Crowdfunding in Texas is Right Around the Corner
October 14, 2014 | By Kevin Vela
The next big buzz word is here. Get ready for “crowdfunding” mania. So, what does it mean?
In short, crowdfunding is when projects are funded through the collective efforts of a number of unrelated individuals. It has existed for some time for disaster relief, film projects, cooperatives, and through the donation model used by sites like Kickstarter, but a whole new medium has been instituted so that startup businesses can offer equity positions through crowdfunding.
The knock on startup investing is that regulatory requirements (like Reg D and Blue Sky laws) make it expensive and difficult for startups and small businesses to raise money. Moreover, the securities laws in place make it difficult for anyone who is not a “1%-er” to invest in startups. Crowdfunding is going to blow the doors open for startup investing.
You may have been hearing about this for years. The Crowdfund Act was a part of the Jumpstart Our Business Startups Act (“JOBS”), which was signed into law on April 5, 2012 by President Obama. Yes, 2012. (Editorial – I’m not crazy about the acronym, JOBS, because it sounds as if business startups are dead. When else do you “jumpstart” anything? But, I wasn’t on the naming committee.)
The gist of the Crowdfunding Act is that it allows just about any investor to invest in startups by removing 1930s era SEC regulations, thus giving startups significantly greater access to capital. A few of the key points are:
- Allowing companies to crowdfund up to $1 million over a 12-month period (or up to $2,000,000 with audited financials – audited means “expensive”).
- Allowing individuals earning less than $100,000 to invest up to $2,000 or 5% of their annual income, whichever is greater, over a 12-month period. Individuals earning $100,000 or more may invest up to 10% of their annual income, capped at $10,000, over a 12-month period (investments can be made in multiple companies).
There is some other stuff that’s important, so make sure you consult with an attorney.
Now, the actual guidelines were supposed to be released in late 2012, but the SEC has been redlining the proposed rules like they get paid by the hour, so we likely will not see crowdfunding at the federal level until sometime in 2015.
Rather than wait for the SEC, twelve states have gone ahead and adopted their own intrastate crowdfunding rules, and Texas is lined up to be number thirteen.
Intrastate means “occurring within a state” and the SEC has little to no jurisdiction with what goes on between Texas companies and Texas investors. With that in mind, last May, the Texas State Securities Board (probably my favorite regulatory agency) issued proposed rules that will allow equity crowdfunding within Texas. According to the Securities Board, the rules are designed to allow small businesses to make local offerings to those investors that are likely customers or members of the community, promoting Texas’ business-friendly philosophy and encouraging investment from residents who benefit most from the company. The Board is expected to vote on the proposed rules at the next board meeting on October 22, 2014. The rules would then take effect by the end of November after a 30-day registration period. (Disclaimer: It was originally stated that the rules would be passed in August, so the October 22 meeting date is not a hard deadline.)
The proposed regulations are similar to the proposed federal ones, but are not exactly the same. The current proposed rules would allow Texas companies to raise up to $1 million per 12-month period and non-accredited Texas investors to contribute up to $5,000 per offering. Expectedly, the rules also contain several restrictions. For example, an offering must comply with the federal intrastate offering exemption and SEC Rule 147, which demands that the company be a Texas entity and only offer securities in Texas (startups must have 80% of their assets and revenues within the state to meet this criteria), and the investor must be a resident of Texas, as verified by documents such as a Texas driver’s license, voter registration card, or property tax records.
Additionally, issuers must not be certain investment companies, SEC reporting companies, or blind pool and blank check companies. Offerings must be carried out exclusively online through a registered dealer or Texas crowdfunding portal. The company must post information about the offering on the website at least 21 days prior to when the securities may be sold, and communications between the issuer and investors must occur on the website. A notice of the offering may be distributed to potential investors, but the rules restrict distribution of the notice only within the state and require a disclaimer that the offering is limited to Texas only. Thus, no advertising of equity crowdfunding offerings is allowed through mass social media. Finally, a disclosure statement must be posted on the website that includes material information and risk factors.
There have been some serious concerns raised about crowdfunding, and some hypothesize that we’re going to return to the Wolf of Wall Street-like scenes of the mid-80s when slick-talking entrepreneurs were grabbing large chunks of cash at a time from unknowing grandmothers. In my mind, the concerns are valid, but that’s why we have magnificent agencies like the State Securities Board setting the parameters for us. There will be some initial hiccups, but in the long-run, crowdfunding is going to be great.
Now, I believe that many people expect crowdfunding to open up a new portal for high-tech-type startups that are going to raise a seed round of $100k – $500k through crowdfunding rather than a friends-and-family or angel round. Heck, the proposed maximum raise per company is $1M per year, so it’s possible that companies will raise significant funds via crowdfunding. This may happen a few times shortly after the State Securities Board flips on the crowdfunding switch, but I think the transactional costs related to dealing with multiple investors are going to suffocate the process. And by costs, I don’t mean dollar costs, but rather, cost regarding time, resources, and frustration.
If you have ever been a part of an early investment round, you’ll know that the less investors the better. This means less people calling with questions, less attorneys to deal with (always a good thing), less signatures to get for company decisions, less financial reports to circulate, etc. Further, you really don’t want to give up more than 10%-20% in your first round. If you’re crowdfunding and you have 10 investors in that seed round, they’re each getting 1%-2% ownership in the company. That sounds sexy right now if you think that every company is going to be Uber or Alibaba, but after a period of follow-up investment rounds, crowdfunded investors’ 1%-2% gets diluted down to mere basis points, and I think that small investors will go back to their IRAs. To make matters worse, larger investors and VCs who will come in after the crowdfunding round will likely be turned off by the multitude of small investors.
Moreover, I think there is going to be a transition period while the new lot of crowdfunders (which I think should be a class apart from “Angels,” just like Angels are separate from VCs) become accustomed to startup investing. Investing in startups involves a radically different risk appetite and understanding compared to traditional investment vehicles, and crowdfunding is simply going to exacerbate the learning curve. I expect some negative feedback at first until the general public becomes better educated about the process.
Now, eventually, I expect these issues to work themselves out and for crowdfunding to become a viable capital raise avenue for a legion of startups and small businesses. I think that investors will flock to startups with broad consumer appeal and potential for growth, and small businesses will be able to crowdfund on a hyperlocal level (you mean, for $1,000, I can own a piece of Joe’s Hamburgers down the street?). Plus, having additional investment vehicles should make every investment category more competitive, and hopefully, should have a positive effect in the long-run.
Crowdfunding is real, and it’s almost here. Kudos to the State of Texas for getting in early and continuing to show why Texas’ economy is so robust. Secretary of State Nandita Berry (probably my favorite secretary of state, except for the woman from House of Cards) summed it up nicely in February of this year when she wrote:
“The combination of low taxes, less regulation and a fair legal system has made Texas the best state in the nation to live, raise a family and start a business. We’ve cut red tape and made it possible in many cases to start a new business in Texas virtually overnight. Texas is wide open for business. Welcome to the land of opportunity.”
Crowdfunding is an opportunity for startups, small businesses, and investors. Keep an eye out for it.
Note: A version of this article by Kevin originally appeared in Texas Lawyer. Reprinted with permission from the Oct. 6, 2014 edition of Texas Lawyer. © 2014 ALM Media Properties, LLC. All rights reserved. Further duplication without permission is prohibited.