Crowdfunding Law

Let's Get Crowdfunding Right

Month: May, 2012

Startups: Watch the Hypsters-Crowdfunding Exemption is Probably NOT Your Solution

Do not let articles or press releases by crowdfunding portals mislead you into counting on the new crowdfunding investment exemption to fund your current or near-term financing needs. Your company, founders and employees will likely pay a terrible price if you do. As the landing page for the SEC website (the securities regulators–not the college athletic conference that controls college sports) openly cautions: investment crowdfunding is not yet legal. The cold reality is that it probably will not be legal within a time frame that will be relevant for your existing startup business unless you already have enough capital (or have other options beyond crowdfunding) for the next year. Platforms that suggest they are now “opening their doors to entrepreneurs” are either clueless or working on helping their own business–not yours.

What!?! I can just hear the shouts of those of you who know that I am, and have been, a big supporter of the crowdfunding exemption. Look, I share the exuberance now that the JOBS Act has begun the process of making investment-based crowdfunding a reality for everyone interested in participating in startup finance in the U.S. For too long, U.S. securities laws have been outdated and based upon assumptions that intelligence and investment sophistication is only held by the wealthy. But don’t get too excited just yet. Some would-be investment portals are attempting to seize the surrounding press for their own brand development purposes by suggesting that companies should register now in order to be prepared for the coming wave of investment. Don’t buy it. If your business is counting on this capital in the next year, be VERY careful because investment-based crowdfunding in the U.S. is very likely NOT your solution. As long as the utility of the new law does not get killed before then, the investment crowdfunding exemption is going to be a great solution for the companies that get started a year from now–not those that need capital now.

After starting my own companies and working as a lawyer and mentor with countless others over the last decade, I have never known of a single startup company that was looking for investment but could wait a year for the first closing. Startups need to know that it will likely be at least a year before the crowdfunding exemption is a reality for fundraising. The JOBS Act gives the SEC 270 days to promulgate the necessary rules. That means the rules could be known as of December 31, right? Maybe earlier?

Well, not likely. In fact, look only to the SEC’s missed deadlines under Dodd-Frank to suggest that it could be much later before the rules are issued. The Davis Polk firm points out that, as of May 1, 2012, the SEC missed 148 rule making deadlines under Dodd-Frank (67% of the deadlines that had passed). Will the SEC have more resources to direct to a new crowdfunding exemption that the SEC itself did not support? Suspicion is prudent. Do not expect to be fundraising on January 1, 2013.

Let us be optimists for a minute and predict that the SEC will meet the deadline. Part of the process will require SEC registration for crowdfunding portals under these new rules. Will that happen contemporaneously or only after the full rules are known?  How many crowdfunding portals will register? How long will it take for the SEC to review these applications from all of these would be portals? If this process only begins after the rules are fully implemented, start making yourself comfortable.

There are many other places where timelines can slip.  Will SEC officials be impacted by a presidential election that could impact their jobs? How about an impending change in administrations that will clear out the higher offices in the agency? What if that election involves a win by an administration with deep private equity ties that might have a strong opinion on how the crowdfunding exemption should or should not work? Those lobbying dollars will get a seat at the table come November–likely before the rules are released.

What about FINRA? What role will it play? Remember, no Congressional “deadlines” apply to FINRA.

What if the rules, when promulgated, throw the baby out with the bath water and make the actual exemption useless or impractical for your business?

The point is this: early-stage capital is still very hard to find but do not gamble your company’s future on using the crowdfunding exemption for financing needs just yet. Neither the companies relying on crowdfunding soon nor the would-be crowdfunding portals themselves that are “creating a pipeline” or “opening their doors” for this investment exemption will likely be around when the law actually goes into effect. Crowdfunding sites that are clueless or using hype and self-promotion do so at the expense of startups who need financing. This is not the way for a new industry to engender confidence and trust with these startups who are desperately in need of capital soon. Stay tuned.

Kicked to the Curb: Wisdom of the Crowd Roots Out Apparent Fraud

People are prone to finding validation of their own opinions rather than thinking critically about the basis of those opinions.  Therefore, the story of an apparent fraud attempted through Kickstarter has the potential to be used by critics of crowdfunding and supporters alike.  Critics will see this as an example of impending massive frauds.  Advocates of crowdfunding will use it as an example of how the wisdom of the crowd is the most successful tool for self-regulation.  In my last post, I argued that adding a securities exemption under the JOBS Act was not likely to make crowdfunding more attractive for fraudsters because the existing crowdfunding sites that use donation-based crowdfunding would be much more attractive tools to perpetuate such frauds.  After all, Kickstarter is obviously not discriminating in the projects they now host.  They do not have any apparent built-in protections on how the funds raised are ultimately used and contributors do not have any real mechanism to know what happens with those funds.  Why would an enterprising fraudster wait for an investment platform where SEC disclosures will be required and contributors would have an expectation of not just being repaid but to receive an economic return?  My point is that some of the existing platforms are much more susceptible to fraud than any investment platform will ever be.  But even so, we had not seen evidence of any such fraudulent activities.

Enter “Mythic: The Story of Gods and Men”

Now we have evidence of an apparent fraud by promoters of a potential video game on Kickstarter.  It appears that the project promoting “Mythic: The Story of Gods and Men” as a video game was in virtually all respects, well, mythic.  That some enterprising fraudsters apparently faked bios, stole graphics and invented a business opportunity is disappointing.  However, the fact that this story was uncovered by the crowd with amazing speed is evidence that crowdfunding is inherently geared toward thwarting such frauds.  Detailing how this was uncovered is outlined by others in such detail that I cannot add to it.  The point is, the system worked and no one lost their contribution to this apparent scam.  Does anyone think regulators would have been as effective?  Chalk one up for the crowd.

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