Some equity crowdfunding platforms are putting startups at serious risk. Working with a platform that doesn’t structure your deal appropriately could jeopardize your ability to raise future capital or worse, force you to become a public reporting company.
The emergence of equity crowdfunding is a great thing for entrepreneurs. Equity crowdfunding can save founders a lot of time, it can help them obtain an army of loyal brand ambassadors and it enables them to secure the capital they need to grow. But raising capital on the wrong equity crowdfunding platform can also potentially destroy a company’s prospects down the road. It’s critical that founders do their homework before raising capital through Regulation Crowdfunding to avoid a few potential landmines that can come along with raising capital from hundreds of people.
Traditionally startups raised capital from venture capitalists or a handful of wealthy angel investors and had just a few people on their cap tables. With equity crowdfunding, it’s now becoming common to have hundreds or thousands of investors after your seed round. Some platforms have structured their deals to alleviate all of these concerns for entrepreneurs. But most platforms have not and are putting companies at risk.
The Exchange Act
As we pointed out in detail when the final Reg CF rules came out, The Exchange Act typically requires companies to become public reporting companies when they have 2,000 shareholders of record or 500 non-accredited investors. As part of Title III of the JOBS Act, equity crowdfunding investors will not count towards the shareholder of record count under Section 12(g) of the Securities and Exchange Act of 1934 so long as the following three conditions are all met:
- Companies are current in ongoing reporting obligations;
- Companies do not have assets exceeding $25 million; and
- Companies engage a transfer agent registered with the SEC.
It’s relatively easy for companies to comply with #1 and #3 above so long as they work with a platform that facilitates Reg CF reporting requirements and work with a registered transfer agent. But, #2 is a huge potential landmine for any startups which are successful down the line.
Basically, if you are a startup that raises capital through equity crowdfunding, exceeds 500 non-accredited shareholders of record and scales to greater than $25 million in assets, you will be required to become a public reporting company (just like Apple and GE). Given that the goal of most startups is to grow rapidly and exceed $25 million in assets in a few years (and not go public before startups are ready or potentially ever), this should be concerning.
[clickToTweet tweet=”If you use #RegCF & top 500 non-accredited investors & scale to $25M+ in assets you’re in trouble #Crowdfunding” quote=”If you use #RegCF & top 500 non-accredited investors & scale to $25M+ in assets you’re in trouble #Crowdfunding”]
Equity crowdfunding platforms have known about this huge looming issue for a while now. Therefore, most of them devised a clever way to “keep investors off cap tables” through modified versions of SAFE Notes. These SAFE Notes contain one the following provisions to attempt to address the Exchange Act Issue:
- Unlike typical convertible notes which convert to preferred stock upon a qualified financing, companies may elect to keep these SAFE Notes outstanding indefinitely (ie. until an exit).
- Unlike 100% of angel and venture investments, on some platforms the company may actually repurchase shares from investors at “fair market value” whenever it decides to.
It’s scary that certain platforms are allowing (actually encouraging) investors to invest in deals with provision #2. That is basically saying;
“Hey small investors, if the startup you are investing in happens to actually take off, you are going to get taken out early whether you like it or not.”
So all of this talk about “getting in on the ground floor” and “investing in the next Uber” is total BS because anyone who is lucky enough to actually invest in a good company through these platforms will simply be forced to sell their shares early on, leaving the vast majority of the upside on the table for VCs who come in later. This issue is so alarming for investors that it might just justify its own article now that I think about it…
The thought behind the first provision above, leaving converting notes outstanding after a qualified financing, is that convertible noteholders are not technically shareholders until their convertible notes actually convert into stock. So, if companies keep these SAFE notes outstanding indefinitely, startups will never have to worry about exceeding 500 non-accredited shareholders and getting forced to become public companies…right? Wrong.
Credit to Mark Roderick at Flaster Greenberg who wisely pointed out the following issue with keeping SAFE Note investors from converting into stock in order to keep them off cap tables.
There is a little-known SEC Rule which would count SAFE note investors as holders of record under Section 12(g) of The Exchange Act. SEC Rule 3a11-1 includes “any security convertible, with or without consideration into such a security, or carrying any warrant or right to subscribe to or purchase such a security” in the description of an equity security. Therefore, a company that surpasses $25 million in assets that has 500+ non-accredited investors in a convertible note would still trip-up The Exchange Act and be forced to become a public reporting company.
As an early-stage startup, the last thing you want to do is cutoff your ability to raise capital in the future, or worse, force yourself to go public (and incur millions in costs, among other things) a few years down the road. It’s critical that founders which are considering equity crowdfunding ensure that the platform they are considering has these issues covered. Choosing the right equity crowdfunding platform is important so make sure you ask them these tough questions before you decide to fundraise through them.
Ryan Feit is the CEO and Co-Founder of SeedInvest. Prior to founding SeedInvest, Ryan worked at Wellspring Capital Management and Lehman Brothers in New York City where he invested in, financed, and managed dozens of private and public businesses. Ryan was instrumental in the passage of the 2012 JOBS Act, which changed 80-year-old U.S. securities laws to make it possible for entrepreneurs to raise capital over the Internet. Since then, Ryan has served as a focal point of the budding Equity Crowdfunding industry, co-founding the Crowdfunding Professional Association and serving as a board member of the Crowdfund Intermediary Regulatory Advocates. He also worked closely with members of the SEC, FINRA, the White House, and the Treasury Department on the implementation of the JOBS Act.