Small Business Obligations to and from Crowdsourcers

By | July 5, 2016

Raising capital to launch a startup has long been a very difficult part of getting a business idea off the ground. But over time, funding has become more democratized. The venture capital industry grew and angel investors became an alternative along with venture capital (VC) investing. And with consumer crowdfunding added to funding capital options, there’s just one more layer available for entrepreneurs. However, even with these financing options, the process can be difficult to navigate, as there are similarities and differences.

Crowdfunding vs. Angel Investors vs. VC

One of the differences between crowdfunding and angel investors or VC is that none of the investors are shareholders in the company. This means that you get to keep equity while raising capital. At the same time, you have to deliver something to get the funds; whereas VC and angel investing provides investments up front, which allows you to deliver the product to consumers down the road. Crowdfunding is a viable option for startups when you’re attempting to prove an idea. It also helps with your pitch if you’re intending to take additional funding from a VC or angel investor. In itself, crowdfunding isn’t the best option for long-term funding and doesn’t necessarily indicate how the product will perform in the real world.

Unlike crowdfunding, an angel investor invests capital in a company in exchange for equity in that company. When compared to VC, angel investors are more forgiving on the metrics used to measure potential investment. They expand the reach of the VC model. Typically, it takes less time with an angel investor than it does to raise a similar investment with an AC firm. It works well for those who need quick access to funds. In addition, there are angel investor groups, which provide even more access to capital. One of the caveats of VC is that it’s a lot like getting married. But if things go south, it’s a lot tougher to get a divorce.

While all VCs are not created equal, they do offer portfolio benefits, access to experts, productive board members, value added investors and follow-on capital. VCs are set up to help a startup grow and evolve. Often, additional capital is reserved for follow-on investment rounds, unlike crowdfunding and angel investors. With experience, specific expertise and additional funding, VCs bring a lot to the table besides just a check.

Every startup is going to have its own unique needs, and some may be better suited for crowdfunding, VC or angel investors. Whichever one you choose, it’s critical to have a plan for the money, so the right investment can be targeted.

The Liability of Issuers in Crowdfunding

Under the Securities Act, Securities Exchange Act and the Code of Federal Securities (CFS), issuers in crowdfunding can be legally liable. Section 12(a)(2) of the Securities Act imposes liability on an issuer who includes an untrue statement, omits a material fact or makes a misleading statement. Rule 10b-5 of the CFS makes it unlawful to defraud or act in any way that defrauds or deceives the other person. Section 5 of the Securities Act generally requires all offerings of securities to be registered with the SEC. All crowdfunding offerings count on regulatory exemptions. However, those exemptions must meet specific requirements. If an issuer doesn’t fulfill all of the requirements, the issuer has engaged in an illegal offering and is liable.

The newly added Title III of the Jumpstart Our Business Startups Act requires all companies using crowdfunding to file financial statements for the past two fiscal years. Companies with offerings over $500,000 must submit audited financial statements, and smaller offerings need to be certified by the company’s CFO or an independent public accountant. Additionally, offerings must go through an online portal hosted by a registered broker dealer. Overall, the new regulations aren’t too burdensome. The focus is on due diligence, fraud and helping to ensure that inexperienced investors don’t get over-extended. Companies that participate in crowdfunding are taking on liability with misstatements in any of their disclosures.

There are also state common law rules and state statutory rules. Issuers can be liable for fraud, breaches of fiduciary obligation and breach of good faith. Under state statutory rules, issuers can be liable for failing to register an offering under state law or lose an exemption for using an unlicensed broker dealer.

Insurance for Crowdfunding

Up to 90 percent of startups do not succeed, and many close their doors within an average of three years. Other risks include fraud, inexperienced project owners, intellectual property theft and illiquid investment. Typically, investments made via crowdsourcing have no secondary market; crowdsourcing platforms don’t provide intellectual property theft protection; and project owners don’t know how to stretch funds over the long term. Without a doubt, there is high risk.

Preliminary SEC rules required crowdfunding platforms to have a fidelity bond of at least $100,000. This form of insurance protects online platforms from dishonest employee acts. It does not provide investor insurance or claims against the platform for technical failure or data breach. This leaves project managers and investors with additional risk. Hence, a new market of crowdfunding insurance is emerging. Soon, there will be intellectual property insurance, Director and Officer insurance to protect owners from claims made against the platform and investor insurance. Some insurance agencies are beginning to offer these types of insurance policies to fit the crowdfunding investment model.

The field of potential investors is now much larger with the passing of Title III. Non-accredited investors making less than $100,000 per year can now participate in equity crowdsourcing. The pool of investors has expanded to over 200 million individuals. Despite the high risks associated with crowdfunding, many investors manage to reap high rewards. Avoiding the common pitfalls is key to success. With proper due diligence, it can be well worth it.

About Author:

 Stephen Thienel is the founder and managing partner of the Maryland law firm Thienel & Lusk, LLC Attorneys at Law. Stephen specializes in small business law and offers an effective approach to conflict resolution and, if necessary, litigation.

Leave a Reply

Your email address will not be published. Required fields are marked *