What Does the New Crowdfunding Bill Do?
If the crowdfunding bill becomes law, all of the foregoing prohibitions and requirements will be lifted, and a startup will be permitted to sell securities via crowdfunding sites like Kickstarter and/or social networking sites like Twitter or Facebook so long as the company (and its intermediary, if applicable) complies with the bill, including these key provisions:
The company may only raise a maximum of $1 million (or $2 million if the company provides potential investors with audited financial statements);
Each investor is limited to investing an amount equal to the lesser of (i) $10,000 or (ii) 10% of his or her annual income; and
The issuer or the intermediary, if applicable, must take a number of steps to limit the risk to investors, including (i) warning them of the speculative nature of the investment and the limitations on resale, (ii) requiring them to answer questions demonstrating their understanding of the risks, and (iii) providing notice to the SEC of the offering, including certain prescribed information.
Are There Any Downsides to Crowdfunding for Startups?
Yes, there are several significant downsides that startups should be aware of:
First, startups must understand that minority stockholders have certain key rights under State law, including voting rights, the right to inspect the company’s books and records, the right to bring a derivative claim on behalf of the company and certain protections against oppression by the controlling stockholders. Indeed, the more stockholders a startup has, the greater the likelihood that a disgruntled stockholder will cause problems, including filing lawsuits.
Second, having hundreds of stockholders is an administrative nightmare and will be time-consuming and costly. Presumably, each stockholder will be required to execute a subscription agreement and/or stockholders’ agreement to address key issues such as transfer restrictions, rights of first refusal, drag-along rights, etc. There will also be administrative issues relating to voting and stock transfer issues.
Third, startups will likely have difficulty raising funds from VC’s and other sophisticated investors if they have hundreds of unsophisticated stockholders. Needless to say, few sophisticated investors will want to sit on the Board of Directors of such a company due to the risks of lawsuits relating to director liability, and D&O insurance rates will presumably sky-rocket for these companies.
The bill now moves to the U.S. Senate, which hopefully will quickly pass a similar bill. The White House supports the bill, so upon reconciliation, it will be signed into law, whereupon the SEC will be required to promulgate applicable rules within 90 days.