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Cautious optimism seen as equity crowdfunding begins

Lawyers: benefits, flaws revealed in SEC’s rules

hron-benjaminWhile there hasn’t exactly been a stampede to online exchanges, “equity crowdfunding” — a means of raising capital from throngs of non-accredited investors, many of modest means — is off to a somewhat promising start, according to local attorneys who have been monitoring the situation closely.

The wait for the Securities and Exchange Commission regulations related to the federal exemption under the securities laws created by the 2012 JOBS Act had been a long one. The SEC was particularly concerned about protecting members of the public from overextending themselves on an admittedly risky form of investing.

To that end, the regulations contain a sliding scale of annual investment limits: Those with an annual income or net worth under $100,000 can invest the greater of either $2,000 or 5 percent of their net worth during any 12-month period. Those with an income and net worth over $100,000 can invest up to 10 percent of the lesser of those two figures but are capped at investing no more than $100,000 annually.

In the six months since the window opened on May 16, 132 companies, most of them startups, have come forth to seek funding, including four based in Massachusetts. One — Beta Bionics, which manufactures a bionic pancreas for Type 1 diabetics — has become one of equity crowdfunding’s early success stories, quickly raising the full $1 million allowed under the SEC’s rules.

But extrapolating any larger lessons from Beta Bionics’ campaign may be a fool’s errand, given the perfect storm of its product and audience, said Serafina Raskin, the company’s vice president and general counsel.

While many companies pledge dedication to their customers, Beta Bionics’ devotion runs uncommonly deep. Like Raskin herself and several board members, CEO Edward Damiano is a parent of a child with Type 1 diabetes. The company also was formed as a public benefit corporation under Massachusetts law, which allows it to put being socially responsible ahead of being profitable.

Raskin said people with a personal connection to Type 1 diabetes would email “all the time,” looking to back the company financially.

“We were forced to say, ‘At this time, we don’t have a vehicle for that,’” Raskin said.

Then equity crowdfunding came along. Beta Bionics was one of the first offerings out of the gate in mid-May and was oversubscribed in short order.

In addition to what Raskin joked is “almost a cult following” among those with a personal connection to the disease, the company also had the benefit of “amazing scientific results” documented in the New England Journal of Medicine. Thus, the company had reason to believe that it had the support to meet its $1 million goal. The pleasant surprise, Raskin said, was that its credentials attracted investors beyond the “cult.”

Beta Bionics had other built-in advantages as well, none the least of which was having a general counsel — Raskin — on board, so that it did not have to expend the potentially prohibitive cost of outside counsel, while also going far beyond the SEC’s minimum filing requirements.

“We hold ourselves to a higher standard,” she said. “It’s not like we’re selling bow ties.”

Beta Bionics also is fortunate to be well-capitalized for where it is, Raskin said. The $1 million it could raise through equity crowdfunding was not a make-or-break proposition but more about giving its potential customers a personal stake in the company for which they had been clamoring.

Early returns

Local attorneys’ read on equity crowdfunding is that it has the potential to be a useful, if imperfect, tool in the right situations.

That its adoption has been somewhat slow is “to be expected,” said Jeffrey A. Clopeck, a partner at Day Pitney in Boston.

“People are feeling it out,” he said. “The real question is the level of activity after a year or so.”

One concern that surfaced almost immediately was that the $1 million cap on equity crowdfunding may make it a nonstarter for many. A bill proposing to raise the cap to $5 million was approved by the House Financial Services Committee in the spring but stalled thereafter.

Count Raskin among those who would be in favor of raising the cap. For many companies, it currently doesn’t make sense to spend $200,000 in legal fees to chase $1 million in funding, but it might make more sense to do so if the amount were $5 million, she said.

Raskin also is in favor of raising the number of investors an entity can accept before being treated as a publicly traded company, given how disappointing it was to have to turn away some potential investors.

The financial limits on individual investors also are too low, said Samuel A. Effron of Mintz, Levin, Cohn, Ferris, Glovsky & Popeo’s New York office. Raising both would make equity crowdfunding more useful to a wider range of companies, he said.

Last December, Effron and Kristin A. Gerber of Mintz’s Boston office co-authored an alert whose title pessimistically asked: “Is Equity Crowdfunding D.O.A.?”

Effron said he is still generally down on equity crowdfunding’s potential but acknowledged it has “proven useful” in some circumstances, namely smaller business that may have encountered difficulty tapping other funding sources, such as venture capital or angel investors, which are typically available to entities with higher growth potential.

His and Gerber’s pessimism is rooted in part in the “particularly burdensome and expensive” compliance requirements for issuers and intermediaries, beginning with the SEC’s new required form, known as Form C, which asks for detailed information about the issuer and its business.

In addition, issuers are required to provide investors with financial disclosures, with the complexity of those disclosures climbing as the fundraising goal increases.

The early evidence is that business owners are indeed giving strong consideration to those requirements. Many are setting their goal at $100,000, the limit to fit into the first disclosure tier, which requires only that the company’s principal executive officer certify financial statements and tax-return line items. A penny more, and financial statements have to be reviewed by an independent public accountant; at a penny over $500,000, the independent accountant’s review becomes a full-blown audit.

Benjamin M. Hron of McCarter & English in Boston noted that almost none of the initial issuers announced that they were targeting sums in excess of $500,000, though some, like Beta Bionics, exceeded their goals.

“Clearly, people were trying to avoid the more significant burden in terms of getting reviewed financials,” he said.

Unlike issuers that rely on the SEC’s Regulation D to conduct private offerings, equity crowdfunders will be subject to ongoing annual public reporting requirements after an offering is completed, Effron and Gerber noted.

“These annual reporting obligations are not indefinite, but they will last for most issuers at least one year,” they explained.

Still, at least in some circumstances, the power of crowdfunding sites such as Indegogo and Kickstarter — in which supporters of a project might get first dibs on a product that a business or artist is trying to bring to market — has translated to an environment in which backers receive securities, rather than a souvenir T-shirt or other token of appreciation.

The attorneys differed somewhat as to whether the 132 offerings thus far are a good number. While Effron was less than impressed, Hron said he was “pleasantly surprised.”

“People are clearly interested in giving it a chance,” he said.

So, too, are the investors. Clopeck likened it to the Green Bay Packers, a professional sports team owned by stockholders, whose shares were purchased for reasons other than their liquidity.

In the six months since the window opened on May 16, 132 companies, most of them startups, have come forth to seek funding.

Trends

Enthusiasm for a particular product may explain some of the early trends attorneys have detected with equity crowdfunding.

Effron noted that of the initial 126 offerings, half of the 17 that met their funding goals related to food, wine or beer.

Like Effron, Hron was not necessarily expecting that to be the case, though it makes sense, he said, given that those are physical products that people can get behind, which are not particularly capital intensive.

“In some ways, I’m not surprised,” Effron agreed, noting that crowdfunding allows businesses to tap into “affinity groups” of people who may already be enjoying, say, one restaurant and want to see a sister eatery become a reality.

While not an eatery, Beta Bionics likely benefited from a similar phenomenon. But Hron said that Beta Bionics is also part of a trend that was more predictable. Many of the companies availing themselves of equity crowdfunding are from the tech sector, or at least have a technology component.

Another trend, Effron said, is that a large percentage hasn’t raised any money at all, with only about 45 percent of the offerings garnering more than $10,000 in pledges.

One issue may be advertising restrictions, which require issuers to direct would-be investors back to the funding platform and limit how much they can promote on their own websites and social-media channels, he said.

Even for successful campaigns, that’s an issue, Raskin said, noting that Beta Bionics declined news media inquiries while the offering was pending out of an abundance of caution. The regulations and guidance from the SEC indicate that the company would have been held responsible for everything in those news articles, even if they were not the source of the information, she noted.

Effron pointed out that, geographically, a good chunk of the businesses making offerings “are still in places where you’d expect.” With a few dozen, California has the most, while another 10 or so emanate from New York, not exactly states starved for financing options. To the extent that equity crowdfunding was intended to democratize financing and extend it to “flyover country,” there is work to be done, he said.

Unsurprising, Hron said, is that it has generally been newly formed companies seeking seed capital that have been giving equity crowdfunding a shot: two-thirds of issuers had existed only since 2014, and one-third had been formed this year. About two-thirds have fewer than three employees, and about the same portion are “pre-revenue,” he said.

“I’m a fan of the concept, and I think it has a lot of potential,” Hron said. “One of the big questions has been: What industries will this work in? For some industries, where capital requirements are fairly small, it could be a great way to launch a new business that may never need capital again.”

“I think it’s going to take a while — I don’t know if it’s one year or five years — to figure out where the pain points are in the regulations.”

— Benjamin M. Hron, Boston

Future issues

As a corporate lawyer, Clopeck said he envisions some “post-closing difficulties” eventually surfacing with equity crowdfunding.

“If I’m a small privately held business, the last thing I want to do is have 200 stockholders to communicate with and answer to,” he said.

And yet, that’s exactly how many of the offerings have been structured, he noted, adding that the challenge in keeping those stockholders happy is a chapter that has yet to be written.

Effron and Gerber also wrote about the concern that issuers and perhaps intermediaries will find a drawback to be greater exposure than exists with Regulation D offerings.

With equity crowdfunding, companies are liable to investors for material misstatements and omissions, and the liability may extend to their individual officers and directors. With Regulation D, an investor must prove actual intent to defraud or reckless indifference to the truth of the representations made to bring a federal claim, and there is no liability for individual officers and directors.

“This new liability is a real risk that issuers and intermediaries and their principals may not want to expose themselves to for the limited offering amounts available,” they wrote.

But the bottom line, according to Hron, is that it’s probably too early to draw any definitive conclusions, especially given the apparent willingness of Congress to tweak the regulations as needed.

“I think it’s going to take a while — I don’t know if it’s one year or five years — to figure out where the pain points are in the regulations,” he said.

Only time will tell, too, whether the deals prove to be viable, not just for the issuers and investors, but the rest of the ecosystem — including the operators of the portals, lawyers and accountants — that has and will continue to grow up around equity crowdfunding.

“Eventually, everyone follows the money,” Hron said.

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