By Fred Olds, Contributing Editor
Under new securities laws, biotech entrepreneurs gain increased access to potential investors. The Jumpstart Our Business Startups Act (JOBS Act) of 2012 authorizes biotechs and private companies to use general solicitation (public solicitation) of funds from accredited investors in exchange for equity in their companies using SEC-certified crowdfunding websites.
Amidst industry skepticism, some biotechs have succeeded in crowdfunding their startups. Their experience shows that entrepreneurs will need to hire legal expertise and select crowdfunding sites that cater to their science.
Crowdfunding is not new. Small startups have raised capital on crowdfunding sites prior to the JOBS Act, but legally only by soliciting donations, not selling equity. Think Kickstarter. These sites operate using short time frames and budgets in the thousands of dollars when biotech needs millions.
Biotech has special issues that crowdfunding platforms will need to accommodate. The most significant are the large amounts of money and the long time lines necessary for biotech drug development. Additionally, biotech startups need to protect their IP and find sophisticated investors who understand that IP. Raising large amounts of money through crowdsourcing implies large numbers of investors. But can a small biotech entrepreneur deal with “a crowd” of owners?
BE PREPARED FOR A STEEP LEARNING CURVE
Mike Moradi feels crowdfunding will probably be a large part of capital formation for biotech startups in the future. Moradi is cofounder and CEO of Sensulin LLC, a biotech developing a once-daily glucose-responsive insulin that may mimic a healthy human pancreas. He is a veteran of a number of startups through VCs, but he chose crowdfunding to fund Sensulin. “I had no idea what we were getting into, but we now have investors from all over the United States and sizable commitments from China, Luxembourg, Hong Kong, and England,” he says. “I had a steep learning curve determining how to raise money using crowdfunding. It’s safe to say a number of sites are on their own learning curves.”
Sensulin looked at about a dozen platforms that dealt with healthcare or had a substantial investor base. The company registered with four. One of the four, a site focused on cutting-edge technology, was able to bring in an institutional and several private investors to join Sensulin’s existing institutional investor. That essentially completed Sensulin’s entire Series A round of funding.
The lesson, says Moradi, is that it’s critical, especially for biotech companies, to deal with sites that have expertise in the science your company is developing. “For example, we have proof-of-concept in animal studies. But the average angel investor may not easily understand the significance of that science.”
Even platforms focused on technology may not focus on biotech. You want a platform that does more than simply attract investors who are willing to support your company. Find a platform that is familiar with your company’s scientific space that will be able to provide the legal and business advice to make your proposal attractive to investors. As Moradi says, “You need an audience that knows the science.” Of course, that audience is small and spread worldwide. Crowdfunding brings them to one virtual location.
ENLIST THE HELP OF EXPERTS TO AVOID BEING SUED
Erik Weingold, founder and general counsel at PPM LAWYERS, a law firm working exclusively in securities law and private placement, says biotech startups have had two primary routes to raise capital through equity transactions. A company could file a registration statement with the SEC to sell stock publicly or conduct a private placement under Rule 506(b), Regulation D of the Securities Act of 1933. “Registration is a very lengthy and expensive process,” says Weingold, “so most biotechs use some form or combination of self-funding, debt/loans, warrants, or in the case of equity, a private placement.”
Rule 506(b) authorizes and restricts companies to sell equity in a nonpublic offering to accredited investors and up to 35 nonaccredited investors. Accredited investors are those with a net worth in excess of $1 million, excluding their primary residence, and certain high-income earners. In this type of private placement, individuals can self-certify they are accredited investors. That is, companies can rely on individuals’ statements that they are certified. Private placement may require companies to provide investors specified disclosures about the offering. Weingold warns that companies should employ legal experts in corporate securities. Companies can be sued or even investigated by the SEC and state securities commissions for errors or omissions in these documents even without proof of intent.
"Most biotechs use some form or combination of self-funding, debt/ loans, warrants, or in the case of equity, a private placement."
Founder and general counsel, PPM LAWYERS
A LOOMING MAY 16, 2016 DEADLINE
Title II and Title III of the JOBS Act reduce restrictions on equity transactions, but Weingold feels biotech entrepreneurs may find some provisions of the JOBS Act difficult and expensive, particularly in Title III.
Title II, under Rule 506(c), took effect in the summer of 2013. It generally follows the same disclosure, reporting, and accredited investor rules as private placement with three exceptions. 1) Title II allows general solicitations through accredited crowdfunding portals. 2) Funds can be raised only from accredited investors. 3) Startups have to certify that every investor is accredited. Companies can engage third-party vendor services, lawyers, or CPAs to preform certification; or the company itself can request supporting documentation from investors.
Title III goes into effect May 16, 2016. It opens equity sales to nonaccredited investors. “There are, perhaps, several million accredited investors in the United States, but there are nearly 250 million nonaccredited investors,” says Weingold. That is a lot more opportunity, but there are some problems for biotech startups. A company can raise no more than $1 million annually, and an individual’s investment is limited based on income. Simple math shows that company leadership might have to deal with hundreds of equity holders in making critical decisions, including dilutive funding issues, for instance.
Title III has a lot of regulation and restrictions built into it. “With a $1 million limit and robust disclosure rules,” Weingold says, “frankly, I’m not sure how useful it will be for biotech startups where usually much more money is required. Although, it may be useful as a seed round.”
FINDING “THE RIGHT” INVESTOR WILL BE A CHALLENGE
Crowdfunding sites can be so specialized or general that an entrepreneur’s proposal might be ignored or get lost. Swati Chaturvedi is cofounder and CEO of Propel(x), a crowdfunding site dealing exclusively with deep (cuttingedge) technology. She says selecting the right specialized platform is critical for entrepreneurs developing these technologies, especially in esoteric sciences like those in biotech.
“These are companies that will change the world and lead us into the next century. They make good business sense,” says Chaturvedi. “But there are difficulties investing in deep technology.” Biotechnology is hard to understand. Both investors and startups are rare, making introductions very difficult.
There are few investors who understand life sciences and have a tolerance for technology risk. And those investors are dispersed globally. Chaturvedi says crowdfunding platforms serve as a global nexus for these investors and entrepreneurs. These sites can reach thousands, even hundreds of thousands of investors.
In addition, crowdfunding platforms can help entrepreneurs reduce the challenge of dealing with numerous investor owners.
KEY ELEMENTS TO LOOK FOR IN CROWDFUNDING SITES
Many platforms offer hands-on instruction and tools to improve the chances a company will catch the eye of an investor. Crowdfunding site EquityNet, for instance, provides a standardized template to help companies analyze the marketplace, develop business plans, and determine funding requirements. CEO James Murphy says, “A standardized business platform provides peer-to-peer evaluations. Entrepreneurs can compare their results to others in the same industry using that same template.”
Choose a site that actively introduces investors to appropriate startup opportunities. Look for features such as database screening so investors can search for companies in their areas of interest, and entrepreneurs can identify likely investors. When an investor finds a company to discuss a possible deal, disclosures and due diligence should be well-formed virtually before the parties ever meet. “Imagine the time saved for both sides by eliminating a long series of lunch meetings to discuss terms,” says Murphy.
Consumer feedback is very important when choosing a crowdfunding platform. Look for sites that provide some process for investors, peers, or experts to make suggestions to entrepreneurs on improving their business plans. Unlike presentations at investor meetings, these sites should offer companies the ability to correct missteps in their presentation and repromote their proposal to investors on the site.
“It’s the quintessential American dream to change the world by inventing a new widget,” says Moradi. “These platforms are a way to introduce innovators to investors who share that dream.”