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Thursday
Mar292012

The JOBS Act and the Capital Raising Process (Crowdfunding and Concerns with the After Market)

A central problem with crowdfunding is the absence of any meaningful exit strategy once the shares are purchased.  Shares must be restricted.  Investors will need to wait a year before selling unless they sell to accredited investors, back to the company, in a registered offering, or to a family member. Presumably after a year, shareholders can get the restriction removed and sell them to anyone.  But if investors think that at the end of a year they will be able to sell, they will need to think again. 

A number of factors suggest that, in fact, it will be very difficult to sell shares purchased through the crowdfunding exemption. 

First, the exemption cannot be used by companies already public.  As a result, there will be no preexisting public market for the shares. 

Second, the large private companies intending to do a public offering will not use the exemption.  The amount that can be raised is too small.  Besides, companies thinking of going public probably have already obtained some venture capital financing.  For the most part, venture capitalists do not like the crowdfunding exemption, particularly the complex ownership structure that will result.  So crowdfunding investors will not have a public offering to look forward to as an exit strategy. 

Third, the most likely candidates for crowdfunding are those companies that intend to stay small and private.  Some may be listed in the pink sheets, but this will only occur if brokers can obtain the information required by Rule 15c2-11.  It is highly possible that many crowdfunding companies will not even be listed in the pink sheets. 

This will leave investors without the benefit of a trading market of any kind.  In those circumstances, it is possible that the investors may have to hold onto the shares indefinitely.  Nothing in the crowdfunding exemption addresses these problems except for the requirement that investors answer questions demonstrating that they have "(i) an understanding of the level of risk generally applicable to investments in startups, emerging businesses, and small issuers; [and] (ii) an understanding of the risk of illiquidity".  

It is not clear that these "questions" will ensure that investors understand the problems of illiquidity in any meaningful way.  They may only realize the consequences when the time comes to write a tuition payment or pay off a car loan and discover that no one will buy their shares.   

What is the consequence of an indefinite holding period?

In addition to the possibility that shareholders may never be able to liquidate the investment (until the company liquidates, at which time there may or may note be funds around for distribution to shareholders), shareholders will be at risk as minority investors. Minority investors can see their interests diluted through the issuance of additional shares or the value of the company dissipated through the sale of assets. 

The crowdfunding exemption merely requires companies to provide a description "of the risks associated with minority ownership, corporate actions, including additional issuances of shares, a sale of the issuer or of assets of the issuer, or transactions with related parties." This is likely to result in boiler plate disclosure that will in some cases not be understood, in others ignored and, invariably, forgotten when the corporate action actually occurs. 

In some cases, these transactions may even be a result of deliberate design.  In other words, companies (and their controlling persons) may intend to raise the capital then engage in transactions designed to eliminate shareholder value.  Because these transactions will occur after the sale of shares, perhaps long after, it will be much harder for regulators or private parties to bring actions under the securities laws based upon false disclosure or registration violations. 

Some of the referenced transactions may require shareholder approval.  But it is not clear that shareholders will even receive voting shares.  In any event, as minority investors, they will have little actual say in the outcome. 

Investors relying on the crowdfunding exemption may be subjected to fraudulent transactions.  Even investors purchasing from legitimate companies, however, will incur the risk that they will have to hold the investment indefinitely.  They likewise will incur the risk that the company may engage in subsequent transactions that dilute the ownership interest and the value of the shares purchased. 

In short, for many investors, this will prove not to be a good use for any available funds. 

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