Photo via Bigstock

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.

William Carleton

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.

More by William Carleton

[Angel funding photo via Bigstock]

Comments

  • http://twitter.com/DaveParkerSEA Dave Parker

    Bill, great post… thanks for tracking and “interpreting” the legislation.

    What I think is most exciting is how Crowdfunding is synching up with the Lean Startup model/movement and how a small amount of capital placed in a highly efficient internet business can be used to validate a business model.

    For the startup it could provide the ability to go raise $5-18k to get a prototype up and running and to prove the concept with customers with efficient marketing spend. With a small amount of capital you might actually be able to get to “traction” (the moving goal posts oft quoted by investors as the requirement for funding).

    $18k… wait that’s the same amount seeded by TechStars – looks like they are onto something.

    Crowdfunding isn’t going to allow you to fund your startup team initially, in fact it could change the dynamics that require Founder to leave Microsoft or Amazon before they get funded… But it would open up seed funding to a new generation of entrepreneurs.

    • goldhat

      Right you are Dave. I don’t see this as a kickstarter type platform at all. This is meant to allow a handful of friends and interested people to get equity in return for their seed investments in the $5K each range that it will take to show product viability and get customer validation, which most angels want to see before kicking in larger amounts. This is much more likely to happen via Linkedin, among classmates, at club meetings, at church, on the golf course, at meetups, and via the incubator communities out there. Nobody wants to post their software business plan on kickstarter, so debating the tradeoffs is kind of pointless. What people with an idea do want to do is explain it to 10 of their friends, tell them that they can get startup equity for this potentially great business idea in exchange for $5k, and that they don’t have to be a 1%er to have the opportunity. And Dave is right, once 3 or 4 of them take the chance, off it goes to the next phase. This is really an exciting prospect. 

  • kagorges

    Angel investors could benefit greatly from the crowdfunding bill in the US: this would enable startups to have enough of a small initial round to prove themselves and provide more data to angels looking to invest.  

    Additionally, serious crowdfunding (unlike kickstarter where there’s no skin in the game as there is with stock) creates greater diversity of the pool of founders: right now the ecosystem favors those who have already had some success because they have the cash to infuse their next startup.  Crowdfunding makes it possible for capable entrepreneurs with innovative products and services to come forward even if they don’t already have connections or experience.All will benefit from opening this opportunity up: angels, startups, and the general public — who will finally have the opportunity to participate in the startup world.

    -Kathryn Gorges

  • Anonymous

    Bill – as always, great and thoughtful
    post.  The original intent of the
    Crowdfunding bill (as drafted by Scott Brown) was to help replace Friends &
    Family money that has dried up with real estate prices.  (Gone are the days when an entrepreneur could
    take out a mortgage on their home!) 

    As every professional angel knows, angel investing is not
    for the faint of heart.  Many deals (even
    ones that seem like a sure thing) go to zero. 
    Some are successful, but take a very long time.  Almost every deal will take multiple rounds.  (There is a reason for the “accredited
    investor” rule!) I don’t think anyone believes that a company can be funded
    from inception to exit by Crowdfunding.

    And, angels provide much more than capital – they provide
    knowledge and assistance. 

    One historical perspective: in the early days of angel
    investing, VCs often would not invest in angel deals.  Less experienced angels (particularly those
    not in groups) would screw up the valuation and terms, so VCs wouldn’t want to
    take the time to fix them up.  As you
    highlight, Crowdfunded deals might follow the same path – the terms might just not
    be right to incent angels to invest.  And
    cleaning up the deal for angels to follow might be a great deal of work, especially
    at a time like this where there are a lot of deals vying for our attention.

    This next year will tell a lot about how this will play
    out.  It’s going to be interesting!

  • http://twitter.com/Drwright1 Dr. Letitia Wright

    I think it will be great if it passes, but if it does not, people will still work to use basic crowd funding for their business.
    Dr. Wright- Wright Place TV Show

  • Anonymous

    @@Bill, thanks — this post was valuable for me in two ways.

    First it reinforced the power of social media (not only had I not heard of you before, I hadn’t heard of your firm — which is rare for me as a 25-year resident, involved with some 50 startups!)

    Second, I had previously blogged about how this bill would further distance VC’s from early stage action — but hadn’t thought through the implications of angel “crowdout”. 

    @@Letitia, presumably you mean continued crowdfunding, just non-equity?

  • http://twitter.com/jclaussftw Jason Gerard Clauss

    You know what would be even better? Getting the government COMPLETELY out of this business. Pretty brilliant huh?

    • Steve Chayer

      Jason, If only it were that simple. I’m the last guy to welcome more regulation, however this new funding opportunity promises to eliminate long standing barriers to entry for so millions of entrepreneurial people. Personally, I think it will create millions of start ups at a pace we can even imagine.  We’d better be careful to protect this resource from the inevitable thieves and incompetents who will attempt to exploit it and possibly ruin it for everyone else. that, I can see would lead to layer upon layer of law that smothers the golden goose.  Sometimes regulation is a good thing. The comments above and below by the legal and lending veterans sheds valuable light on how meaningful regulation is being shaped to do this. I am very grateful. I feel, after reading this that the right stewards are on the scene.

  • Rob Hammond

    I think that you missed the elephant in the room.  What sort of reporting requirements will be required for these “publicly traded” startups?  Are they going to have do be SOX compliant?  Is there a special audit?  How much will it cost the startup?  

    Also, are there startups in the pink sheets markets that you would invest in?  That market is probably what you’ll see if this goes through.  

  • Caroline

    Great post…,

    you wouldn’t believe how this bill is awaited even in France where I created an equity based crowdfunding platform with several friends. 

    Even though we got less problematic regulations here, crowdfunding still isn’t well rewarded by government and laws.

    I truly hope that the bill will pass. If any of you is interested in launching a business, or even to invest in new business feel free to visit our website : anaxago.com. 

    I truly hope that crowdfunding will be the new face of finance in the next decades…

  • http://twitter.com/JoeHarb Joe Harb

    Great article, thank you., Explains well what’s coming up.  Definitely affects the way I’m looking at investors as an entrepreneur, eventhough not at the initial prototype phase any longer.  Looking forward to such a law as it frees entrepreneurs from the burden of raising funds from angels who are approached by so many, and rightfully so, skeptical.  this allows entrepreneurs to raise the necessary amounts with investors taking small and manageable risks, and maybe in a second phase approach angels.

    But even for startup companies at a more advanced stage, raising up to $1MM could be vital and change the outlook of these companies.  Moreover being able to raise the amount publicly allows the company to focus its efforts on developing and selling instead of trying to raise money, which is extremely timeand energy consuming.

    As for the angel investors that are already in, why not a preferential treatment? because the new funds reduce the risk of their own investments as one of the biggest risks startups run into in the lack continuous funding, and in a rollercoaster economy where a demonstrations in athens affects angel investor decisions to make an investment or not may kill a great idea and a great potential.

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