How Equity Crowdfunding Can Bankrupt Your Company

smarchiveA recent entry on whiteboardmag.com tells a crowdfunding horror story where a German company called Smarchive had difficulties getting VC investment after a successful crowdfunding round. From the article…

(Smarchive founder) Steffen Reitz: “Back in the time, I thought that crowdfunding was nice and good because it gives companies in countries with little access to preseed money a chance to raise funding. But those platforms are incredibly unprofessional in terms of legal stuff.”

“When we worked with Seedmatch, they told us that crowdfunding wouldn’t cause any problems to raise money later. The truth is that their terms were completely unacceptable to our VC’s when we were raising money later. I mean, there was not one dealbreaker, there were a couple of them. There were so many things in the contract that made an exit impossible.”

Any company should carefully consider the legal framework they agree to by taking on an equity crowdfunding round. The structure of shareholder agreements can limit future financing opportunities if specifics are overlooked. In the case of Smarchive, one particular aspect of corporate law that was neglected was any inclusion of drag-along or tag-along rights.

Drag-along and tag-along rights govern investor options when changes are made in equity ownership.

A drag-along right “assures that if the majority shareholder sells his stake, minority holders are forced to join the deal.” A tag-along right “assures that if the majority shareholder sells his stake, minority holders have the right to join the deal and sell their stake at the same terms and conditions as would apply to the majority shareholder.”

Drag along rights protect majority shareholders while tag-along rights protect minority shareholders. Venture capitalists are going to want to see a drag along right in any shareholder agreement because it protects their right to an exit independent of the whims of a single minority investor.

In the absence of these rights, Smarchive ended up with 140 individual investors. They were not pooled. Any single investor had the option to block a deal. Once Smarchive was able to secure investment from a VC in principle, they had to contact all 140 investors individually. It was a headache to say the least, and it took weeks.

In turn, Smarchive almost went bankrupt, and their crowdfunding investors almost lost 100% of their investment simply due to the difficulties of reaching all of them.

What a mess.

Read more about the situation here, and don’t let it happen to your company if you decide to participate in an equity raise.

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