Crowdfunding a startup: rags or riches?

May 20, 2010 · 6 comments

Crowd-everything is super hot, and super cool. The vastness of Wikipedia alone is sufficient to teach every one of us that when “crowd” is applied to your field, really neat and seemingly impossible things can happen.

To me, “crowd” is just the plural of “open,” as in open data.

But crowd doesn’t always work, and crowd doesn’t always scale (or, as I’ll discuss here, not in the right way).

Since Kickstarter got a lot of press as a way to make “projects” start moving with seemingly free or no-strings or on-my-own-terms money, people have been asking me about extending this to startups as a [pre-]replacement for venture capital and angel investment, both of which are seemingly harder to come by and once again slower in the bust than in the boom.

First off, we need to get a quick leader’s reconnaissance in, a lay of the land so that we’re all talking about the same thing. This is particularly important when it comes to “raising money,” which in startup-land usually means one very particularized thing, namely the sale of securities by an issuer to investors in an unregistered offering. Yes, I know I should have turned on the “legalese” tag for that sentence, but this is one area where you can’t fool around and paraphrase, or worse yet, euphemize.

Selling stock, warrants, options, and convertible notes to investors is generally always the sale of securities. Borrowing money through traditional promissory notes can be the sale of securities. The sale of securities is regulated up, down, and sideways by the federal government in the form of the SEC (and its regular partner, the DOJ) and by the states through the state attorneys general.

Take this lesson to heart:

1. Sale of securities  = highly regulated

2. Highly regulated => do yourself and your lawyer a favor and call before agreeing to do anything.

Securities law is one area of the law where even lawyers get lawyers. This is not DIY.

Your working model for securities should go like this: sales of securities require lots of expensive formal paperwork unless my lawyer tells me we have an exemption. Exemptions are available for most traditional venture investments (VCs are accredited investors and so are most real angel investors). Getting $1000 each from your cousins is generally not okay. Asking everyone you know or putting “raising series A” in your email sig are outright bad. These last two are examples of what the SEC may readily describe as a “public offering.” Public Offering, when it’s part of IPO, has a nice ring to it. When it’s part of your seed or series A round, it’s definitely flat.

Public offerings always require lots of expensive paperwork because that’s how you get to sell shares to everyone who wants them: the disclosure in the prospectus, written in “plain English” to comply with voluminous SEC regulations, is considered enough to allow a reasonable investor to evaluate the wisdom of buying stock from the company.

Crowdfunding, IF YOU MEAN selling securities to people through a nice public website with lots of visitors, is a problem. It’s almost certainly a public offering and will create big problems for you, the kind of problems that can easily kill a real venture financing.

Actually, Kickstarter itself doesn’t allow “investment and loan solicitations.” IndieGoGo, another site, is “not offering equity investments.” (I think it’s good that these sites are keeping people out of trouble.)

Advanced Masterclass Tip: you could conceivably use this method to sell securities only to foreign investors, but it’s probably not worth the trouble of trying to make the required restrictions fit into a site that’s designed to show everything to everyone. You’d be better off looking for some sort of angel investment opportunity site — which would at least be more likely to keep you out of inadvertent trouble.

NEXT: Crowdfunding a startup: what does work?

Post or email your questions on crowdfunding, and if they’re not already planned in the next post, I’ll work them in.

Are any of your intrigued by soliciting an investment in yourself, paying back with a portion of your earnings? The FAQ page is, sadly, empty; questions abound that the “template” contract doesn’t answer.

{ 2 trackbacks }

Getting crowdfunding wrong
May 28, 2010 at 15:09
Innovative selling models are constrained by the law
May 13, 2011 at 14:03

{ 4 comments… read them below or add one }

1 David Amster December 21, 2010 at 23:49

Hi Rick- Great article. I have been researching Crowdfunding recently as a potential form of project finance for community or regional solar projects. In particular, funding residential solar systems, and then selling the power back to homeowners at a discount to their general utility’s electric rate. The revenue then pays off the loans. The model works (as with CA based SunRun), yet the funding has never come from a dispersed group of investors, which I believe would drastically increase general knowledge about the profits in renewable energy, and overall an increased level of adoption. One idea I had, yet i’m not sure of whether this takes it out of SEC regulation, is to sell individual solar panels to the distributed group of ‘investors.’ Those solar panels would be part of systems on other homeowners roofs, and the revenue from the power would be passed through to the actual owner of the panel, which would give him something around a 10% ROI. Would the sale of an actual solar panel instead of a security/loan/share sidestep the SEC regulatory issues you discuss?

Reply

2 rickcolosimo December 22, 2010 at 10:13

David, that’s an interesting idea and an innovative application to your segment.

There is related and useful precedent for the idea of selling a real piece rather than a security: tenant-in-common real estate investments. These funds are really collections of individual investors who each own a portion of a single real estate property, such as an apartment complex. The tenant-in-common ownership structure, which is a common part of regular real estate ownership, is what allows each owner to act as an owner, be treated like an owner under the law, and still contract, with co-owners, to have a single management entity run the building, for example.

The TIC investment structure has been the subject of lots of scrutiny and line-drawing over the years, which is good for you because it points the way to how to construct your proposal in a way that complies with the securities laws. In general, you will (if memory serves) be effectively limited to 35 co-owners. (The reason for some practical limit is that at some point it just seems too far-fetched that the folks involved are really acting as owners rather than just as de facto securities holders.) I’m not familiar enough with the number of panels per installation in the market you’re considering to know how that would equate to investment amounts. I’m sure you can figure it out and see whether that makes sense.

It’s an interesting take, as I said. Please let me know once you’ve taken the next step.

3 David Amster December 30, 2010 at 13:26

Rick, Thank you for your response. This is very helpful. I’m not used to online discussions, so didn’t realize I had to check the page for the response. Thought it would just go to email. Anyhow, I saw this several days ago, and have been investigating.

The TIC applied to solar could have the potential for a unique distributed investment model, whereby a standard framework was created, potentially by a non-profit even, tested in a community, and then distributed to other communities. The model would basically be a framework for establishing a special purpose vehicle that would own residential solar systems.

Local entrepreneurs could then do the legwork of finding investors for the SPV and registering it. They could receive a ‘management’ fee similar to what they would receive from the TIC structure. All solar systems would essentially be owned locally, which could provide a strong sales incentive to the homeowner and local solar installer vs other companies that take investments in project funds from traditional banks.

There is one significant issue i’ve run into, however, which are the legal costs associated with setting up solar project funds. Based on some digging i’ve done, setting up such funds for residential solar systems originally had legal fees of $1.2 million when they were first pioneered in 2007. The latest info I have is from 2009, where the cost was down to $300k for each project fund (for a company that already had experience setting up several). These figures would make small funds impossible, unless there was some way to create a standard model with ‘fill-in-the-blanks’ for the local entrepreneurs. I don’t understand the legal issues enough to be able to asses whether that is a possibility.

Another note is that in 2009 and before, the SPV’s had to be structured to process state solar incentives, generally in the form of rebates, an accelerated depreciation benefit, and a 30% federal investment tax credit (ITC) for solar, as well as the revenue received from the power being sold to the homeowner.

My hunch is that a lot of the cost was tied up in the distribution of the ITC to institutions with tax equity investments. The stimulus package changed the credit last year to a tax grant, which eliminates the need for tax equity investments, since the bottom fell out of the tax equity market, but that change only runs through the end of 2011 unless extended. Any model that was created would have to be structured to pass the ITC onto investors starting with new investments in 2012.

The legal transaction costs to the entrepreneur would probably need to be brought down to $15,000-$30,000, depending on the size of the fund. Do you think this is possible?

Reply

4 rickcolosimo December 30, 2010 at 13:50

David, yes, there are big differences between the funds you have come across and a TIC approach. The old funds required very complicated securities filings, audited or reviewed financials, and expensive printing and filing fees.

The TIC approach, assuming it’s appropriate for what the investors want, is more like buying an apartment building with a handful of friends. There is still a need for legal advice, drafting, and some particularized tax advice under state law to ensure the incentives flow the right way and under federal law to ensure that the TIC structure will be respected by the IRS.

As an aside, I’ll see if I can arrange for comments to be emailed. I’m sure there’s a plugin or setting for that.

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