As early as next week, we may know whether Congress will change US securities laws to permit startups to sell stock to the general public over the internet.
You know how, today, companies raise money on Kickstarter by offering products, t-shirts, and other bennies? Imagine those same companies selling stock to investors over a Kickstarter-like platform. If the law changes – and this is something that one chamber of Congress has already passed and that President Obama supports - entrepreneurs seeking capital will have one more alternative to angel investors and venture capital firms.
Sound too good to be true? There is a catch. The proposed law (known as a “crowdfunding exemption”) would apply only to offerings that place strict limits on how much money can be raised and how much an individual investor may invest. For example, the new crowdfunding exemption might say that the startup may raise no more than $1,000,000 in a given year. And that each investor may invest no more than $1,000 per deal. (Actual limits are still being debated in Congress.)
Where does this leave angel investing? By virtue of another securities law exemption, the one typically used by startups for angel financings, startups have no limit on how much they can raise, and angel investors have no limit on how much they can invest. The key difference is that angels are “accredited.”
To borrow from the vernacular of Occupy Wall Street, angels are part of the 1 percent. Crowdfunding would be for the 99 percent.
Some angels like the idea of crowdfunding because they know it will be good for entreprenuers to have more financing alternatives. Others are skeptical and fear the practice will bring disrepute to the startup financing ecosystem (which, admittedly, has been remarkably free of fraud).
But many entrepreneurs and angels I’ve talked to want to know if angel deals and crowdfunding deals can exist side by side.
To put it in legal terms, how should a crowdfunding exemption and the all-accredited Reg D exemption synch up?
Let’s use a hypothetical to illustrate some of the potential problems. Suppose a new startup thinks it should reach out to angels and angel groups, in the traditional way, and at the same time, pursues crowdfunding through an online, Kickstarter-like platform. Suppose it targets raising $500,000 through crowdfunding, and another $1,000,000 from accredited angels. It makes its pitch online to the public, and it presents to meetings of local angel groups at the same time.
In that scenario, at least two key questions arise:
- Are the angels, who are accredited and have no limits on investment under Rule 506 of Reg D, free of the caps on individual investment under the crowdfunding exemption?
- Do the angels and the non-accredited (crowdfunding) investors get the same deal terms?
Probably the biggest impediment to the scenario of angels and crowdfunders investing together at the same time in the same startup, at least if you suppose that angels will have no dollar limits, is Reg D’s prohibition on “general solicitation.”
It’s a bit ironic. For crowdfunding, general solicitation is a-okay. In fact, it’s the whole point. But for the supposedly more sophisticated accredited investors, who ostensibly do not need the protections of the law that the wider public needs, general solicitation kills (at least in theory) the exemption.
The Reg D prohibition on general solicitation is one of those legal rules that has come to be “observed in the breach” and needs to be fixed, one way or another. But in the crowdfunding context, it ought to be expressly clear that the public nature of a crowdfunded offering will not “taint” or disqualify the startup from raising money from angels at the same time it pursues crowdfunding.
Let’s suppose we get past that technical incompatibility between the two exemptions. If we assume that angels will have more bargaining power with the startup, a dilemna arises: should angels have the flexibility to bargain for a different security, or should they receive the same kind of stock offered to crowdfunding investors?
The case will be made — and it will be a sound one (at least to the ears of those of us who participate in the current startup financing ecosystem) — that angels and other sophisticated investors who put money in under a Reg D exemption, by virtue of their larger investment and other factors, deserve better treatment, in the form of a liquidation preference, participation rights, and other benefits.
But suppose a preferred stock offering for accredited investors and a crowdfunded common stock offering happen at the same time. Further suppose the particular startup later sells the company to Google or Microsoft, but for a price that only covers the liquidation preference enjoyed by the angels, leaving the common stock – in the hands of the crowdfunders – worthless.
Don’t the angels and the issuer have at least a perception problem on their hands? To the general public, to the crowd, will this not look like the one percent taking from the 99 percent?
After a lull in activity, the crowdfunding exemption concept is “hot” again, with the Senate now addressing it in earnest. Now is the time for advocates for crowdfunding and guardians of angel investing to huddle and see if they might arrive at a consensus direction to give legislators and their staffers. How should angel deals be coordinated with crowdfunded deals? Are there circumstances in which the two should not overlap?
Attorney William Carleton is a member of McNaul Ebel Nawrot & Helgren PLLC, a Seattle law firm. He works with startups and emerging tech companies, their founders and investors. He posts regularly about tech-related legal issues on his blog.
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[Angel funding photo via Bigstock]