Tuesday, April 3, 2012

Numerous Crowdfund Shareholders are Not a Problem

Recently there have been a lot of concerned comments coming from the venture capital and investment banking segments regarding the following:  Will a crowdfunded company be too shareholder-heavy to be a viable second-round, VC funding candidate?   Frankly, my response is, "Whatchutalkinbout?"  

A little perspective.   Venture capital (VC) firms (and here I am including investment banking firms and angel investors and their ilk) invest in start-up or first stage companies upon two usual parameters:  the company must look to have a very large upside potential, and the VC firm must be able to have some level of control until that break-out.  Thus, when the company has raised its initial funding from numerous friends and family members, and given them common stock for those funds, that can be cumbersome for the VC who later must deal with those shareholders.  Sometimes those shareholder-heavy start-ups are simply too cumbersome and the VC passes.

Thus, with the onset of legalized investment crowdfunding, and the new limits of shareholders for a non-public company boosted to 2,000, the VC marketplace is abuzz with concerns.

But this is quite easily resolved through planning by the company at the outset of their crowdfunding offering.  Most notably, the VC concerns can be allayed through the company's use of one or all of crowd-prenups, crowd-shares, and/or crowd-convertibles.

These are the terms, set out clearly, in the crowdfunding offering, and to be agreed to in writing by any crowd-investor, establishing how the crowd for that offering must operate in the future, including but not limited to acting with one voice (cumulative voting), management of joint claims, and rights regarding later rounds of financing.  This is very important, not only for the protection of the company, the crowd-investor, but also for easing the concerns of VCs and others who may wish to offer larger financing down the road.  These crowd-prenups should be part of every deal, whether or not they use other strategies like crowd-shares or crowd-convertibles.

Simply put, the company can authorize and issue a preferred class of stock for the crowd-investors, which I propose should be called crowdshares.  Though the crowdshare class of stock may be counted in the SEC's 2,000 limit headcount (yet to be decided by SEC), the VC concerns would be significantly mitigated.  Through the limitations placed on the crowdshares, and clearly explained in the company's crowdfunding offering documents, the crowd-shareholders can will be limited in their voting, proxy, dividend, buy-back and equity allocations.  Thus, when the time came for a VC to come aboard, the VC will have full flexibility in voting, common share equity allocation, etc.

Convertible debentures, a common form of security for start-ups and first stage companies, would work well in crowdfunding.  Here the crowd-investors would receive crowd-convertibles (debentures convertible to common stock, preferred and or crowdshare stock on some pre-determined (and fully disclosed) basis.  The triggers and options for conversion would be designed such as that even upon full conversion, future second round financiers (VCs) will still have the flexibility they need.  I have found that convertible debentures are also very psychologically pleasing to first round investors, as they give a time certain at which the company must return to them to either convert or pay out on those debentures.  That soft future line has a comfort value over a raw equity investment with an open-ended future.

There are other options as well, such as traditional preferred shares, other debt vehicles, a Class B common stock tied to crowd-warrants or crowd-options, etc.

I hope this helps alleviate some of the unwarranted VC concerns currently floating around regarding crowdfunding.  I invite comments.


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