Washington Crowdfunding – Is it right for your Company?

Crowdfunding is live in Washington state as of November 1, 2014, when the Department of Financial Institutions’ rules become effective for ESHB 2023, the “Washington Jobs Act of 2014″.   You can find the final rules and the final crowdfunding application form here.  

For those who haven’t heard, ESHB 2023 allows an internet offering of up to $1 million to Washington residents.  Issuers (i.e., the company raising the funds) must take steps to ensure that only Washington residents are presented with the actual offering.   Any Washington resident can invest, but the following restrictions apply:

  • For investors with an annual income or net worth of less than $100,000, the greater of either (i) $2,000 or (ii) 5% of the investor’s annual income or net worth (not counting personal residence).
  • For investors with an annual income or net worth of $100,000 or more, 10% of the annual income or net worth of the investor (not counting personal residence), up to $100,000.

If you are interested in pursuing a crowdfunding offering.  Joe Wallin has written an excellent summary of the steps to take now which you can find here.  Joe is the attorney who originally proposed the idea for a Washington Crowdfunding law last year to representative Cyrus Habib, who was instrumental in getting it through the Washington legislature.  These two should be commended for making Crowdfunding a reality in Washington.

There are many ramifications to consider before launching into a Washington crowdfunding campaign, Before you do it, consider the following: 

Investor limits and integration.  Remember that if you use the Washington law you cannot take funds from investors who don’t live in Washington.  The maximum individual investment limits apply to every investor for one year, including wealthy individuals who are limited to $100,000. You might think that you could split up the offering, say for example by doing  a separate accredited investor private offering in another state.  But there is a concept called integration which means basically all of your fundraising for one year will be lumped into the same offering, unless two offerings are sufficiently different (e.g., a different type of security offered) to quality as a separate offering under the rules.  For example, if you sold $500,000of series A Preferred Stock in your crowdfunding campaign, and then a few months later find a wealthy investor or fund that is willing to invest $2 million, you may be prevented from accepting the investment unless the type and price of the security are sufficiently distinguishable.   Another thing to be careful about is any previous offerings of the same class.  Integration works both ways (back and forward).  The applicable time period is six months.  Under WAC 460-99C-200, non-crowdfund offerings that are six months before the crowdfund offering or six months after it will not be considered integrated with the crowdfund offering if no similar securities are offered or sold during those time periods.  WAC 460-99C-200 also lists the other standards for determining whether two offerings are similar enough to be considered integrated.  So, before you launch a crowdfunding campaign, you need to wait at least six months since your last offering of any similar securities, and you need to have a plan for how you will accomplish second and third financing rounds as you grow. 

Ongoing public disclosure.  The rules require you to make executive compensation, identity of 20% shareholders, and a business summary “publically accessible” on your website on a quarterly basis as long as the crowdfunded securities are outstanding.  In most circumstances, the crowdfunded securities will be outstanding for a long time, usually until the company is sold or there is a major restructuring.  So the public disclosure requirements are likely to extend long after the crowdfunded securities are sold.  During the rule formation process, there was disagreement about the meaning of “publicly accessible”.  The same wording is used in the statue, and many of those involved in getting the law passed understood it to mean available to directors and shareholders on the public website, but not necessarily available to every member of the public.  I testified about this at the public hearing and submitted written comments when it became apparent that the DFI was sticking by its interpretation that publically accessible means available to all members of the public.  Given the many original supporters of the law who think quarterly information should be available to investors, but not the general public, there is a good chance that the DFI will change its interpretation or that the law will be amended to clarify this next year.  In the meantime, this is something that you need to take into account when considering whether to use HB2023.  In particular consider 

  • whether as a founder, you are okay with making your compensation and that of your other executives and directors available to the general public;
  • whether you have any concerns about competitors having this information; and
  • whether there is any risk that the requirement to publicly disclose ownership will dissuade a large shareholder from participating in a subsequent equity offering.

GAAP Financials.  To do a crowdfunded offering, you must submit GAAP financials, including any required footnotes.  Depending on your past operations, preparing GAAP financial statements may be somewhat expensive.  Make sure you have discussed this with your accountant so you can plan for the cost.  

Type of Security.  Convertible debt, though typical for many initial financing rounds, is not allowed under the rules.  Basically your choice will be common stock  or preferred stock or the LLC equivalents.

Minimum Amount; Escrow Agent; Right to Cancel.  The rules require you to set a minimum amount of subscriptions that you must have received before you can close the offering.   The minimum amount must be large enough so that the company can execute its business plan if it only raises that amount.  This is a good rule and is typical in most private offerings.  The reason for a minimum amount is that it protects against the situation where the company takes funds from people who commit early but doesn’t raise enough to execute its business plan and fails for that reason.  The early investors get a raw deal in that case.  To make the rule effective you are required to hire an escrow agent to hold funds until the minimum amount is reached.  So you need to calculate the cost of an escrow agent when considering whether to do a crowdfunded offering.  Also, another thing to be aware of is that until the minimum amount is reached, investors have the right to cancel their subscription.  This would be an unusual provision in a private offering but something the DFI added to protect consumers.

Risks of encouraging competitors.  Consider the stage of your company.  Crowdfunding can be great exposure to the public if that’s what you need right now.  On the other hand, for some companies it makes sense to operate in stealth mode while you are developing your product.  If you are at this stage, it might not make sense to make potential competitors aware of your company and its progress.

Managing Shareholders.   A typical privately financed startup would have less than 30 shareholders.  A crowdfunded company may have hundreds, which significantly increases the organizational work and paper flow.   Your company needs to have a method for restricting its offering online to Washington residents only, an efficient way to exchange residency information, signatures, and other information from investors, processes for coordinating the exchange of all of that information and investment funds with the escrow agent.  You need an efficient way to provide quarterly informational updates meeting notices to shareholders, and receive back shareholder votes.   Most of the models for handling these tasks will be taken from public company precedents.  If you are going to be an early mover on crowdfunding, expect to spend some extra time and money breaking new ground.

500 Shareholder Limit.  Under Section 12(g) of the federal Securities and Exchange Act of 1934, a company must register with the SEC if it has more than $10,000,000 in assets and a class of securities held by more than 2000 shareholders or more than 500 non-accredited shareholders.  Most shareholders in a crowdfunded campaign will probably be non-accredited investors.  So while the whole idea behind crowdfunding is to raise small amounts from many people (thereby spreading the risk in a certain way) the effect of Section 12(g) is to put downward pressure on the number of shareholders and upward pressure on the minimum investment that you can accept.  To put some numbers on it, you can raise $1 million if 500 investors invest $2,000, each, the maximum amount for those earning less than $100,000 a year.   So a company that wants to accept smaller subscriptions would be limiting itself to raising $500,000 if minimum investments are $1,000, $250,000 if minimum investments are $500, etc.  This of course doesn’t leave any breathing room for subsequent  financing and stock option and warrant exercises, all of which could throw the company over the threshold, triggering expensive SEC reporting requirements.  The take away is that you should not be expecting to do a fund raising where you take donations of $100, $50, or less.  Depending on on your target raise, $500 or $1,000 minimum investments will probably be your practical limit.

So how can you manage the 500 shareholder issue?  Here are some suggestions:

  • Set a minimum investment amount that will make it hard to go over the shareholder limit.
  • Carefully monitor subscriptions and include in your offering documents a right to close the offering if the number of subscriptions goes over a certain level.
  • Obtain shareholder agreements to notify of accredited investor status, and track it.
  • Consider including in your articles of incorporation a company right to redeem shares for a certain price if the number of shares and/or the value of the company’s assets goes over a certain level. 
  • Consider provisions in your employee stock option plan that allow the Board of Directors to delay exercise until just prior to a liquidity event if the company is at risk of going over the threshold.

New regulatory landscape; DFI Oversight.  This is new for Washington.  No one knows exactly how it is going to work in practice.  Whereas most private placements have no practical oversight from regulatory authorities, Washington crowdfunded offerings will be reviewed and must be approved by the DFI.  You company will be subject to the DFI’s ongoing oversight as long as crowdfunded securities are outstanding.   You are submitting your company to this oversight when you launch a crowdfunding campaign.  The DFI has a responsibility to protect consumers, and as the rule enactment process demonstrated, they don’t always draw the line where advocates for issuers might have them.   But the DFI has gone out of its way to help small unsophisticated companies accomplish SCOR offerings, which are similar to offerings under ESHB 2023, and we can expect them to do the same here.  We also know that DFI has shown remarkable professionalism in the speed at which they have promulgated draft rules, accepted, summarized and responded to comments, and published the final rules, all well within the deadline set forth by the statute.  All of this represents a lot of work and they should be commended for their job.  So I think that responsible companies with solid business opportunities will find the DFI to be a good partner.  But be prepared to be flexible when they ask you to make changes to your disclosure. 

Consider Other Methods to Raise Equity.  Lastly, before you launch a 2023 offering, consider whether other options are better for your company, such as a private placement to angel investors in the traditional way, through a new 506(c) offering that allows internet advertising to accredited investors, or a Washington or regional SCOR offering that also allows internet advertising to accredited or non-accredited investors.  See my post comparing SCOR offerings to 2023 offerings.

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