The Wall Street Journal came out guns a-blazing against equity crowdfunding, namely the Regulation A exemption known as Reg A+. The headline says it all: “The Shortcut That Allows Risky Startups to Raise Billions From Rookie Investors.” The piece decries “slick marketing” and “lighter-touch rules” compared to IPOs.
Lighter touch may be an understatement. The writer, Dave Michaels, suggests the companies can raise millions with “little oversight.” As proof of the potential fleecing, Michaels offers two examples, Aptera, a solar car company and Boxabl, a miniature home manufacturer. Michaels warns:
Aptera and Boxabl have both relied on catchy social-media campaigns that hype their progress creating game-changing technologies. Crowdfunding platforms—such as StartEngine and Republic—match the fledgling firms with novice investors who can behave more like fans than shrewd financiers looking for a solid return on their investment.
Putting aside that StartEngine and Republic are mostly used for a different exemption, Regulation Crowdfunding (Reg CF), are the WSJ claims about equity crowdfunding warranted?
Wall Street Journal Flubs Crowdfunding by Never Asking ‘Compared to What’?
It does seem the two companies the piece features are struggling to survive and the founders of one may have engaged in financial subterfuge. (Many of their issues seem typical for startups, e.g. design changes, vendors going out of business).
Nonetheless, if either have defrauded investors the Securities and Exchange Commission (SEC) should prosecute them. But the larger question Michaels never asks is, compared to what?
Are public companies free from fraud? Is Reg A+ really a “shortcut”? Is there “little oversight”? Should retail investors be barred from private capital markets because some startups fail or turn out to be frauds? The answer to these questions is, emphatically, no.
Reg A+ is heavily regulated
The onerous disclosure requirements the SEC imposes on public companies has not stopped fraud; lying for gain is simply a part of human nature that must be punished when exposed. As professors Stuart R. Cohn and Gregory C. Yadley wrote in 2007:
[E]xamination of the securities violations that are of principal concern reveals that no amount of technical exemption requirements will hinder the fraud artists from their endeavors. . . . Fraudulent and deceptive schemes have unfortunately continued unabated and independent of formal registration or exemption requirements.
Reg A+ was part of the Jumpstart Our Business Startups (JOBS) Act of 2012. It is not a shortcut. Congress designed it to be on an onramp for companies headed toward registration to ease into the substantial burdens of being public companies, hence its nickname “mini-IPO.”
The exemption has proven popular in finance, insurance, and real estate. Community banks, for example, have used it successfully to raise capital from a larger potential investor pool whilst maintaining their private status.
And far from containing “little oversight” the SEC must “qualify” offerings–usually a months-long process. Reg A+ “Tier II” issuers (overwhelmingly the preferred use) must produce an offering circular, annual, semi-annual, and current-event reports. This includes independent audits. Retail investors also face investor limits based on a net worth/annual income scale.
If some don’t research their purchases properly, the market will soon discipline them. And current rules ensure they won’t lose their shirts. In fact, the real tragedy of Reg A+ was that the SEC refused to “cover” secondary trading, preventing markets from arising because of state-level restrictions. A free and open trading market would include price signals that reflect the success or failure of companies and give potential investors more data to evaluate beyond CEO bluster.
Young companies should be able to integrate fans, investors, and customers
Beyond these false claims is a normative one. Is it bad, as Michaels infers, that “novice investors . . . behave more like fans than shrewd financiers looking for a solid return on their investment”? No. Being a company fan is part of the allure. It brings people closer to companies they like by becoming investors. Reg CF offerings uniformly come with swag escalating with larger investments.
For the company this proves the loyalty of their current or future customers. These small investors are often happy to help advertise the offering or the company’s products for free. As startup capital raising evolves, melding customers and retail investors will become ever more integral.
Despite what the Wall Street Journal and their academic, regulatory, and nonprofit allies believe, ordinary people should be able to risk their money on their favorite startup. Most of these companies will fail, some will be frauds. A few, however, will become giants. The frauds must be punished. But freedom means the ability to take the chance to get in early on the big one.
RS BioTherapeutics develops life-changing medicines for the millions of people suffering from diseases characterized by pulmonary inflammation. RS BioTherapeutics’ first investigational compound (RSBT-001) is a first-in-class therapeutic in development as an alternative to corticosteroids for the treatment of respiratory diseases characterized by pulmonary inflammation.
For Regulation Crowdfunding (Reg CF) issuers, Spring means more than tax time. Uncle Sam, through the Securities and Exchange Commission (SEC), requires an annual report, Form C-AR. Companies must submit these reports 120 days after the fiscal year (usually December 31) until they become eligible to stop.
And while an SEC Enforcement Division letter may not seem as scary as the IRS kind, ignoring these reports, which update investors on company progress and financials, comes with dire consequences.
First, the SEC could deem Reg CF securities as unregistered. This can mean personal liability for founders and other officers. Indeed, it could put the entire company at risk. The Commission is particularly protective of Reg CF-eligible retail investors. In its 2015 release the regulator stated it may prosecute delinquent filers, even if they had remedied. “We note that even if an issuer has regained eligibility [by filing past reports], the Commission could still bring an enforcement action under the federal securities laws based on the issuer’s failure to make the required filings.”
Reg CF Issuers must file Annual Reports to avoid SEC trouble
But even without this extreme action, founders ignoring Form C-ARs face potential legal headaches. First, the company will be ineligible to do another Reg CF raise until the company files past-due reports dating back two years. Second, companies must be current on these reports to exclude Reg CF investors from the 12(g) record-holder count. Exceeding this shareholder number requires companies to formally register with the SEC—an expensive and time-consuming process almost no recent Reg CF issuer is ready for. Third, issuers must disclose past failure to comply with reporting requirements on any future Reg CF offering statement and annual report, risking reputational harm.
More broadly for the industry, low filing rates give ammunition to those hostile to retail investor access to the private capital markets, particularly state-level regulators.
Reg CF issuer compliance with Annual Reports is abysmal
Despite these myriad negative repercussions, issuer compliance with Form C-AR is abysmal. In a recent Crowdfund Insiderarticle, Howard Marks, founder and CEO of the StartEngine portal compiled the following data:
Based on my team’s calculations, an estimated 1,548 Form Cs were filed in 2022, signifying the start of new Reg CF offerings.
From that group, we further estimate that 810 companies that filed Form C-U – this typically indicates a successfully completed Reg CF funding round.
We estimate that of the approximate 1,548 Form C filings, only 361 filed Form C-AR’s; and of the 810 successful rounds, as few as 253 completed the filing on time.
This results in compliance rates of 23% and 31% respectively. As stated, noncompliant founders and officers risk professional and personal harm.
Companies may stop annual reporting after as few as one C-AR, depending on number of shareholders and total assets, although it must notify the SEC with Form C-TR: Termination of Reporting. Other companies must report until some event occurs like registering the securities, repurchasing them, or ending operations.
Regulation Crowdfunding (Reg CF) is helping small businesses and startups across a broad range of demographic and geographic cohorts. But some tweaks could make it even more appealing for founders. So concluded the Securities and Exchange Commission Office of the Advocate for Small Business Capital Formation (the SEC Advocate) in its recently released annual report.
Reg CF allows private companies to accept investment from its own “crowd” of supporters, friends, customers, clients, and anyone else, without the wealth requirements that have traditionally limited investment to Accredited Investors.
Since going live in 2016, Reg CF has successfully opened private markets to companies in a vast array of industries. It has also become “social validation” for venture capitalists less eager to write large checks than they were a few years ago.
Reg CF is helping a broad array of founders
Founders across the spectrum are incorporating this tool into their capital-raising portfolio. The SEC Advocate reports:
28.5% of offerings in Q3 2022 had at least one woman founder
25.2% of offerings in Q3 2022 had at least one founder of color
71.5% of offerings in 2022 exceeded minimum funding targets
70% of capital is distributed outside the top 10 capital hubs
$1,578 average investor check size
$428,486 average raise in 2022
Source: Securities and Exchange Commission
Still, Reg CF comprises only a small part of the overall private capital market. The SEC last modified Reg CF in 2021, raising investor and offer limits, allowing Special Purpose Vehicles (SPVs), which cabin Reg CF investors on a single cap table line, and allowing pre-raise communications with potential investors. These fixes made Reg CF more founder and investor friendly.
Are Changes Coming to Reg CF?
The SEC Advocate now recommends additional changes to further this effort. They include allowing non-GAAP accounting for small businesses raising up to $500,000 to satisfy financial requirements and increasing the offer ceiling on for financial self-certification. Currently, for offerings between $124,000 and $618,000, or for the first Reg CF of up to $1,235,000, the issuer must provide GAAP-based CPA-reviewed financial statements.
They also propose allowing companies operating under the Investment Companies Act to utilize Reg CF. The SEC Advocate asserts this would smooth existing complications with the SPV model.
The full Commission will consider these recommendations along with the others the SEC Advocate recommended to help small business capital raising.
Regardless of whether the SEC acts, founders should be weary of the myriad legal pitfalls they potentially face with Reg CF. It is always best to engage legal counsel before undertaking any securities transaction, but especially those with retail investors. The SEC is especially protective of these less sophisticated investors in contrast to exemptions where only Accredited Investors are eligible.
Reg CF changes means hiring expert counsel
Founders should hire experienced counsel to guide them through the process. The original SEC Regulation Crowdfunding release is almost 700 pages and the commission has added guidance and interpretations several times. Moreover, the SEC Enforcement Division is ramping up scrutiny on Regulation Crowdfunding.
Firm client Zero Cheating closed its Reg CF round on Wefunder with $716,800.
Zero Cheating is a patent-pending solution to stop all cheating in online exams. Learn more about the raise and the company here: https://wefunder.com/zero.cheating
Crowdfunded startup survival more likely amid VC pullback
“Startups are dying amid a historic drought in venture funding,” began one recent Wall Street Journal article. “The pace of startup shutdowns, fire sales and sharp business-strategy changes is picking up,” began another. Yikes!
Higher interest rates, macroeconomic concerns, and unsettled geopolitical events have all contributed to a shaky environment for startups recently awash in cash. A startup “mass extinction event” is underway, as the head of one capital fund remarked. This is due partly to belt-tightening measures among venture capitalists. Startups seeking capital raised $37 billion the first quarter of this year, a 55% decline from last year. Indeed, according to Pitchbook, in 2022 the -7%, the return rate for venture capital firms was its lowest since 2009.
VC-backed startups are struggling
Anecdotes back the numbers. Once unicorn-potential startups with massive valuations are flatlining as market realities sink in. Hopin, an events startup once valued at $7.8 billion recently sold for a measly $15 million. Zume, a robot pizzamaker, once valued at $2.35 billion couldn’t turn pies into dough fast enough and is winding down. WeWork a hotshot of yesteryear whose valuation peaked at $47 billion is headed for a Theranos-style downfall. The list of lesser knowns failing to keep afloat grows daily.
Startup survival has always come with long odds. 7.5 out of 10 venture-backed startups fail. Only 16% went public or had a successful acquisition within seven years of getting their first VC check according to one study.
Crowdfunded startup survival more likely
But those that choose equity crowdfunding (Reg CF) over or in addition to the whales are more likely to survive. Unlike VC partners, Reg CF are more likely to be patient with startups trying to find their footing or pivot due to market conditions. By definition, they are casual, passive investors, investing disposable income. With lower stakes comes less pressure and more willingness to support a further round. Reg CF investors also tend to be more loyal as they are more likely to already be in the founder’s extended network and are often investing in part to support the founder personally. Further, for consumer-facing businesses they are more likely to already be customers or clients engendering further loyalty.
These factors matter when times get tough as they currently are in the present startup environment.
Crowdfunded startups add extra benefits beyond survival
Beyond surviving tough times, here are other reasons founders should consider a Reg CF round in place of or in addition to VC money:
Broaden your investor base: Unlike other funding models, Reg CF can diversify your investor base from both a financial and geographical standpoint. Portals can accept investors from anywhere in the US, giving your business a potential foothold in all 50 states.
Turn your customers into marketers: Reg CF allows your customers to become financially invested in your business and see their investment grow as your business grows. This provides a free marketing campaign for your business with every new investor.
Incentivize your investors: Reg CF allows you to provide perks as part of the investment. Depending on the product this could include the product itself, ‘founder’ status on your website, access to events, or anything else that may induce an investment.
Prove value to institutional investors: A successful Reg CF raise can show larger, institutional investors your business is ready for the big money. Many larger investors are now requiring “social proof” of a company’s business model. Your business can show larger investors value and momentum and provide your business “bridge money” while larger investors evaluate your model.
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