By George Colindres at law firm Perkins Coie
I recently participated in a panel discussion on crowdfunding for biosciences, and I wanted to share some of the ideas we discussed. Although focused on life sciences companies, many of the issues are applicable to tech companies too.
There are different types of crowdfunding. Crowdfunding where the contributor receives an ownership interest in the business that is collecting the funds is different than crowdfunding where the contributor receives goods (e.g., some product to be developed using the contributions or a tchotchke) or nothing at all. This first type of crowdfunding is referred to as “equity crowdfunding,” and because the ownership interest is a “security” under federal and state securities laws, it is highly regulated.
Why is equity crowdfunding important? Some are hailing equity crowdfunding as a democratization of investment, which gives the “little guy” access to high risk -- but also high potential reward -- investments previously only available to angels, venture capitalists and the like. I will not argue with this. However, from the entrepreneur’s standpoint, the importance of equity crowdfunding lies in the potential to solicit funds from the public at large -- whether or not the investors end up being the little guy. Under securities laws as they currently stand, only companies registered with the SEC can offer their securities to the general public. There are various federal and state private placement exemptions that allow the sale of securities to certain types of investors, but the offering of the securities cannot involve a general solicitation to the public at large.
What are the laws with respect to equity crowdfunding? As my colleagues have discussed in prior Founder Tips of the Week, the SEC has not yet developed the regulations implementing the Capital Raising Online While Deterring Fraud and Unethical Non-Disclosure Act, or “CROWDFUND Act”, but even if these regulations are implemented as described in the Jumpstart Our Business Startups Act (the JOBS Act), equity crowdfunding will have significant costs associated with it.
Costs of equity crowdfunding. As discussed by my colleagues, if the CROWDFUND Act is implemented as contemplated in the JOBS Act, entrepreneurs who receive equity crowdfunding will have to bear the burdens of:
(1) potentially having to manage relationships with hundreds of minor investors, some of whom may be unsophisticated and may require more “hand-holding;”
(2) paying the fees of broker-dealers and funding portals; the fees currently charged by crowdfunding sites are likely to increase (they typically charge a few percentage points of the funds collected) if the SEC begins regulating them as funding portals in connection with the CROWDFUND Act; and
(3) providing investors with the information required by the CROWDFUND Act. In addition, companies that receive equity crowdfunding may scare away certain types of future investors. Venture capitalists are sometimes hesitant to invest in companies that have more than a handful of angel investors, even though such angel investors may be sophisticated. Venture capitalists are likely to have a similar and more intense reaction when faced with a company with hundreds of unsophisticated investors. Finally, many who have not engaged in crowdfunding do not understand how much marketing is involved. Those raising funds on crowdfunding sites have to actively reach out to their contacts and others to try to raise funds. It is a time-consuming process that takes time away from other endeavors.
$1 million may not be enough for life sciences companies. The CROWDFUND Act limits the amount of money that may be raised through equity crowdfunding in a 12-month period to $1,000,000. This may not be enough for some companies, particularly given the costs of raising those funds cited above. Life sciences companies, in particular, can have product development, clinical trial, patent prosecution and other costs in the hundreds of millions of dollars.
There is a place for crowdfunding in the life sciences. Nonetheless, there is a place for crowdfunding in the life sciences. Crowdfunding should be considered with other capital raising tools, and life sciences companies do not necessarily have to give equity in return for contributions. Life sciences companies are often engaged in endeavors that have the potential to benefit mankind in general, and the public is often receptive to donating funds to such philanthropic endeavors whether or not equity is offered in return. Crowdfunding sites are already chock-full of researchers raising money to conduct preliminary studies or build prototypes. This pre-incorporation fundraising should continue. Admittedly, it will be more difficult for a company that has raised a few million dollars to use this philanthropic angle to raise non-equity crowdfunding, but it can be done. For example, a company might crowdfund to raise money to be able to provide its medical device, drug or treatment to an underserved community or a terminally ill patient (e.g., pursuant to a compassionate use exemption) that it would not otherwise be able to provide due to budget constraints. I have also seen life sciences companies provide contributors with other non-equity rewards, such as exclusive updates on the progress of their studies.
Watch out for Rule 506. The JOBS Act’s also called for changes to Rule 506 of Regulation & D. Rule 506 permits a company to raise an unlimited amount of funds so long as securities are sold only to accredited investors and to not more than 35 non-accredited investors. Pursuant to these changes, companies raising funds under Rule 506 would be allowed to engage in general solicitations to the public at large so long as they sell only to accredited investors. This may end up having an even greater impact on the way start-ups raise funds than the CROWDFUND Act.
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