companies raise funds, I haven't ever used it and don't know of anyone who has. The requirements which must be met in order to safely keep your offering within this exemption are tricky and make it useless for most tech startups.
It is within this small, not-often-used, "dangerous" federal exemption that the States have created the new State-level Crowdfunding laws.
Virginia's New Crowdfunding Exemption
Against that backdrop, the first thing you should know about the Crowdfunding exemption is that, as an Intrastate exemption, it is purely for Virginia companies raising money solely from Virginia investors. You are not allowed to offer shares to anyone outside of the Commonwealth. You will also need to be sure that shares aren't transferred to persons outside the Commonwealth within a certain period of time after the offering. There are other requirements designed to keep this exemption purely a state affair.
The potential to fall outside of the Intrastate exemption once you have started an offering creates a lot of risk. You will be in violation of securities laws with potential fines, penalties and actions by the SEC. You may have to offer investors the chance to sell their shares back. It can cause trouble for future offerings.
And once you start down the road of offering shares under this Intrastate exemption, it would be very difficult to change your mind and go another route if it wasn't working. For example, if you started advertising online in a Crowdfunding offering under the new Virginia exemption, but found you were getting interest from someone out-of-state and wanted to take their money, you wouldn't be able to simply shut down your website offering and switch over to a more traditional private offering to raise the funds from investors elsewhere. The fact that you had already conducted this online 'general solicitation' would make the traditional securities laws exemptions unavailable to you. (And you also couldn't just declare that the original online Crowdfunding offering was now "over" and you are starting a new, different offering - securities laws would mostly like integrate the two offerings, meaning essentially that they'd be treated as part of one offering.)
This could mean that you'd have to shut down your fundraising efforts for a period of time and wait for six months or more before trying to start a traditional private offering. This is a lifetime for most tech startups in need of cash. This alone makes the new Crowdfunding exemption such a risky prospect that I wouldn't advise it in most cases.
THE DEVIL IS IN THE DETAILS: THE REGULATIONS
As with the federal Crowdfunding exemption, the Virginia exemption now awaits the passage of the specific rules from a regulatory agency - in this case Virginia's State Corporation Commission (SCC) - before the law can be used. Unlike the SEC, the SCC is expected to finalize and enact the rules for the Crowdfunding exemption relatively quickly. The Securities Division of the SCC has already put forth the proposed rules, which are in a waiting period for public comment and final consideration by the SCC. The discussion below is a summary of just some of the requirements of the proposed rules, which remain subject to change before final passage.
Limitation ON THE AMOUNT RAISED
The Virginia Crowdfunding exemption permits companies to raise up to $2,000,000 in the aggregate, and up to $10,000 from each investor, except that you can accept more than $10,000 from investors who are "accredited." The term "accredited investor" under securities laws has a very specific meaning - for individuals, it generally means someone who has over $1,000,000 in net worth (not including the value of their principal residence) or has made $200,000 in income each of the past 2 years and expects to do so again this year ($300,000 if investing as a couple). There are other categories of accredited investors, but for individual investors, this is the most common category.
If you want to use the exemption to raise the full $2,000,000, you will need to have audited financials from your most recent fiscal year. Having a CPA audit your financials can be quite an expense for a true startup, so many will not be able to raise up to the full amount. Without audited financials, the most you can raise under this exemption is $500,000, and that requires a "review" of the financials by a CPA which, will not as expensive as a full audit, does require an expense up front if you haven't already had your financials reviewed. Without audited or reviewed financials, the most a company can raise is $100,000.
Limitation on Type of Securities Offered
The exemption is also limited to equity securities - meaning, generally: shares. It is not available for debt offerings. Presumably, this means that you would not be able to conduct a Convertible Debt offering through this exemption. In lieu of Convertible Debt (which is often used as a placeholder when the Company and the investors don't feel ready to yet put a value on the company and its shares), Companies could utilize one of the new convertible securities like yCombinator's SAFE securities which are treated as shares but which aren't fully priced at the time of offering. However, using Crowdfunding to sell these more complicated securities to unsophisticated investors presents its own risk.
The new exemption rules will require that a Company first file with the SCC a "Disclosure Statement" or use a new form called Form ICE (cool name, boring form) at least 20 days before starting the Crowdfunding offering. That form will require some information about the Company, the securities being sold, the Company's officers, shareholders holding more than 10% of any class of shares, the Company's intended use of the funds and each website on which it will offer shares. The rules also discuss the need to identify a bank to which the investor's money would go, and require that the Company provide a copy of the escrow agreement with the bank (if there is a minimum threshold for the offering).
The Disclosure Form will also contain information on any lawsuits, anticipated future offerings that might dilute current investors and financial statements of the Company for the past 3 years (or as long as the Company has been in existence if shorter).
Additionally, once a Company raises any money through this exemption, it will be required to provide quarterly reports to its investors as long as any of the shares sold in the offering are outstanding. This quarterly report will also have to be filed with the SCC and I believe will be publicly available. Along with a discussion by management of the Company's operations and financial condition, it will include a listing of the compensation of every director and executive officer of the Company (or its affiliates), including all cash, stock, options, etc., received by each.
Most startups I have worked with would strongly prefer that this information not be made public. Many VCs do not like this kind of information about their portfolio companies to be made public.
Increased Risk of Lawsuits?
In addition to the limitations and requirements listed above, there is also a general fear (shared by me) that raising money from so many people who don't have experience with startup investing, who may not have a lot of money to spare and who have no connection to the Company or its founders other than clicking "BUY" on a website will lead to far more lawsuits when things go poorly. Generally speaking, VCs and experienced angels understand the risk they're taking and understand that tech startups fail and run out of money all of the time. Lawsuits from these kinds of investors over failed startups are remarkably rare and generally only occur when there has been true fraud by the founders. However, the risk of lawsuits go way up when taking money from less-experienced investors.
These lawsuits can occur when the company goes under or when investors feel like the founders or executives are siphoning money out of the company, but they also tend to occur at a particularly inopportune moment: when the company is being acquired. When the company is being acquired, there is almost always a shareholder vote required and a lot of information to be provided to the shareholders ahead of that vote. If a shareholder feels that the deal is no good, or that the management or later investors are coming out ahead in the deal at the expense of early shareholders, they can take certain actions which put the deal at risk. Having a large number of shareholders who don't have experience in this realm or and don't have a real connection with the company heightens the risk that there is a threatened lawsuit at the time of an exit event. And acquirers are very afraid of these threats - "We're not buying a lawsuit" is a common refrain when there is a vocal disgruntled shareholder. This may require negotiation with the grousing shareholders, giving them more than their fair share, just to get the deal done for everyone else.
Impact on Future Activities
If your company wants to have the option of raising additional rounds of capital, either from experienced angel investors or from VCs, this large pool of small, unsophisticated shareholders is likely to cause hesitancy, at the very least. The combination of heightened litigation risk from other shareholders, public reporting requirements, and risk of the Intrastate exemption in general will be negatives when later investors are considering putting money into your company. If they do invest, because they will perceive your crowd investors as unsophisticated, they will require terms which ensure that these investors have no control over the company. Taking the investment and putting these terms in place are likely to create some ire among your crowdfunders, many of whom will believe that you should just continue crowdfunding no matter how much you need to raise.
* With a couple of limited exceptions.