As you are probably well aware by now, Congress passed a federal crowdfunding law.

This was really exciting.

But the federal law is problematic for many, many reasons.

What are the problems with the federal crowdfunding law? To name just a few:

  1. Companies won’t be able to use crowdfunding as a fundraising tool until the SEC issues lengthy, complex regulations. We have no idea how long this will take. Already the SEC has delayed issuing regulations on a much simpler topic. The crowdfunding regulations may very well be delayed as well.
  2. The federal crowdfunding exemption forces companies to use registered broker-dealers or registered funding portals. Most private companies raising funds do so without the help of broker-dealers or other intermediaries. But for a company to crowdfund under the federal exemption, it will be forced to use an intermediary. This is unfortunate.
  3. By virtue of the particulars of the law, companies are going to have to expend significant resources in order to comply with it to raise funds (e.g., PPMs, audited financial statements, etc.). It is going to be very expensive. Call it “Sarbanes-Oxley for Startups.” The law’s costs and burdens are disproportionate to the capped amount of money companies are allowed to raise.

In short, the federal law is, in the opinion of many (and not just lawyers, but other business persons as well), not going to work very well. It is unfortunate that out of the JOBS Act the law appears headed toward making it more difficult for early-stage companies to raise money rather than the opposite — when it was clearly the intention of the Congress that the JOBS Act would make fundraising for early stage companies easier.

It is a common lament in Washington that there is not enough funding to go around for all of the companies here. We suffer some “flight”— meaning that smart folks take their pitches to Silicon Valley, where there is more money to fund companies. I agree that we need more money for companies here, and that is why I am writing to advocate that the state of Washington should adopt its own “mini-crowdfunding” law.

It is not uncommon for states to pass “mini” laws. For example, California has a “mini-Warn Act.”

Washington should enact its own mini-crowdfunding exemption, but it should not be modeled on the federal act. Instead, the Washington Securities Division or the Legislature should craft an exemption that will work for local businesses and investors.

What Does A Good Crowdfunding Exemption Look Like?

A “good” crowdfunding exemption would have the following elements:

  • A simple, easy-to-determine aggregate proceeds amount, for example not to exceed $1 million during any twelve month period); normal integration standards would apply to prevent evasion.
  • A simple, easy-to-determine per investor limit, for example no more than $1,000 per natural person or legal entity.
  • Support from state regulators to issue simple regulations or to support legislation in order to bring the exemption to life.
  • Protection for directors and officers so that they can have some certainty that they are not going to be personally liable in the case of a business failure (excepting fraud or breach of fiduciary duty, obviously).

The Statutory Approach: Proposed New Statutory Provision

I propose a new subsection to RCW 21.20.320, which exempts certain transactions from the state securities law registration requirements. I propose a new RCW 21.20.320(18) to read as follows:

“The following transactions are exempt from RCW 21.20.040 through 21.20.300 and 21.20.327 except as expressly provided:
(18) Any issuer transaction or sale, if:

    a) the aggregate offering proceeds do not exceed $1 million during any twelve 12 month period;
    b) all purchasers of securities in the offering are residents of the State of Washington as of the purchase date;
    c) no offers of the securities are made to persons who are not residents of the State of Washington;
    d) only entities organized in the State of Washington and doing business in the State of Washington may be issuers;
    e) no purchaser invests more than $1,000 in the offering;
    f) each purchaser executes in writing, in a separate written document, the following:

“I acknowledge that I am investing in a high-risk, speculative business venture, that I may lose all of my investment, and that I can afford the loss of my investment.”

    g) no investor who has signed the aforementioned acknowledgment may bring an action against the company or any director or officer of the company except in the case of fraud or breach of fiduciary duty; and
    h) the offering is conducted in accordance with the requirements of Section 3(a)(11) of the federal Securities Act of 1933.”

Why Washington Residents Only?

Joe Wallin

You might ask: Why limit this exemption solely to Washington residents, and why prohibit the offers of the securities to anyone but Washington residents? The answer is that we have to fit within federal securities law requirements.

Section 3(a)(11) of the 1933 Securities Act exempts from registration “any security that is part of an issue offered and sold only to persons resident within a single state if the issuer is a person resident and doing business within or, if the issuer is a corporation, incorporated by and doing business within that state.”

Federal laws provide a federal “safe harbor” for offers and sales in compliance with Section 3(a)(11) and creates a checklist for compliance with the federal standard that could be built into a Washington crowdfunding exemption.

Washington companies utilizing this exemption would have to take steps to ensure that no non-Washington residents were offered or sold securities in the offering. This requirement could potentially be satisfied by requiring certifications by prospective investors that they are Washington residents in order to log into secure portals to review potential transactions. Each issuer could be required to certify that it is truly a local Washington business, with its principal office in Washington, generating revenues primarily from Washington operations.

Help From State Regulators

To make crowdfunding a reality under a Washington-specific exemption, advocates, as a practical matter, will need to convince our state securities regulators that the benefits of crowdfunding as a local financing strategy outweigh the potential costs of administration and the risks to the public.

If state regulators can be involved in the process of drafting and passing proposed legislation (or, alternatively, adopting a state rule), it will be possible to craft a crowdfunding exemption that will work. Washington could become a leader in crowdfunding, and attract the next generation of entrepreneurs here.

Conclusion

Washington recently became a leader in Social Purpose Corporations. It needs to become a leader in crowdfunding as well.

Joe Wallin is an attorney at Davis Wright Tremaine. He’s the editor of the Startup Law Blog. Related posts: Crowdfunding: Current Legalities & Proposals… The President Favors Crowdfunding, But Is It Good Enough?The Troubles With The New Crowdfunding Law


Comments

  • Guest

    This is a good analysis. I’ve already seen through the Kickstarter “get a free trinket if you invest in our game” scam, but I was wondering why I wouldn’t be able to help myself to a piece of the profits. We need small-scale investment gathering to help put the power of venture capital in the hands of the customer where it belongs.

    • joewallin

      We need @jayinslee to pick this up. During the campaign, @robmckenna responded to me on Twitter that he liked the idea…

    • Steve Chayer

      KickStarter a scam? How careful an investor are you to be labeling this funding model so callously??

      • Guest

        Do me a favor, Steve, and google “Kickstarter scam.” Not every project on there is a scam, but if you do some due diligence, you’re staking your money with virtually no recourse if the project fails and no ownership (except for the aforementioned trinket) if the project succeeds. The only winner here is Kickstarter itself, which takes a cut of every dollar kicked into a project.

        I invest, Steve. Not even a gambler would like the odds Kickstarter offers.

  • http://wac6.com/ William Carleton

    Great call to action, Joe. Love that you are actually supplying, not only the diagnosis, but a remedy.

    Quick question: under clause (d) of your proposed exemption, would an issuer have to be a WA corporation, or could it be a DE corporation that is qualified to do business in Washington State?

    • joewallin

      Would have to be incorporated in WA.

      • http://twitter.com/garyjaybrooks Gary Jay Brooks

        Could you be a international company and move your corporation to WA and run under WA exceptions?

        • Squareholder

          Doing business in the state of issuance could mean that you need to earn 80% of your revenue from that state. This could be quite difficult for some companies, especially in tech.

  • Guest

    I think crowdfunding could potentially work well, but I don’t think it will if potential investors don’t get a little more transparent view of how the crowdsourcing market as a whole is performing. Otherwise, the air will be filled with anecdotes about jackpot returns and total losses, but there will be little sound information about anything in between available to anyone except mini-angles who invest $1K across each of hundreds of crowdfunded startups.

    Reporting doesn’t have to be at the level of public company reporting, but I think it’s perfectly reasonable that any further equity investment rounds, convertible debt offerings or M&A activity be reported, along with the associated valuations. Dissolutions would be reported as well. The state can then report aggregate statistics and distributions of outcomes over time. Armed with this information, a potential investor has a better view of the industry.

    Potential investors could go to a website and learn that one year after crowdfunding:

    – X% of crowdfunded companies still exist as going concerns;
    – Y% have taken further investment, with an average valuation change of Q% from when they were crowdfunded and an average dilution of D%.
    – Z% have been acquired, generating an average return of R% for investors.

    More than just averages, deciles or even full distribution curves would be ideal. Obviously those who invest in the first year of the program would not get this information because it would not exist. But over time it could be published for two to five year horizons as well.

    None of this creates any serious burden on the companies. Any event that triggers a reporting requirement already requires the company or its counsel to produce documents containing the relevant numbers. All that is added is that they have to log into a web site and type them in.

    This data gives us all a way to understand, at least in aggregate, how the crowdfunding program is performing. We don’t have to wait for a financial archeologist from a business school to dig up the data years after the fact and analyze it. Every founder’s elevator pitch will still claim they are going to be way above average for one reason or another, but at least investors will have a yardstick to measure their claims against.

    If investing in a crowdfunded startup ends up looking like buying a lottery ticket or spending a weekend gambling in Vegas, potential investors will know that and can choose whether to invest or not. If it ends up looking roughly as risky as investing in public companies, investors will know that too.

    Either way, the transparency is going to help the market be efficient, attract investors with the appropriate risk appetite, and reduce legal claims against officers and directors by investors claiming they were inadequately informed.

    • joewallin

      I agree, but we need to keep the law simple. The federal law is atrocious, and ridiculous.

  • http://www.facebook.com/people/Martin-Tobias/1406231168 Martin Tobias

    this is idiotic. $1k limit per investor. never work.
    we need a workable crowdfunding process. but your proposal (and the feds) is not it. bummer.

    • joewallin

      Martin, well, the first step is to get a state legislator–any one of them–to actually sponsor this. You can ask them to bump up the per investor imited to whatever you desire. Call your legislators and ask them to pick this up!

    • Steve Chayer

      I agree. Why just 1 million? Seems arbitrary to me.

      • joewallin

        Contact your legislator. Ask him or her to support it. And tell them you prefer a higher aggregate raise amount than $1m.

  • BradMueller

    One sure way to kill an idea is to get the government involved in it. It was nice while it lasted.

  • http://bottomlinelawgroup.com/ Antone Johnson

    Joe, what a great idea to implement at the state level! I’m on the record* as a strong skeptic regarding equity crowdfunding in general; I think the great paradox is that the more issuer-friendly it is, the more it will attract widespread abuse of investors by snake-oil salesmen. But I would love to be proven wrong, and I can’t think of a better way to silence critics than to try it out in a state like Washington and witness its success.

    *See http://gust.com/angel-investing/startup-blogs/2012/03/19/crowdfunding-train-wreck/

    • joewallin

      Thanks Antone. I think that if we have companies publicly announcing that they are raising money, many, many web sites will pop up evaluating these offers. Scammers will be called out immediately. At least, that is the theory. We wont’ know until we try it!

  • http://www.facebook.com/wmcunningham William Michael Cunningham

    The JOBS Act is designed to reopen American capital markets to small companies, in part via crowdfunding. Like open source software, crowdfunding is simply open source financing. The regulations required by the JOBS Act are clear.

    So is the task before the SEC. I like the idea of moving on your own if the agency takes longer and makes this more complicated than it needs to be. I discuss this in my book on Crowdfunding: http://www.amazon.com/The-JOBS-Act-Crowdfunding-Businesses/dp/143024755X

    • joewallin

      William, thanks for your comment. Even if the federal regulations are issued in the next 6-12 months, federal crowdfunding is still going to be very expensive. If you want to raise more than $500,000, you are going to have to have audited financials, for example. And you are going to have to work through a registered broker-dealer or registered funding portal. State-level crowdfunding has the opportunity to be substantially less complex and substantially less expensive than federal crowdfunding. We have a significant state-level opportunity we ought to pursue.

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