Since Regulation CF went live in May 2016, there have been approximately 280 companies that have made offerings made in reliance on it. Of these, only 51 or so have filed a Form C-U to show they have met their target offering amount and closed.
It might be argued that this approximately 20% success rate itself indicates that there is no limitless pot of money awaiting companies who make it through the Form C disclosure process. However, it is early days yet, and many potential investors do not even know of Reg CF’s existence. Many companies are still in the offering process. It may also be the case that the crowd is showing discrimination – maybe some of the offerings have just not convinced the crowd that they are worth investing in.
Some commentators have argued that the reason for the slow takeup is that the rules are too complicated or burdensome. We would disagree with that. While we believe that it is risky for a company to try to comply with the disclosure requirements of Reg CF completely without professional assistance, that assistance need not be heavy-handed or expensive.
At CrowdCheck, we have assisted scores of companies through Reg CF offerings, and in general it hasn’t been compliance with the disclosure provisions of Rule 201 of Reg CF that have presented problems. It’s the provisions of corporate law, which the SEC has no power over.
I’ve often said that crowdfunding introduces regulatory complexity into a company’s life earlier than was previously the case. Companies would raise funds from experienced angel or VC investors, who would frequently fix any problems in the company’s corporate documentation as part of the investment process. By the time the company was ready to make an IPO and sell securities to the public, there would be enough money to hire experienced law firms to go back through the company’s records and fix all the corporate housekeeping hat had been neglected while the company built its business.
Crowdfunding changes that. As we frequently tell the companies we work with, crowdfunding involves selling securities to strangers over the internet, and those strangers may not be so forgiving of failures to comply with the corporate niceties, especially if it means that their investment is worth nothing.
Let’s look at some of the corporate niceties I’m referring to, with examples from real life:
- You have to be in “good standing” to issue securities. In the spring, franchise taxes are due in Delaware and some other states. It’s amazingly easy for young companies to fail to pay these. We’ve seen cases where the company failed to pay because all the corporate notices were going to the email address of a co-founder who had since quit the company. Or where the founders just assumed that “the lawyers were taking care of all that” despite the fact that “the lawyers” hadn’t heard from (or been paid by) the company in a couple of years. A critical representation that companies make in their offering documents (sometimes assumed to be “just boilerplate”) is that the company is in good standing with its state of incorporation. By not being in good standing, a company may lose access to courts to assert any rights, may experience difficulty obtaining credit, and be subject to fines, penalties, and tax liens. Also, representing that the company is in good standing when it is not is likely to be a material misrepresentation. In one notable case, the company had failed to pay Delaware taxes for more than three years and its corporate existence had been declared void by Delaware. Despite that, the company had issued a series of convertible notes. Not only did the company make material misrepresentations to investors as a result of being void, but the founder was taking on liability as if he was a sole proprietor.
- You can’t issue securities that don’t exist. To be able to issue equity securities, the type of security (common, preferred, etc.) must be specified in the company’s constitutive documents (such as the Certificate of Incorporation), and there must be enough of them not yet already issued to be able to sell them to new investors (we call this “headroom”). If the class of securities you want to sell in a crowdfunding round doesn’t yet exist (or you don’t have enough of them left to sell), you create the new class of securities or increase the number available by filing an amendment to your constitutive documents, which will probably need both board and shareholder approval. Even then the securities don’t exist until the board approves their sale and the company gives instructions to the transfer agent to issue them. We’ve had a couple of companies recently not understand the distinction between “authorized” (you have enough securities to be able to offer them to investors) and “issued” securities (you sold them and now someone owns them). One company we know of instructed the transfer agent to issue shares of a class that did not exist.
- Even when classes of securities exist, the rights that go with them have to make some kind of sense. One company managed to create classes of securities where no holder of any class had any voting rights. Seriously, no-one had the right to take any decisions on behalf of the company. The company copied some precedents they got from the internet so they might not be the only company out there with this problem.
- Corporate law does not transcend mathematical reality. One company adopted bylaws that provided that a quorum (the number of board members you need to take a decision) was “a majority of authorized directors.” The company (doubtless looking forward to its IPO one day) authorized 13 directors but only appointed three. Even lawyers can do that math. Nothing the company had thought it had decided on was actually authorized.
An additional set of complications arise when the company is issuing a new class of securities the rights of which need to be coordinated with existing classes. Adding a class of preferred securities to the capital structure of a company that has only common stock is relatively easy, but it becomes more complex when the company has already issued a class of preferred stock. Describing the rights of the various classes of preferred stock and how they relate to one another, as required by Rule 201, is not necessarily easy, but far more complex is establishing those rights and relationships in the first place. And that is a matter of state law, which securities law does not touch.
Sorting out issues like these does generally require some legal advice, and that legal advice is generally more expensive than assistance in making the required disclosures. To the extent there is regulatory friction in this market, we think it comes from state corporate law, not from securities law.
Although we have to note that companies aren’t that good at complying with the securities law. Watch out for the CrowdCheck Disclosure Compliance report, coming soon!