The following article by Joel Nied of LeClairRyan is an insightful examination of the changing environment in Washington towards ‘crowdfunding’ and entrepreneurship as both the Senate and House of Representatives pursue landmark legislation.
The Entrepreneur Access to Capital Act (EACA), which has been dubbed the “Crowdfunding Bill,” has been approved overwhelmingly by the House of Representatives. The Senate passed a similar bill, the Capital Raising Online While Deterring Fraud and Unethical Non-Disclosure Act, on March 22, 2012¹. Assuming the final bill approved by both legislative bodies more closely resembles the EACA and is signed into law, the only remaining question about the EACA will be the effect it will have on the startup community.
The answer is that the impact will be stunning. Although discussions about the EACA have focused on “crowdfunding,” the reality is that the EACA is a new, broad exemption in the heavily regulated realm of stock sales. First, I will describe the current state of selling stock in a startup. Then, I will discuss how the EACA will turn that process on its head.
Currently, federal and state law, and the corresponding regulations, govern the sale of securities (stock, membership interests, limited partnership interests, warrants, options, etc.) sold by every company. For the sake of brevity, all forms of securities will be referred to as “stock” in this alert. It doesn’t matter if the stock sale is conducted by a publicly traded multinational company or a one-man startup issuing stock to the founder’s brother. Every sale is governed by a complex web of state and federal laws and regulations. In general, no company, whether a corporation, limited liability or limited partnership, can sell stock without registering the stock (such as through an IPO), or finding an exemption to registration.
The exemption most commonly relied upon by startups is the “Regulation D” exemption, also known as the “Reg. D” or “private placement” exemption. The Regulation D exemption, although widely used, is fairly restrictive. The exemption is a compromise. On the one hand, the startup’s stock offering documents and structure are not subject to prior review by the Securities and Exchange Commission (SEC). The disclosure requirements are lax, as well. Under some circumstances, the startup is not required to provide any material amount of information to prospective investors. On the other hand, the startup cannot advertise the offering or publicly solicit investors. Further, the startup cannot compensate a third party (an intermediary) for successfully soliciting investors, unless the intermediary is a licensed broker-dealer.
Although the two restrictions above sound benign, they prohibit startups from doing what they often do best: marketing and leveraging relationships. Startups using the Regulation D exemption cannot advertise on the internet (or any other medium) that they are selling stock. They cannot send out e-mail blasts and they cannot put notices on supermarket bulletin boards. The commonly accepted interpretation of the prohibition against public solicitation and advertising is that a startup can only approach people with whom the founders have a preexisting relationship.
That public solicitation restriction often leads startups to seek intermediaries to find the investors for them. The practice of using intermediaries that are not registered broker-dealers is widespread. Using unregistered broker-dealers, however, is unequivocally prohibited and can lead to an unwinding of the investment, significant civil penalties and, arguably, criminal penalties.
The EACA eliminates the public solicitation restriction and the intermediary restriction. The ultimate application of the EACA is largely dependent on the regulations put in place by the SEC. The language of the bill, however, appears to make it a game-changer. The constant reference to the bill as the “crowdfunding” bill hides the scope of the change the EACA brings to the entrepreneurial environment in this country.
The days of relying on friends and family, word of mouth and good connections will be over. Rather, a startup with virtually no history, no money and a savvy marketing plan will be able to raise up to $2,000,000 from as many investors as it can reach. Anyone who has tried to raise money under the Regulation D regime will realize the stunning change — gone are the days of ferreting out and trying to impress the local angel investors or hiring the “right” accountant or “business advisor,” all to get the first $200,000 needed to prove the business model or perfect the product. With the right idea and the right marketing, anyone, anywhere, will be able to raise money.
The EACA also allows intermediaries, whether registered broker-dealers or not, to offer stocks on behalf of startups for compensation. That means that currently existing crowdfunding sites, with minor modifications, will start selling stock. The EACA will be a boon to startups.
It will not, however, be without headaches and pitfalls. The conventional method for structuring startups assumes the startup will have a handful of investors living in one or a few states. The EACA will result in a startup having dozens, if not hundreds, of investors potentially living in every state in the nation. Startups that are anticipating venture capital investment after the EACA raise will have to consider how to structure the EACA investment to fit within the framework of the new law and the future VC investment.
Founders will also have to consider which state’s business laws most favor the founders of a company with hundreds of small investors. Also, founders will have to deal with logistics, organizational structure and the relevant state statutes so that they do not inadvertently end up in a situation where they need hundreds of people to approve changes in the business structure, elections of directors or amendments to the organizational documents. Without some forethought, the accounting expenses alone could dwarf the amount raised by the startup.
The EACA, if it becomes law in its current form, will create dramatic and positive changes to the startup funding process. Founders who are aware of the opportunity and plan for growth after their “crowdfunding” raise will reap the benefits of this radical departure from the currently available capital-raising methods.
1) There is no need to give the Senate bill a nickname. The acronym for the bill, which must have been dreamed up by one of the apparently dozens of legislative aides who think it is clever if the acronym of a bill refers to the substance of the bill itself, is CROWDFUND.