Bar News - December 21, 2016
Business Law and Business Litigation: Analysis: Early Trends in Equity Crowdfunding
By: Kristin A. Mendoza
In 2012, Congress passed the Jumpstart Our Business Startups (JOBS) Act to, among other things, permit equity crowdfunding as a capital formation tool for small businesses. The final rules implementing the JOBS Act went into effect in May 2016 and, since then, a number of equity crowdfunding campaigns have launched.
Although it is still too early to draw any conclusions about the effectiveness of equity crowdfunding to help solve the capital formation issues of many startups, a review of the first 100 crowdfunding campaigns as filed with the US Securities and Exchange Commission (SEC) between May and early September 2016 provides an interesting view of the initial landscape.
Businesses Using Equity Crowdfunding
As one might expect, providers of mobile applications and online business platforms were the clear leaders among businesses using equity crowdfunding for capital formation, totaling 33 percent of all campaigns. This was followed by makers of high tech consumer products at 12 percent. Interestingly, makers of craft beer and spirits were the third largest segment, followed by those looking to open local restaurants and hotels.
Those campaigns falling into the “Other” category were truly diverse and included such things as owning thoroughbred race horses; charitable and social service enterprises, such as opening a summer camp for girls; and highly specialized devices, such as shark repellent for commercial fishermen.
Regardless of industry, about 60 percent of the offerors had been in business for one year or less. A staggering 85 percent of offerors had been in business for five years or less. A significant majority of businesses were in the startup and pre-revenue stages, with 70 percent having annual assets of $100,000 or less. These trends are consistent with what one would expect and the purpose of the JOBS Act in creating an avenue for startups and newer businesses that are not ready or able to access traditional capital markets.
Types of Securities Offered
Common stock (or LLC membership units) was the predominant type of security offered in equity crowdfunding campaigns. For those offering some type of stock, the strong preference (about two-thirds) was to offer non-voting stock. In preferred stock offerings, a liquidation preference, consistent with what one would expect to see in a traditional round of seed financing, was the most frequent right and preference.
About half of the debt offerings were revenue-sharing notes that offered purchasers a return of between 150 and 200 percent of their investment. Term notes and convertible notes comprised the remaining half of debt instruments offered. The most common annual rate of interest was 5-6 percent, although there was a noticeable outlier at 18 percent. The term of the notes widely varied, with some having maturity dates of 12 months, three years, four years and even 12 years. Because repayment of debt is so closely tied to the financial projections of each business, this variation in repayment terms is perhaps not so unexpected.
Simple Agreements for Equity (SAFEs) were the most common type of convertible security, allowing holders to convert their SAFE into preferred stock at the next financing of the offeror (or into common stock if additional financing was not secured). Discounts on next round pricing commonly ranged from 20-25 percent with valuation caps ranging from $1.5 million to $4 million.
Transaction Fees and Documentation
Currently, 19 registered crowdfunding portals are registered with the SEC. Transaction fees charged by these portals ranged from 3-10 percent of the total amount raised through a campaign. Unsurprisingly, the most commonly used crowdfunding portal, WeFunder Portal, charged the lowest fee at 3 percent.
While it is difficult to quantify how many offerors engaged legal counsel in the preparation of their crowdfunding offering documents, a few observations can be made. A significant number of offerors prepared a private placement memorandum type of disclosure document. Ten or so offerors provided almost no disclosure documentation at all apart from the mandatory information included in the electronic filing with the SEC. A majority relied upon the Question and Answer format of SEC Form C in providing their disclosure information and supplemented those responses with printouts of the offering information available through the crowdfunding platform of their selected portal.
Offerings posted through WeFunder, for example, used the Question and Answer format, along with supplemental materials from their portal’s crowdfunding platform. Offerings posted through JumpStart Micro had a more traditional private placement memorandum format. This difference in the quality and presentation of the disclosure materials might justify the higher transaction fees charged by some portals.
Crowdfunding Success Rates
About half of the crowdfunding campaigns surveyed were aiming to raise a minimum target amount of $50,000, and 80 percent had a minimum target amount of $100,000 or less. It is too early to offer a definitive reason as to why these initial campaigns were seeking relatively small amounts of funding (federal regulations allow companies to raise up to $1 million in crowdfunding).
It’s possible that these businesses were trying to stay below the thresholds that would have required more detailed ongoing financial reports to investors. Also, given the all-or-nothing stakes in meeting the minimum target amount in order to receive any money, it is possible that some businesses wanted to set the bar low enough to ensure a successful result. One additional possibility, based some of the disclosure documents, was that some were using their crowdfunding campaigns to supplement traditional seed rounds already underway and therefore were not necessarily looking to satisfy their capital needs only through equity crowdfunding.
It is too early to predict whether equity crowdfunding will match or exceed the rewards-based crowdfunding success rate of roughly 33 percent. In reviewing crowdfunding campaigns that opened in May 2016 and closed within 90 days, only 28 percent reached their crowdfunding goal. Out of all the campaigns surveyed, regardless of closing date, only 15 percent had successfully reached their crowdfunding goal. However, a number of these campaigns are still open and raising funds, so this success rate will likely climb.
Interestingly, among those campaigns that reached or exceeded their minimum goal, very few are in the internet or mobile app space. Two successful businesses have already launched second crowdfunding campaigns to raise additional funds.
Sample of Successfully
Business advisors will need to continue to review the data to determine any lasting trends about the effectiveness of equity crowdfunding and to assist their clients in developing effective equity crowdfunding strategies.
Kristin Mendoza is the founder and principal of Millyard Tech Law, a boutique business law firm located in Nashua, NH. She is also a member of the NH Bar Association Communications Advisory Council.