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Consider the pros and cons

Equity crowdfunding may be tempting for university start-ups as investments dry up

This article appeared in the June 2020 issue of Technology Transfer Tactics. Click here for a free sample issue or click here to subscribe.

With venture capitalists less approachable during the pandemic shutdown, TTOs are looking for investment alternatives for university start-ups and some are wondering if equity crowdfunding is a good option. It can be, the experts say, but tread carefully and consider the potential downsides.

VCs may not be looking at as many deals right now because they are trying to focus on their existing portfolio companies, says Amit Singh, JD, a shareholder with Stradling Yocca Carlson & Rauth in San Diego, CA. With everyone hurting from the shutdown, investors are looking to preserve their interests in companies they already have committed to rather than taking on new risks, he says.

For example, if a VC invested in a company that is about to do a pay-to-play round and investors who don’t participate in that round will get hurt, the VC will want to be sure to have money available.

“They’re thinking they have to reserve money for all those investments in case there are additional rounds and those companies need money, so they are less interested in investing in new projects right now,” Singh says.

That is particularly true for early stage companies seeking investments of $1 million or less, Singh explains, because VC funds with $200 million or $500 million under management don’t usually make small investments like that in normal circumstances. An investment of that size does not promise enough return, and partners cannot take on too many individual investments to manage, he says.

The angel market is more receptive to investments of that size, so for many early stage companies the choice is really between angels and equity crowdfunding, which the SEC limits to $1.07 million in a 12-month period, Singh says.

Interest in crowdfunding spikes

Equity crowdfunding gained plenty of interest several years ago but seemed to have faded from view as the economy churned forward and investment dollars become plentiful. That’s all changed in the current climate.

“There has been more interest in equity crowdfunding, and I do think there is good reason to be thinking about it now,” Singh says. “One thing that makes crowdfunding tough is that you don’t know how much money you can raise. Normally if you talk to VCs or angels you can determine how much money is going to be coming, but with crowdfunding it’s sort of a crapshoot and you don’t know if you’re going to be raising any money.”

Also, if you’re raising more than $107,000 through crowdfunding the SEC requires you to provide financial statements reviewed by a certified public accountant, and after $535,000 the statements must be audited by a CPA. Those expenses must be figured into any crowdfunding plan, Singh notes.

“However, the SEC put out a temporary order that through August 31 you can omit the financial statements so that you can do your basic filing, with the statements just certified by your CEO, if your company has been around for at least six months,” he explains. “You can test the waters to see if there is enough interest, and then do a follow-up filing. It’s a big benefit that you don’t have to have someone come in and review your or audit your filings.”

Which start-ups are fit for crowdfunding?

There is still the question of whether crowdfunding is right for a particular start-up. Singh says it may be most useful for a start-up with a product that is a singular, standalone item or license that just needs a capital investment to get it to market. For something more complicated like a medical device or computer chip technology, equity crowdfunding probably isn’t the right choice, he says.

“The type of company that would do well with crowdfunding is the same type that would do well with a Kickstarter campaign — a company that has a strong social media presence and they have something that is more of a consumable consumer product,” Singh says. “Something tangible that people can understand easily — that is what works best in a crowdfunding scenario.”

The major downside to equity crowdfunding is that you can end up with thousands of people attached to your company, Singh says. If you want to solicit VCs later, they will not like the look of that.

“My worry is that you’re going to have thousands of investors on the cap table and that doesn’t appeal to investors. It also makes it harder to do a sale of the company because if there is a stock transaction, for instance, you’re going to have to find a securities exemption for getting the stock to those folks,” Singh says. “It may not be so easy if they’re not accredited, so it’s easier to have only accredited investors on the cap table.”

Equity crowdfunding could grow in popularity if the SEC follows through with proposals to increase the $1.07 million limit and to have those investors in a special purpose vehicle that would avoid the problem of having thousands of people on the cap table, Singh says.

“If they modify the rules it could get a lot better, but if the rules stay the way they are, it’s going to be limited to companies that aren’t eventually going to get VC funding, because having so many people on your cap table is a real killer,” he says.

A last resort?

Barry D. Burgdorf , JD, special counsel with Pillsbury Winthrop Shaw Pittman in Austin, TX, has a couple of clients considering equity crowdfunding, both spinouts from universities. They are looking at all possible options because they may not hold enough appeal for VCs now, he says. Burgdorf agrees with Singh that equity crowdfunding is most appropriate for less technologically complex start-ups.

“The more technologically advanced the business is, the more crowdfunding becomes challenging because you may not have the understanding of the technology that you would from [a VC]. It’s going to take a lot more to explain what you’re doing and why it is a good investment,” he says. “Tech transfer offices, to the extent they’re expected to take part in this, will probably have to inboard the expertise to help make that technology accessible in a crowdfunding scenario.”

Equity crowdfunding is not equivalent to other capital investment options, Burgdorf points out. Even if you raise the same amount of money through crowdfunding, what you don’t get is the help of your investors in building your company, which can be critical to long-term success.

“If you work with a big tech venture capital firm, they’re going to be able to add to your board, to your business plan, your networking and all those needs,” Burgdorf says. “Crowdfunding is a true money play like friends and family funding, which comes with its own problems by complicating those relationships. Crowdfunding might get rid of those problems with relatives, but you would consider it only after you’ve worked through the other options.”

Also remember that investors on crowdfunding platforms tend to be more impatient than typical investors.

“On a tech start-up that may take five years to get to market, they may not be very patient for that. So you have to look at not only the number of investors but also their expectations,” Burgdorf says.

VCs still an option

It also could be a mistake to focus on equity crowdfunding instead of VCs right now, says Louis Lehot, JD, founder of L2Counsel, which provides investing and legal advice to start-ups. Start-ups that think VCs are on hiatus because of the pandemic lockdown are mistaken, he says.

They won’t be back in their offices for a good while, he says, but they’re still interested in investing.

“The reality is that I don’t think anyone is going back to their offices in Silicon Valley until early 2021 at the earliest. I work with a lot of venture capital firms and they have zero interest in going back to an uncertain environment until there’s a vaccine or a cure,” Lehot says. “They’ve gotten quite comfortable working from home, contacting their clients and doing everything they need to do online. They’re carrying on, but founders seem to think everything will be over in September and VCs will return to work then, so they will just wait.”

Lehot says some VCs actually are more available now than before the pandemic because activities such as conferences and other professional meetings have been cancelled.

“Does this mean they have more of an appetite for investments that are outside the strike zone? No, this doesn’t mean they are going to reach further to do a deal that they wouldn’t do otherwise,” Lehot says. “I do think they are taking meetings. Online meetings. So I encourage founders to target the investors that are the best fit for their companies and try to network their way to a meeting with them.”

Start-ups should consider equity crowdfunding but not until they exhaust better options, Lehot says. He also points out one additional downside to crowdfunding that many entrepreneurs don’t realize until too late. Crowdfunding platforms always have a communication channel in which the investors can chat about their experiences with the start-up, often through programs like Telegram or WhatsApp. If the investors aren’t happy, the start-up may receive a lot of negative publicity, he says.

“If you haven’t delivered on the objectives you set out, missing the benchmarks, you’ll have an angry crowd of people” complaining about lack of progress and results. “That’s tough on entrepreneurs because it usually isn’t their fault,” Lehot says. “You have a crowd of people essentially trying to get their money back and assassinating you in an online forum.”

Contact Lehot at 650-796-7280 or Louis.lehot@l2counsel.com; Singh at 858-926-3012 or asingh@sycr.com; and Burgdorf at 512-580-9636 or barry.burgdorf@pillsburylaw.com.


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