By Mary Hull of Stoel Rives LLP
In January 2018, I sat on a panel about crowdfunding at an OEN PubTalk. The panel discussed Oregon’s crowdfunding legislation (which was brand new at the time) and also federal Regulation Crowdfunding (Reg CF), which was not that new at the time (it’s been in use since 2016) – but the jury was still very much out with respect to the practicality of Reg CF as a fundraising tool for early-stage companies.
Let me take a step back before going further. What is crowdfunding? I am not talking about Kickstarter here. I am talking about the use of the internet and social media to raise little bits of money from a large number of people (the crowd!) through the issuance of securities. The offer and sale of securities, e.g., stock, convertible notes and SAFEs, brings into play federal and state securities regulations. Pursuant to those regulations, when an early-stage company wants to offer or sell securities, it must either register the offering or find an exemption from the registration requirements of federal and state securities laws. Registering a securities offering is a big deal (going public!), so the early-stage company needs an exemption from the registration requirements. The most popular exemption by far is SEC Rule 506(b) (not Reg CF), and most companies that use Rule 506(b) offer and sell only to “accredited investors,” i.e., the rich (meaning persons or entities that the SEC has decided are wealthy enough to fend for themselves and don’t need the protection of the securities law registration requirements). But what if you are an early-stage company and you don’t know any rich people or your company is not the type of company that most VCs or angels are likely to be interested in? What if you need another means of raising capital?
Enter crowdfunding. I still don’t think Oregon’s crowdfunding legislation is very useful for most early-stage companies. That exemption has many requirements, including that you generally can’t use it to raise more than $250K in a 12-month period (and you can only use it to raise money from Oregon residents). There is also a $2.5K cap on funds received from any one investor, although if the investor meets certain income and net worth requirements, you can raise up to $10K from that person. I’m not going to say anything further about that exemption in this blog post.
The much more interesting exemption is Reg CF. When I was on that OEN PubTalk panel back in January 2018, a startup could use Reg CF to raise up to $1.07M in a 12-month period. There were (still are) lots of requirements, including, generally speaking, that if you wanted to use the exemption to raise more than $107K, you had to have reviewed financial statements. A nice thing about the exemption (then and now) was that if you complied with the exemption, you didn’t have to worry about state securities laws (for the most part) because Reg CF preempted state securities laws (generally speaking). Back in 2016 when Reg CF first came out, the companies that were using Reg CF were mainly issuing common stock (mainly non-voting common stock) directly to the crowdfunding investors – so these companies potentially had (maybe still have) literally hundreds (maybe even thousands) of small equity holders on their cap tables. Yikes – imagine the logistics of managing all those people. I wondered back in 2018 whether, if you raised money through Reg CF, you would forever cut off any future potential you might otherwise have had to raise money from VCs. Would VCs be interested in investing in a company with hundreds or thousands of unaccredited investors on the cap table? What if those people were asking for updates all the time and consuming all of management’s time? What if they could hold up a financing or sale of the company because, depending on how their investments were structured, the company needed them to sign documents and they refused or you couldn’t even find them in order to ask them to sign? Given all these potential headaches, I didn’t think back in 2018 that Reg CF was particularly useful – but I did see the potential that, in later years, as crowdfunding templates perhaps evolved to deal with some of these concerns (e.g., by not issuing stock to the crowd, by including mechanisms to avoid any possibility that crowdfunding investors’ signatures would be required in connection with a future financing or sale of the company, etc.), perhaps VCs and angels might get more comfortable investing in a company that had used Reg CF.
Fast forward to now – and I think we are there: Reg CF’s time is now. In March 2021, Reg CF was amended. Now, you can raise up to $5M in a 12-month period. The limits on how much you can raise from each investor have also been raised – and there are no per investor limits on how much you can raise from accredited investors. And I think the crowdfunding templates have come light years in sophistication from where they were in 2016. For example, at least one of the crowdfunding platforms out there offers startups a custodial solution for companies to hold investors’ securities “in street name” with the platform’s banking partner. According to the platform’s website, the solution is intended to, among other things, make cap table management easier for companies using the platform. Companies currently raising money on that platform’s website include VC-backed companies and companies accepted into Y Combinator. They include a company with $150K in sales since launching in February 2020 and a company with $25M in revenue in 2020 – and everything in between. Why are they using Reg CF? They can set their own terms, e.g., discount and valuation cap on a SAFE, and they can increase brand loyalty. A company currently raising on one of the platforms, when asked “What are the reasons you decided to do equity crowdfunding campaign at this point when you could easily do a much bigger VC round that will help you scale to the next milestone of $100m in ARR?,” answered “I believe that when our supporters and customers become owners of [the company], that will create as much value as raising a large round.”
There are certainly pros and cons of using Reg CF – many of which I’ve only touched on (and some of I haven’t touched on at all) in this blog post. But Reg CF is worth serious consideration – for all kinds of companies – and I wouldn’t have said that back in 2018.
About Mary Hull
Mary Hull is a corporate and securities partner at Stoel Rives LLP and is chair of the firm’s Technology Ventures Group. Mary represents technology and consumer companies from formation through private financings (including Reg CF!) and mergers and acquisitions. She also represents investors in venture capital financings. Mary serves on the OEN board of directors and is the immediate past chair.