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Tuesday, November 15, 2011

FAQ: What the new U.S. crowdfunding bill means for entrepreneurs

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Scott Edward Walker is the founder and CEO of Walker Corporate Law Group, PLLC, a law firm specializing in the representation of entrepreneurs.

Last week, the U.S. House of Representatives passed a crowdfunding bill that will allow startups to offer and sell securities via crowdfunding sites and social networks. If passed by the Senate and signed off by the President, the bill will become a law, giving entrepreneurs new options for raising money for their companies. …
What is crowdfunding?
As the term suggests, crowdfunding is funding from a crowd of people; that is, many people provide small amounts of money to finance something. Crowdfunding has its roots in charitable causes, including the advent of microfinancing …
Can startups use crowdfunding now?
Under current laws, startups may not sell stock or other securities through crowdfunding sites or social networks… They may, however, accept donations.
This is because of applicable federal securities laws ... The laws include the following:
  • A prohibition against “general solicitation” — which means that a company may not offer or sell securities unless there is a substantive, pre-existing relationship between the company (or a person acting on its behalf) and the prospective investor. (See “Can I Raise Money For My Startup Via Twitter?”)
  • Disclosure and state law compliance requirements if the investors are not “accredited investors” — which usually makes the offering too costly and onerous. (See “Ask the attorney — securities laws.”)
  • A requirement that any intermediaries (including websites) must be registered with the SEC as a “broker-dealer” in order to legally accept any transaction-based compensation in connection with the sale of securities. (See “Finder keepers could be losers, weepers”).
What will the new crowdfunding bill do?
Basically, if this new crowdfunding bill becomes a law, all of the foregoing prohibitions and requirements will be lifted, and a startup will be able to sell securities through crowdfunding sites like Kickstarter, or social networks like Twitter or Facebook, so long as the company (and its intermediary, if applicable) comply with the bill. According to the bill, the company will have to meet these key provisions:
  • The company may only raise a maximum of $1 million, or $2 million if the company provides potential investors with audited financial statements.
  • Each investor is limited to investing an amount equal to the lesser of (i) $10,000 or (ii) 10% of his or her annual income.
  • The issuer or the intermediary, if applicable, must take a number of steps to limit the risk to investors, including (i) warning them of the speculative nature of the investment and the limitations on resale, (ii) requiring them to answer questions demonstrating their understanding of the risks, and (iii) providing notice to the SEC of the offering, including certain prescribed information.
Are there any downsides to crowdfunding for startups?
Yes, there are several key downsides that you need to be aware of before jumping into crowdfunding.
First, startups must understand that minority stockholders have certain significant rights under state law, including voting rights, the right to inspect the company’s books and records, the right to bring a derivative claim on behalf of the company, and certain protections against oppression by the controlling stockholders. …
Second, having hundreds of stockholders is an administrative nightmare and will be time-consuming and costly. …
Third, startups will likely have difficulty raising funds from VCs and other sophisticated investors if they have hundreds of unsophisticated stockholders. …
What’s next?
Now we wait for the U.S. Senate, … The White House supports the House bill, so upon reconciliation, it will be signed into law. Then entrepreneurs will have a new option to consider when raising money for their startup.

About the Author, Scott Edward Walker

Scott Edward Walker is the founder and CEO of Walker Corporate Law Group, PLLC, a boutique corporate law firm specializing in the representation of entrepreneurs. Scott has 15+ years of broad corporate law experience, including nearly eight years at two prominent New York City law firms. He has built a strong team of lawyers, with offices in Los Angeles, San Francisco and Washington, D.C. You can follow him on Twitter as @ScottEdWalker or check out his blog.
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