Five Things to Consider Before Launching a Crowdfunding Offering
In 2015, the Securities and Exchange Commission (SEC) adopted Regulation Crowdfunding. This created a new way for small companies to raise the capital they need to build their businesses by publicly offering investments online to retail investors. Historically, these kinds of companies have used private placements limited to certain entities and high-income or net-worth individuals (“accredited investors”) under Rule 506(b) of Regulation D to finance their operations. Regulation Crowdfunding gives early-stage companies a new tool in their fundraising toolbox, one that lets them reach out to the much larger group of non-accredited investors for fundraising.
Before you use Regulation Crowdfunding to raise money, here are some factors to consider:
- There are legal and practical limits to how much you can raise. A company is limited to raising $1 million in any 12-month period under Regulation Crowdfunding. To date, only a handful of companies have actually reached $1 million, while the average raise for a successful campaign so far has been around $200,000. Before launching a crowdfunding offering, you need to consider whether the amount of money you are reasonably likely to raise (less the expenses described below) is sufficient to execute your business plan.
- You are making a commitment. Because of the way the securities laws are structured, switching between Regulation Crowdfunding and the traditional fundraising approach can be problematic. For example, once you launch a Regulation Crowdfunding offering, you will usually be viewed as having engaged in “general advertising” within the meaning of the securities laws. Engaging in “general advertising” may, in turn, prevent you from engaging in traditional private placement (Rule 506(b)) offerings for a period of several months unless you can conclude that the purchasers in the private placement offering were not solicited by the crowdfunding advertising. This makes switching between the two methods of financing challenging, so companies that embark on a Regulation Crowdfunding path should be prepared to stick with it in the short term.
- It’s a lot of work. To plan and launch a successful campaign, you’ll want to give yourself approximately one to two months before it goes live online. This time will be spent completing the Form C (the disclosure document required by the SEC), perfecting your marketing and messaging and managing the various service providers involved (legal, accounting, marketing and the funding platform). Before launching a crowdfunding offering, you will need to factor in the distraction from running your business.
On the other hand, marketing materials prepared for the crowdfunding campaign are certainly transferable to advertising your products or services to prospective customers. Further, traditional private placement financings also involve countless hours of networking to accumulate a sufficient number of investor commitments to close out a round of financing, which may not be as important to a crowdfunding offering, and therefore may offset the time committed to launching the offering online.
- You need to budget for the transaction costs. Unlike traditional Rule 506(b) private placements, Regulation Crowdfunding offerings carry some upfront and ongoing costs that can catch unprepared companies unaware. First, companies generally engage a number of service providers to assist in launching the campaign, including legal counsel, accountants (for most offerings, SEC rules require financial statements reviewed by an independent accountant when the campaign is launched), marketing agencies, the funding platform and escrow agents. Some of the costs will be based on a fixed fee or time spent on the project (attorneys and accountants), while others will be based on the amount raised (funding platform). Either way, do not be surprised if approximately 15-20% of the funding raised goes to executing the campaign itself.
Following the closing of a crowdfunding campaign, all companies will need to have financial statements prepared annually for the required annual report (although they do not need to be reviewed or audited by an accountant) and many companies engage a transfer agent to maintain their stock ledgers. While these costs are usually not enormous, they do further erode the amount of the offering proceeds that can be fully committed to growing the business.
- You may end up with a lot of investors. You are not allowed to group investors into a special purpose vehicle (SPV) under Regulation Crowdfunding. Given that average amounts committed per investor are around $800, you could end up with 200 shareholders for a stock offering (widely successful campaigns can result in more than 1,000 shareholders). This many shareholders adds extra time and expense related to shareholder relations and could discourage angel and venture capital investors from investing in future financings.
While there are costs to having such a broad base of shareholders, such costs are partially offset by the benefit of having a built-in foundation of individuals committed to supporting the growth of your business, including consuming its products or services.
Despite the limitations described above, there are many reasons why you may determine that a crowdfunding offering is the appropriate fundraising option for your company. This is particularly true for retail businesses that are able to capitalize on affinity investors who have a personal connection to the company, whether because it is in the same community where the investor lives or it produces a product or service meaningful to the investor.
Outside of Regulation Crowdfunding, we are also very excited about the other new avenues for early-stage financing, including Regulation A+, accredited investor offerings that allow for general solicitation (Rule 506(c) of Regulation D) and local intrastate crowdfunding offerings. The tried-and-true method of accredited investor private placements also remains the most suitable for many start-up companies.
In the end, equipping yourself with information on the strengths and limitations of all of the options now available for early-stage financing will help you to choose the option that is best suited for your company’s needs (even if it’s not the one you originally thought it should be).
Please contact us if you have any questions or would like to learn more about the information covered in this Alert and for further guidance if you are considering a crowdfunding offering.