Crowdfunding In Colorado Is Now Available: Let The Offerings Roll! (Part 4)
Is There a Role for Attorneys?
Although crowdfunding is intended to be a simple concept for small businesses and startups in Colorado to raise capital (as described by Representative Lee in his press release issued August 5, 2015), and even though the rules and the forms are written in a step-by-step nature, anticipating that most issuers will proceed without sophisticated legal counsel, there remain sophisticated legal issues that each issuer will have to address. Crowdfunding issuers proceeding without legal counsel will be well-advised to understand the rules and the statute. On-line intermediaries and other advisors need to consider issues surrounding the unauthorized practice of law before assisting prospective issuers in their efforts to comply with the CF Act.
Among the legal questions that issuers and on-line intermediaries will need to address in each crowdfunding offering will be:
- What is a “single plan of financing” under Rule 147 and how is that interpreted with the limitations of C.R.S. § 11-51-308.5(3)(a)(XI)? Does any prior securities offering by the issuer restrict the issuer’s ability to conduct a crowdfunding offering?
- Where do the actions of the on-line intermediary become the actions of an unlicensed broker-dealer? Where does the advice provided to the issuer by the on-line intermediary become the unauthorized practice of law?
- Who drafts the escrow agreement and the agreement with the on-line intermediary, and interprets it for the issuer? This is unlikely to be an off-the-shelf form and will have to be tailored to each issuer, on-line intermediary, and offering.
- What is “adequate disclosure” for the purposes of Form CF-2?
- What level of due diligence and documentation will be sufficient to meet the issuer’s and on-line intermediary’s obligations when determining residency of investors and whether they are accredited?
- How does the issuer manage the future transferability of the securities issued under the CF Act, and what in fact are the limitations?
- Does the “reasonable basis” requirement for on-line intermediaries under Rule 3.28.C require that the on-line intermediary take affirmative steps, or does it merely prohibit willful blindness?
- Does the issuer’s notice to the crowd meet the requirements of being “within Colorado” as defined in Rule 3.24.I?
These legal questions have to be considered based on a specific set of facts—facts that likely change from issuer to issuer, on-line intermediary to on-line intermediary, and offering to offering. Those issuers and on-line intermediaries who proceed without competent legal assistance will be taking risks. Unfortunately, lawyers usually want to be paid whether or not the offering is successful, or even commenced. This may be a significant investment for the prospective crowdfunding issuer.
Another consideration for prospective crowdfunding issuers is how to deal with the resulting investors. Assuming that the crowdfunding offering is successful, the issuer may have several hundred to perhaps several thousand new security holders. The CF Act (C.R.S. § 11-51-308.5(3)(a)(XIII)) requires quarterly reporting to these owners. The larger the number of owners, the more difficult reporting will be. Furthermore, experience in the public company world indicates that these owners will be seeking information from the issuer on a regular basis, lodging complaints where performance is not as expected, and trying to develop a trading market. Each security holder is likely to have a different, personalized agenda that may result in significant management time and expense to resolve.
Thoughts on Crowdfunding in Colorado
If the risks can be managed to the satisfaction of the participants, the CF Act may become an extremely useful tool in capital formation for small businesses. It is new, the rules and the Act itself are untested, and there will undoubtedly be many issues that develop. One of the biggest may be whether any depository institution (defined in C.R.S. § 11-51-101) will be willing to act as an escrow agent in a crowdfunding offering at a reasonable cost, recognizing that many investments are likely to be small—$100 or so per person. In brief discussions with certain local banks, they have expressed reluctance to participate in these untested offerings, even though the CF Act specifically provides (in § 11-51-308.5(3)(a)(IV)(D)) that the escrow agent “does not have any duty or liability, contractual or otherwise, to any purchaser or other person.”
It is likely that crowdfunding offerings will be targeted to affinity groups by the issuers—perhaps a broader version of a “family and friends” private placement. Karl Dakin has written a number of blogs that relate to crowdfunding including one entitled “Characteristics of a Crowd” (May 11, 2015). As Professor Dakin indicates, “any message within a crowdfunding campaign must address the perspective of the investor.” Included in the perspective of the investor is whether the investor is considering investing “pocket change” or an investment that could be characterized as “a major life decision.” As Professor Dakin advises with respect to the issuer’s disclosure and other communications with prospective investors:
Too often, entrepreneurs fail to address the perspectives of the investors. They either assume that all investors are alike or that their deal is so good that all investors will invest. This is not true for classical investments based upon seeking a return on investment. And, it will represent a greater error in thinking with regard to crowdfunding.
As a result, Professor Dakin notes that too many issuers are “looking for money in all the wrong places,” “pitching to the wrong people,” “pitching too early” before the issuer is ready, “not knowing the investor,” and considering “investors as ATMs.”
In his paper Teenage Crowdfunding, Professor Andrew A. Schwartz of the University of Colorado Law School predicts that younger entrepreneurs will take advantage of crowdfunding because of their social media and networking skills. Chris Tyrell of Crowdfund Insider suggests that “Crowdfunding is Changing the Female Entrepreneurial Landscape.” Crowdfunding may in fact become the capital formation tool that the Colorado legislature and the U.S. Congress envisioned, but expectations have to be moderated to fit within reality.
Because of the lesser formality of the crowdfunding process, abuse and fraud are possible. Because of the smaller amounts raised, it is hoped that such abuse will be nominal. Nevertheless, prospective investors and attorneys who advise them must be alert for warning signs. Knowing your principals is your best protection, which is why affinity crowdfunding offerings are more likely to succeed than blind offerings to unknown investors. On the other hand, there has been plenty of affinity fraud in the annals of the Securities and Exchange Commission. (See “Affinity Fraud: How To Avoid Investment Scams That Target Groups” (last visited July 15, 2015)).
Properly used and constructed, however, crowdfunding in Colorado may be a very successful tool for smaller businesses seeking to raise capital within their sphere of influence—customers, clients, vendors, friends, family, and others. Although contemplated in the CF Act, it is unlikely that broker-dealers or sales representatives will be involved in the offerings because of their due diligence obligations under their regulatory rules (and the related cost which would be passed on to the crowdfunding issuer). It is also unlikely that issuers will use sophisticated legal guidance, again because of the cost which can quickly make a smaller offering unaffordable.
The best advice for an issuer looking for a crowdfunding offering is to be familiar with the statute and the rules, and to seek an on-line intermediary that will be competent and provide assistance, not only posting the disclosure, but also ensuring the residency of the investors, the required record keeping, arrangements with an affordable escrow agent, and perhaps providing other help in exchange for the non-percentage based fee. On-line intermediaries that are not broker-dealers are operating in other states that have already authorized crowdfunding; as the CF market develops, on-line intermediaries can be expected to appear in Colorado. This may be sooner; this may be later, and it will depend on the market. There will likely be competent on-line intermediaries, and unfortunately there will likely be incompetent on-line intermediaries; issuers should make all relevant inquiries to be comfortable that they are dealing with the correct on-line intermediary.
Let the offerings roll!
By Herrick K. Lidstone, Jr., Burns, Figa & Will, P.C., republished from Newsletter, Business Law Section, Colorado Bar Association, August 2015