Crowdfunding investors might throw money at you today hoping your business will shoot to the moon but by tomorrow, they could be trying to take you down with a class-action lawsuit.
That’s the risk you run when jumping into the crowdfunding pool, a new-age means of raising capital for start-up enterprises.
Sure, getting a money transfer from dozens or even thousands of people who believe in your business can give you a boost, both financially and emotionally. But get a few too many of them on board who don’t know what your business does – or worse, don’t understand the potential pitfalls – and you’ll be spending hundreds of dollars an hour with your lawyer if things go south. (You do have a lawyer, right?)
“The rule of thumb in the sale of securities is ‘seller beware.’ It’s important to be very careful who you pick as your shareholders,” says Roger Royse, owner of Palo Alto, Calif.-based Royse Law Firm, who also gives seminars on crowdfunding.
That’s easier said than done, of course. Besides, how many crowdfunding entrepreneurs ever get to the stage when they can consider turning money away?
Part of the problem is entrepreneurs who have experience with more traditional means of fundraising, such as private placements, get comfortable dealing with a small number of sophisticated investors, Royse says.
Those kinds of backers, unfortunately, can be in short supply with crowdfunding. And unsophisticated investors may have more money than they do brains, which are required to perform due diligence. In the end, they may end up costing you far more than they’re worth.
“It becomes administratively quite difficult to deal with them. It’s expensive and burdensome to deal with a lot of small shareholders. It’s an added expense,” Royse says.
“A shareholder can be just another name for ‘plaintiff,’ and potentially one more person who can complain about management.”
Crowdfunding might seem simple at first blush – putting your idea out there and hoping interested investors will fall over each other trying to jump on board with their chequebooks – but it can be quite complicated and there are a number of rules to be followed.
For example, private companies may sell up to $1 million worth of securities in a 12-month period. The amount sold to a single investor during that period, however, can’t exceed the greater of $2,000 or five per cent of annual income or net worth if their annual income or net worth is less than $100,000; or 10 per cent of annual income or net worth, up to a maximum of $100,000, if their annual income or net worth is more than $100,000.
Got that? It’s the kind of stuff you’d probably pass off to your accountant or in-house counsel to deal with. After all, you’re an ideas person with a business to run.
But there’s no question crowdfunding is a growing phenomenon. This past spring, the Pebble smartwatch, which connects wirelessly with your smart phone to alert you to incoming calls, received $10 million in financing, making it the No. 1-financed project in Kickstarter’s history.
Perhaps the biggest challenge facing start-up entrepreneurs is having to comply with securities law disclosure requirements, a complicated and involved process. Royse thinks a lot of companies simply won’t take the time or effort to do so.
That’s because in order to avoid jumping through an untold number of lawsuit-related hoops, they’ll need to have (or hire) an experienced lawyer to review their securities offering. Canned documents and off-the-shelf templates and forms can be particularly dangerous because they’re too generic.
“(Entrepreneurs) aren’t going to like their medicine. They’re going to need to take the time and the pain to make sure all of the relevant and material facts are disclosed,” he says.
If a company’s financial performance fails to live up to expectations, no matter who made them or how unreasonable may be – and it’s discovered a couple of material facts wasn’t disclosed to investors, momentum for a class action can build up quickly.
“We worry that given the small amounts that can be raised, (entrepreneurs) might miss some things that investors would find important. (Investors) might say, ‘if you had told me THAT, I would never have given you my money,’” Royse says.
Anybody who thinks that just because they’re a start-up that they’re immune from legal action, need only “Google” lawsuit and Kickstarter and they’ll see what the people behind FormLabs, a California-based 3D printing company, are going through. FormLabs was sued by rival 3D Systems Corp., which also named Kickstarter in the action, for patent infringement.
A spokesman for FormLabs said they weren’t able to discuss the lawsuit at this time.
It’s an isolated case but it might not be for long. Investors in a number of other crowdfunding enterprises are also threatening to take the companies to court.
So, what’s the worst-case scenario? If you’re found liable of leaving out material details about your company, you could not only be forced to return all of the capital raised but you may also have some personal liability.
“The investor sues the company, the promoters, officers, directors and possibly some of the advisors. That’s the nature of a securities fraud lawsuit,” he says.
“If things go bad, it can be very bad. If everything is fine, none of this matters because everybody is happy, they’ve made a return. If things don’t go well, it could be a lot of liability for everybody.”
So, hold your breath, scrunch up your face – bite a bullet if it helps – and take your medicine.