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
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.
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.
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.
Franchisors looking to expand into new markets and franchisees looking to “take the plunge” often face a dilemma: where to get the upfront capital. Franchise attorney Schuyler Reidel recently explored some traditional ways franchisees broach this issue. They include Franchise financing programs, loan guarantees, working capital loans, royalty fee deferrals, franchise associations, SBA loans or alternative investment networks.
All these methods have helped entrepreneurs begin their franchise journey. But another method has recently emerged that may overtake all past avenues for the added benefits both franchisors and franchisees get in publicity and more intense customer loyalty. This new method is Regulation Crowdfunding (Reg CF).
Reg CF is a set of regulations created by the Securities and Exchange Commission (SEC) deriving from Title III of the JOBS Act of 2012. Although passed into law over a decade ago the regulations did not go live until 2016. In 2021, the SEC modified the rules making them more founder and investor friendly.
Reg CF allows anyone to become an investor in a small business or startup, this includes franchises. (Publicly traded companies such as McDonalds are not eligible). Investors buy the securities over funding portals or traditional broker dealers. The securities can cover a wide range of financial instruments from equity, to future equity, to traditional notes, and profit-sharing “rev shares.”
Franchisors who have established customer bases are well suited for these types of raises given their consumer-facing businesses and the ability for the company (issuer) to include coveted perquisites thematic to the raise.
Reg CF crowdfunding allows franchisors and franchisees to collaborate on capital needs
Here are two scenarios where the franchisors and franchisees can benefit from a Reg CF raise:
An established BBQ restaurant with a loyal following wants to add two more stores. The total capital needed is $1.2M. They hire an attorney, contact a portal, get the required financial review completed and eventually go live with their raise. In the meantime, the owners reach out to their customer base to “Test the Waters” and gauge interest in the raise. They receive an enthusiastic response. When the raise goes live investors learn their investment entitles them to other benefits depending on their investment level including free T-shirts, “comped” meals, and the opportunity to attend a private dinner with the owners after the grand opening. After three months the raise closes and six months later the owners have two new stores.
A pizza franchisor discusses a franchisee deal with two young entrepreneurs. The potential franchisees are eager to get into the business but do not have the $500k of upfront capital required. The franchisor allows them to use the company’s marks and email list in a Reg CF campaign. Because the raise will be imputed to the franchisor, the security is structured as a “rev share.” That way, the franchisor will not sell any equity in the company. Instead, the franchisees will finance the upfront capital by promising a part of future profits to the investors.
The franchisees hire an attorney, set up an LLC, and conduct the raise through a broker dealer with the franchisor’s blessing. The franchisor brings his customer base “closer” to him by making them investors and not just customers. The customers feel more aligned with the pizza franchise as investors and eat there more often. After four months the franchisees secure the capital needed to open the store. Two years later they have paid off the investors and start the process over for their next store.
*All investment comes with risk; these scenarios are for information purposes only.
Reg CF will upend capital raising for franchises
Reg CF is the future in franchise capital. It allows franchisors the chance to expand their business in a way the promotes brand awareness and loyalty. Franchisees looking for upfront capital may be able to use the franchisor’s goodwill and tap into their existing customers to create an investor base.
For more information on starting a franchise contact Schuyler Reidel at [email protected]
For more information on Reg CF raises for franchises contact Paul H. Jossey at [email protected]
In May, Regulation Crowdfunding (Reg CF or equity crowdfunding), an innovative law that opened the private capital markets to everyone, turned seven years old. In this short time, it has gone from regulatory stepsibling to regulatory success.
The journey has not been smooth.
From its start in the JOBS Act of 2012, critics including state and federal regulators, associations, and some politicians, attacked equity crowdfunding as an unwise and unneeded tool that would attract scammers whilst leaving John Q. Public holding the bag.
Indeed, the Securities and Exchange Commission so opposed Reg CF it took four years to produce the regulations, heaping loads more issuer requirements.
The SEC eventually saw Reg CF as a regulatory success
But after four years of relatively smooth sailing the SEC reversed course. In 2020, it acknowledged the predicted fraud tsunami had not occurred and loosened the rules, making the Reg more investor and founder friendly. This combined with rising interest in online investing because of the pandemic has meant seven years hence, Reg CF has become a regulatory success.
1.7 million investors have invested over $1.8 billion into over 4,100 startups and small businesses across 1,700 cities in the US.
Companies that have successfully raised via Reg CF are now valued at over $60 billion.
Reg CF has contributed approximately $4.7 billion to the overall economy through salaries, inventory, rent, professional services, and various operational expenses.
Besides the raw numbers, Reg CF has performed a social good by allowing entrepreneurs access to capital who were traditionally outside the venture capital pipeline. According to CCA, “women and minority entrepreneurs (that routinely struggle to access capital) have had greater success within Investment Crowdfunding and are raising up to 50% of the capital.”
Securities professionals help keep Reg CF a regulatory success
But Reg CF critics weren’t completely wrong. As with any investment endeavor, there are risks for founders and investors. Founders new to the startup grind may overpromise, choose the wrong security, or fail to disclose material information to investors. Ordinary people investing in startups for the first time may not realize the mechanics of liquidity, valuation, or disclosures. And of course, many startups fail, and investments are lost. If not properly configured, founders could face liability from both investors and authorities. In 2021, the SEC brought its first charges against an issuer and funding portal alleging fraud.
That is why it is so important for Reg CF companies to hire counsel to guide them through the process, file the proper paperwork and advise founders on issues of portal selection, financial instrument, valuation, disclosures, investor communications, and more.
The Reg CF revolution is just beginning. As more companies realize the benefits of democratizing capital raising to include their loyal customers and brand ambassadors, the numbers will keep growing. As younger generations already accustomed to transacting online become founders and investors themselves, the days of wooing Silicon Valley VCs in haughty boardrooms instead of one’s own crowd on Twitter or TikTok may end.
Wherever the Reg CF journey goes, its best days are ahead.
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