How to Work With Final CrowdFund Act — Some Thoughts

Yesterday I blogged my disappointment with the way the CROWDFUND Act included within the JOBS Act is a substantially smaller exemption from the original version of crowdfunding proposed by the House in H. R. 2930.

Today I want to jot down some initial thoughts about how the final CROWDFUND Act can still be useful for fundraising for some startups and young, small businesses.

But before I start, let me pause to note something that, while obvious to professionals, is probably not at all obvious to many small businesses and young entrepreneurs, or at least doesn't seem obvious when I skim search engines and social media for "crowdfunding" information, sites and opportunities.

The overwhelming majority of these startups searching for capital through crowdfunding ARE VIOLATING STATE AND FEDERAL SECURITIES LAWS.  I am guessing most people behind these projects are well-meaning, inexperienced, earnest and ambitious (but perhaps a little cocky)  and are following a script they learned long ago: mimic what others do.  [I know that some are scammers, con artists and crooks, too; but I still believe most are just ignorant, not criminal.] And watching and reading about other fresh and naive entrepreneurs jumping on the crowdfunding bandwagon to finance their projects, they simply do the same.  They don't intend to break the law, they just do, because they don't know any better.

An example from another discipline -- tax law -- illustrates this.   A tax accountant friend told me about a young  client who prepared her taxes using a very popular DIY software/online program (the most widely used, if that company's ads are correct).  That program asked whether she used her personal car in business.  She answered yes.  The program spit out a return that depreciated, for federal income tax purposes, her expensive new car.  Because this looked quite suspicious to my friend (whom, thankfully, she had asked to quickly review her return before filing), he asked her to describe how she uses her personal car for business purposes.  Her answer: "I drive to work in the morning from my home, and from my office to my home in the evening."  She was stunned when my friend explained that commuting does not count as a business expense, she could not depreciate her car for tax purposes, and taking the deduction (thousands of dollars) included by the DIY program could lead to serious adverse consequences for her if the IRS were to select her filing for audit.

Now back to our story.

Here is an illustration of how the CROWDFUND Act -- even in its watered down form -- could work for  entrepreneurs and small businessmen, young and old, and I am not talking about the next uber-successful high tech world-changing technology:

In the neighborhood where our office is located sits an unimproved lot, absolutely vacant and empty except for a sign optimistically boasting "Future Home of [let's call it 'Dan's']."

[I don't represent Dan's or even know the individuals behind it, so nothing after this sentence is based on any factual information about Dan's or those individuals; I am just using their public sign as a starting point to imagine how legal crowdfunding could operate.]

The individuals behind Dan's have an idea and a dream, but they need capital.  And with national and regional banks pulling so far back from real estate and small business loans that they seem to be on the cusp of abandoning those core segments (isn't lending what a bank has a charter to do?), and Dan's principals not having the portfolio to entice a bank to lend for this project in order to get a foot in the door for the hundreds of other projects Dan's plans to roll out across the USA (Dan's principals want to build Dan's place, right here in Fort Worth, a great little place for people who value what Dan's principals value, and not just the first store of a nationwide chain), Dan's principals need to obtain the bulk of their capital from equity investors, and then appeal to community based banks (local banks) to provide the remainder of its necessary startup capital.

And the community bank they do engage will not have the lending capacity or the portfolio diversity to risk furnishing Dan's with a majority of its capital needs.  And leveraging a relatively small equity position using bank debt, to attract investors?  So ten years ago.

Say Dan's business plan and proposed budget shows that it needs $500,000 to construct its storefront and another $250,000 in working capital to get the business opened and to cover operating expenses (above revenues) for the first six months, so that is the target capital raise.  Of that $750 thousand, Dan's can get a commitment from a local bank for 50% of the capital expenditures (construction loan, equipment loan, etc.).  The other $500 thousand needs to be raised from equity investors (for the moment, let's assume the bank won't permit subordinated debt, so that source isn't worth considering at the beginning of the project; but it may be worth considering after Dan's commences operation).

Dan's wants to raise its business on the edge of one of Fort Worth's expanding commercial redevelopments.  There is a neighborhood nonprofit economic development organization (NNEDO) whose mission is to promote commercial and residential growth and success in the neighborhood.

Dan's principals really want to make their dream a reality, and they want to do it the right way.  So they visit the NNEDO and ask it to create a "funding portal" -- not just for  Dan's, but for other businesses based in the NNEDO's neighborhood.  The NNEDO then partners with a Fort Worth SEC- registered broker to build and register such a funding portal.

And Dan's is the first issuer on the portal, because this is where the CROWDFUND exemption does really work, in contrast with other registration exemptions:

1.  It preempts state registration exemptions, so Dan's doesn't need to worry about compliance with Texas securities laws -- or the laws of other states (maybe Okies who visit Fort Worth want to invest in Dan's) on regulation of offers and sales of securities (other than a minimal notice filing with the state or states).

2.  Unlike other federal registration exemptions potentially available to Dan's, the issuer doesn't have to (a) have a preexisting relationship with its investors [I know I am assuming away a Rule 506 offering by Dan's, but it is my illustration] OR -- and this IS the really significant part about the CROWDFUND exemption -- (b) vet the quality of its offerees and purchasers in terms of sophistication, knowledge and suitability for investing.  The intermediary (broker or funding portal; I  call it "The Gatekeeper" but maybe it will evolve into the "MicroStockExchange") has to test potential purchasers to see whether they meet the objective conditions to participate in an offering -- income and net worth qualification, for example -- and must furnish them with risks and warnings about illiquidity, loss of investment, and other "investor education" material to be determined by the SEC, and get answers from potential investors that demonstrate they understand the risks.  The suitability thing has been DRASTICALLY trimmed and responsibility is SHIFTED from the issuer to The Gatekeeper.

3.  In my illustration, Dan's wants to raise $500 thousand, so it will have to furnish financial statements "reviewed" by an independent CPA, but if it doesn't venture over that target during any 12 month period, it won't get to the more expensive "audited" financial statements (although for Dan's, at the beginning of its business life, there would not be much to audit).   Otherwise, the CROWDFUND Act lists what information Dan's must furnish for The Gatekeeper for inclusion on the portal, to potential investors, and to the SEC.  The statutory list is subject to supplementation by SEC rule.

4.  If Dan's finds its budget tight, and its lender unable or unwilling to advance extra funds, then maybe it increases its offering.  It can double the size of its offering to $1 million during its first 12 months (watch out for the certified financial statements, and be ready to update the disclosure information to account for the modified budget and expenses).

5.  Purchasers have to agree to hold their equity investments for at least one year (exceptions: securities can be returned to the issuer, or transferred to family members, or -- and this is potentially significant -- sold to "accredited investors").  When that period lapses, a purchaser can resell to others (subject to compliance with securities laws and, if Dan's got a good lawyer, the shareholders agreement or company agreement of Dan's).

6.  The dollar limitation on Dan's offering is measured on a rolling 12 month scale, so Dan's isn't necessarily capped at raising $1 million on a calendar or other static basis.  For example, if Dan's raises $1 million in Month 1, then it can't raise any more funds by any means until Month 13.  But if it raises $250,000 in each of Month 1 and Month 2, then $500,000 in Month 3 (hitting the aggregate cap), Dan's can raise up to $250 thousand in Month 13, another $250 thousand in Month 14, and another $500 thousand in Month 15.  So Dan's might give thought to hosting a periodic fundraiser (hopefully it will need far less outside capital each year, or Dan's won't be around for long, unless it HAS decided to go national with its concept) to replenish its capital, starting of course with its own loyal equity holders.  (Advisory: If that is Dan's plan from the beginning, be sure to disclose it to the investors, so they are warned about the risks of dilution if they don't meet capital calls.)  (Additional advisory: If Dan's expects to engage in successive equity fundraisings -- a common occurrence among issuers that aren't really "joint venture" type missions -- then its principals better pay close attention in the shareholders agreement or company agreement to lockups, or the lapse of the statutory one year lockup may find Dan's competing with its own holders for the dollars of potential new investors).

 

 

 

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