Crowdfunding Practical Implications

Thu, 07/11/13
By: Simon R. Inman, Partner

This is the last in a series of bulletins about the crowdfunding exemption from the requirement for SEC registration, as included in the JOBS Act of 2012. Links to the previous three bulletins may be found here. The purpose of this bulletin is to explore some of the practical implications for companies looking to take advantage of crowdfunding.

In the first place, crowdfunding intermediaries and funding portals will essentially act as “gatekeepers”. Although they will not be responsible for promoting the investment opportunity or if investments go bad (absent their own failure to comply with obligations imposed by the legislation or the SEC), in order to build their own brands, they will want to be associated with successful projects. Those who develop a track record of picking opportunities that turn into “winners” will attract more investor interest. This may leave a company with a more “risky” or marginal project either not finding a portal or ending up with a less well respected operation whose involvement may not enhance the prospects (or reputation) of the company.

Second, there is a definite sense that more traditional sources of early stage capital (including angel investors) may be reluctant to invest in companies that have used crowdfunding. The fear is that, if there are a large number of early stage investors, they may be difficult to manage in the later stages, particularly when the company moves on to more sophisticated financing structures or a liquidity event. For companies that are likely to need more traditional follow-on financing, crowdfunding may not be the best option.

Third, having a large number of shareholders presents a number of challenges for what will most likely be relatively small businesses with inexperienced management teams. The enhanced corporate governance responsibilities associated with a large pool of shareholders will definitely create additional significant burdens and costs, especially since many of the shareholders may themselves be inexperienced in terms of understanding what to expect from their investments, the type of information that the company will provide, and their rights as shareholders. The potential for unpredictable behavior on the part of such investors is another reason why later-stage investors may be reluctant to invest later.

To counterbalance this:

• Companies will want to make sure they have effective Directors and Officers insurance. While this may not provide coverage for damages for actual breaches of fiduciary duties that give rise to losses, the coverage will typically cover the costs of defending any shareholder lawsuits.
• Many companies may also opt to incorporate in Delaware which has a reputation for being more management-friendly. However, companies based in California and with a significant proportion of California shareholders will find themselves still subject to many of the provisions of California law that are considered to be more shareholder-friendly.
• It is also to be hoped that crowdfunding intermediaries will help provide a package of services designed to help companies comply with their corporate governance responsibilities, from maintaining the stock register to handling the required annual shareholder meetings and other shareholder communications.

For the time being, we must now wait patiently for the SEC rule making process to be completed before we can fully assess the likely impact crowdfunding may have.

For more information contact Simon Inman at srinman@cmprlaw.com or at (707) 526-4200.

100 B Street, Suite 400
Santa Rosa, CA 95401
www.cmprlaw.com