[The following is summarized from my forthcoming article in the George Mason Law Review]
Crowdfunding has been heralded as a revolutionary and democratic way to connect ordinary individuals with innovative projects they would like to support. The version involving equity investments in start-ups will be regulated under the U.S. JOBS Act of 2012.[i] But start-ups who use this legal pathway will become essentially “junior” reporting companies under the securities laws with significant public disclosure requirements. This blog post argues that such disclosures may negatively impact start-ups’ intellectual property (“IP”) portfolios.
As a preliminary matter, crowdfunding is different from crowdsourcing. As its name suggests, crowdfunding involves the funding of a project by a large group of people, generally each investing small amounts. Crowdsourcing involves a large group of people contributing relatively modest physical or intellectual efforts to help achieve a larger goal.
There are two types of crowdfunding. The first is “project crowdfunding” popularized by Kickstarter, IndieGoGo, and others. Supporters contribute small amounts to finance a particular project. This is generally legal, especially when structured as a gift donation and not a purchase. But many innovators and their potential supporters would like to fund an ongoing firm and not just a single project. While this might be structured as a (micro)loan, many would like to use equity investments. I call this second type “enterprise crowdfunding.” It remains illegal under U.S. securities laws until the Securities and Exchange Commission (“SEC”) issues its final crowdfunding rules under the JOBS Act.[ii]
The U.S. Congress endorsed enterprise crowdfunding by including the CROWDFUND Act in the JOBS Act. Many assumed that the statute was addressed to the well-known project crowdfunding sites such as Kickstarter and IndieGoGo. But again project crowdfunding is already legal and did not necessarily need legislation. The JOBS Act provided an overall set of requirements for a legal pathway to enterprise crowdfunding, while mandating the SEC to promulgate the actual mechanism for it. Thus, enterprise crowdfunding will not be legal for use until the SEC promulgates its final rules.[iii]
At the same time, the JOBS Act mandates other changes in securities regulations that may make enterprise crowdfunding less appealing than other private financing options.[iv] The Act generally relaxed mandatory information disclosure requirements for “emerging growth companies,”[v] while raising the trigger levels for companies to become “reporting companies” with significant mandatory public disclosure requirements.[vi] Equally important, it expanded upon the general solicitation already available for private offerings up to US$1MM under Regulation D, Rule 504 to allow such advertising for the unlimited dollar amount offerings under Rule 506, the most popular Regulation D private offering ìsafe harbor.î[vii] It also created a new “Regulation A+” “mini-offering” of up to US$50MM.[viii]
Even as Congress was liberalizing existing private offering pathways, it erected significant regulatory hurdles to the new enterprise crowdfunding private offering exemption. This is understandable, as many commentators are skeptical of both enterprise crowdfunding and the JOBS Act as a means to enable it. Some are worried about the potential for fraud and abuse.[ix] Others worry that small-time “retail investors” who invest through crowdfunding in tech start-ups will not understand the dilution risks they face from later venture capital (“VC”) financing rounds.[x] But the upshot is that these hurdles may simply make the costs of enterprise crowdfunding too high for firms that might benefit from it.[xi]
Notwithstanding these criticisms, enterprise crowdfunding will become a reality sooner rather than later, and tech start-ups will be among the first to explore using it. Yet no one appears to have written about the effects of enterprise crowdfunding on start-ups’ intellectual property (“IP”) strategies. Because IP is arguably the most important asset a start-up holds, this relationship is worth considering. This blog post provides preliminary thoughts about this topic.
Enterprise Crowdfunding Benefits for Start-Up IP Portfolios
Building an IP portfolio for a start-up is a long-term capital expense. Individual IP assets can arise from discrete projects, but the funding model for each project often does not include monies for IP procurement. Technology start-ups generally will have no revenue for a number of years while developing their products/services and business model. An IP budget is far down the list of expenses to be budgeted for, and will have to come from capital investments. VC-funded start-ups can usually budget for IP expenses, but those without such professional funding often cannot. Thus, the unfunded start-ups are the ones most keen on enterprise crowdfunding. Even angel funding may not be sufficient.
At the same time, start-ups arguably need patents even more than do established firms. Patents provide a critical tool in the David-and-Goliath competition they will have with larger incumbents in the field they seek to disrupt. Patents allow start-ups to appropriate the value of their R&D results by giving them legally enforceable exclusive rights that can be exercised against large incumbents seeking to copy the start-up’s innovations. Given the need for patents and other IP, start-ups desperately need funds to procure these rights. Project crowdfunding does not work unless the IP budget can be included in the overall project budget. Even where this can be done, the timelines of the project and IP procurement and enforcement will likely diverge and make it impractical from a reporting and accounting perspective. Enterprise crowdfunding would remove any uncertainty about the use of funds for IP procurement.
Risks of JOBS Act Enterprise Crowdfunding Disclosure Requirements on Start-Up IP Portfolio Development
The JOBS Act creates a new safe harbor private offering exemption for enterprise crowdfunding.[xii] The statute itself sets major parameters. The exemption covers only those offers and sales of a private issuer that raise no more than US$1MM investments capped for each investor by both absolute dollar amounts and as a percentage of the investorís income or net worth. Crowdfunding issuers will have liability for material misstatements and omissions in disclosed material similar to that of IPO issuers. And crowdfunded securities will be subject to a one-year holding period, with limited exceptions. Issuers must use the private market intermediary portals mandated under the Act, but this means that such portals must be created.
Most important for my purposes, the Act imposes substantial disclosure requirements. Beyond basic information on the company and its capital structure, the Act requires disclosure of business, business plans, intended purpose and use of proceeds, risks, and a catch-all for any other information the SEC decides to require.[xiii] If other disclosure regimes under the securities laws are any guide, crowdfunding disclosure will be labyrinth and intrusive. There is a reason why many companies are choosing to stay private, or return to privately held status, especially after the increased disclosure requirements of the Sarbanes-Oxley Act of 2002[xiv] and Dodd-Frank Act of 2010.[xv]
Following the offering, the issuer will have to file annual reports with the SEC that cover the results of operations and financial statements. Issuers must then provide the reports to investors. Under the SECís proposed “Regulation Crowdfunding,” the SEC will require issuers to submit disclosures through the EDGAR system for public access.[xvi] This public disclosure element makes the crowdfunding exemption particularly problematic. Further, the SEC makes it clear that the point is to transform the process of regulated crowdfunding into a form of crowdsourcing:
The proposed rules are intended to align crowdfunding transactions under Section 4(a)(6) [of the JOBS Act] with the central tenets of the original concept of crowdfunding, in which the public (or the crowd) is presented with an opportunity to invest in an idea or business and individuals decide whether or not to invest after sharing information about the idea or business with, and learning from, other members of the crowd. In this role, members of the crowd are not only sharing information about the idea or business, but also are expected to help evaluate the idea or business before deciding whether or not to invest.[xvii]
Thus, the SEC clearly intends enough information to be made public about the issuer that a large number of potential investors can pore over, share, and compare details of its finances, management, business plan, and employees.
The crowdfunding issuer will become a kind of junior reporting company, yet without the experience and legal counsel of a company that makes it to a traditional public offering. By contrast, current Regulation D offerings require only the filing of Form D–which contains minimal information–with the SEC.[xviii] The more extensive disclosures required under Regulation D are made only to purchasers, and do not have to be public.
There are substantial risks for early stage start-ups to enter into a public disclosure regime. By contrast to IPO stage companies, early start-ups rarely have the specialized securities and IP counsel that can help them navigate the risks involved. Without such counsel, patentable inventions and trade secrets might be inadvertently disclosed–especially in the area of business methods–before applications have been filed and rights preserved. This is particularly true under the time pressure of ongoing periodic and material event reporting that can challenge even mature companies with in-house compliance officers.[xix] The likely place for such accidental disclosures will be in the mandated discussion of the firmís business and financial condition discussion (compared by the SEC to the management’s discussion and analysis of financial condition and results of operation under Regulation S-K for reporting companies).[xx]
As the issuer becomes a junior reporting company, it will also have increased pressure to make other public statements. These disclosures can be the most perilous, especially where they include live remarks by company representatives (whether verbal or through social media). Descriptions of the company’s proposed products or services for purposes of soliciting support in the crowdfunded offering will present risks of enabling disclosures that could destroy patent rights. Part of engaging with the “crowd” may be a broad dialogue in which all manner of potential investors draw out responses from company representatives (official or otherwise) that disclose too much about the company’s plans and technologies. In fact, the SEC anticipates this happening and is already considering whether and how to make such disclosures part of the formal–and hence possibly liability generating–disclosures under Regulation Crowdfunding.[xxi]
In the event that potentially enabling disclosures of business methods or other inventions are made, the company will have to accelerate patent filing decisions. But without the funding to prepare and file a strong application (lack of funding presumably being a major driver of the crowdfunding offering), the company may have to file an inferior application, or no application at all. Thus, the crowdfunding effort may negatively alter the companyís IP strategy timeline.
Ultimately, the disclosure required under the crowdfunding exemption means that start-ups will need to retain expensive securities and IP counsel before starting the crowdfunding process. But if they could afford such counsel, they likely would not be engaged in crowdfunding. The downsides of mandatory disclosure and a broad investor base (that may or may not have voting power) should discourage companies from using this funding model unless they really need it.
Managing Crowdfunding Investors’ Expectations About Start-Up IP Portfolios
Beyond the disclosure issues affecting start-up IP strategies, crowdfunding generally presents issues for management’s interaction with shareholders. Publicly traded companies develop significant expertise and staff just to deal with a large, diffuse set of shareholders. Start-ups will be in no position to do this. Further, they may use crowdfunding to avoid professional investors such as VCs, even though those professionals often bring valuable expertise that can help the start-up manage a base of public shareholders.
Professional start-up investors understand the value of IP. They often know more than the founders about the realities and expenses of building IP portfolios with limited resources. Tough decisions need to be made about what to patent among competing promising inventions. Timing decisions for applications also require experience. Likewise, some inventions may be protectable as trade secrets. And in some industries, such as software, copyright will play an equal role with patents for protection of the core products developed. On top of all this, a strong brand–manifested through distinctive, federally registered trademarks–may play a more important long-term role than patents on any particular technology. Unsophisticated investors, who may constitute a large percentage of crowdfunders, will not be able to offer any help on these matters.
Even if some crowdfunders have such expertise, a start-up would need to bring them into a special confidential relationship to give them access to key inside information. But this could run afoul of fair disclosure concepts, which seek to have all outside shareholders on the same footing with regard to company information. Insiders who have access to nonpublic information are restricted in their ability to trade in the companyís stock. We do not yet know whether the SEC will treat a crowdfunded issuer as a kind of public company, which requires such insider-outsider distinctions for information dissemination.
Further, a crowdfunding raise early in a start-up’s life could deter professional investors from investing later. Many VCs lament capitalization tables bloated with too many friends and family investors. This means unpredictable votes on shareholder issues and more potential for litigation from early stage investors who get diluted in later rounds or disagree with the companyís direction and management.
Professional investors also usually understand the risks of IP portfolio value during the life of the company and in bankruptcy or dissolution. Even though significant amounts of money may have been spent on procuring patents, the portfolio may be worthless if the product or service it covers fails in the market. Of course, the portfolio may be monetized in other ways and experienced VCs may have guidance on that as well. But unsophisticated crowdfunders may wildly over- or underestimate the value of the start-upís portfolio. This shortcoming, in turn, could put them at odds with company management in how to manage and monetize the portfolio.
In response, management may become more conservative in its decision-making–the worst thing for a disruptive start-up. Even then, crowdfunders may engage in litigation and other shareholder activism similar to that related to publicly traded companies. While this can provide helpful discipline to management of large entities, it may not be appropriate for early stage start-ups that need a lot of room to maneuver while exploring risky technologies and business models.[xxii]
Start-ups using crowdfunding will have to develop sophisticated investor relations functions, including investor education about the realities of IP portfolio development and management. Investors will need to know the high costs of patent procurement. They will have to learn that not everything will be patentable, nor will the company be able to patent everything that is patentable. At the same time, these investors will likely not have a say in this–and will not be privy to internal discussions affecting these decisions. Because of the perceived nature and rhetoric of crowdfunding, crowdfunders may be more inclined than public market retail investors to believe they have an active ownership role in the company–including a say in important management decisions. Finally, investors will need to know that expensive patents and impressive looking IP portfolios may turn out to be worthless in operation or bankruptcy.
The JOBS Act reduced the disclosure required for many forms of financing emerging growth companies. Yet, the crowdfunding exemption seems to impose heavier regulation and mandatory disclosures than other private offering exemptions. For a meager US$1MM raise, crowdfunded companies will become junior reporting companies. Despite this inferiority of crowdfunding to other funding avenues, it is expected that many start-ups will use it once the SEC promulgates the final rules. If it allows deserving start-ups to obtain funding they would not otherwise have received, then it may be worth it.
Start-ups that use crowdfunding, however, face a number of risks to their IP portfolio development. First, the public disclosure regime may lead to compromised IP assets. Second, to counter this, start-ups would need to hire expensive specialized securities and IP counsel that they cannot afford. Third, they will have a broad, diffuse and possibly unsophisticated shareholder base may not understand the high risk, tough decision environment of start-up IP portfolio development. Fourth, the demands and possible shareholder activism of such a shareholder base may force management to become far more conservative than is fitting for a disruptive start-up. Fifth, the company will have to incur the costs of developing sophisticated investor relations functions to manage shareholder expectations and provide education. The question is whether the financial benefits of crowdfunding outweigh these risks. More to the point, it may be that start-ups simply cannot afford crowdfunding because costs of managing it will outrun the US$1MM that can be raised.
[i] Jumpstart Our Business Startups Act, Title III, Pub. L. No. 112-106, 126 Stat. 315 (2012).
[ii] A start-up could engage in a public offering with a low offering price per share and achieve the legal equivalent of enterprise crowdfunding. But that is prohibitively costly and impractical for most early stage start-ups.
[iii] On October 23, the SEC issued proposed rules for ìRegulation Crowdfunding.î U.S. Securities and Exchange Commission, SEC Issues Proposal on Crowdfunding (Press Release 2013-227, Oct. 23, 2013); Securities and Exchange Commission, Crowdfunding (Releases 33-9470; 34-70701; File No. S7-09-13)(Oct. 23, 2013); Securities and Exchange Commission, Crowdfunding, 78 Fed. Reg. 66428 (Nov. 5, 2013). The comments period ends February 3, 2014. Thus, a final rulemaking authorizing equity crowdfunding might be promulgated in spring or summer 2014.
[iv] See Sean M. O’Connor, Crowdfunding’s Impact on Start-up IP Strategy at 8-17, available at http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2366937 (forthcoming 21 George Mason L. Rev. __ (2015)). Under the Securities Act of 1933, the default form of offering is “public” which must be registered with the SEC under Sec. 5 of that Act. 48 Stat. 77 (May 27, 1933) (codified as amended at 15 U.S.C. Sec. 77(e)). Because this is expensive and time consuming, Congress allowed for “private offerings” which do not have to go through the registration process. But the uncertainty of what constituted a ìprivateî or “limited” offering led the SEC to promulgate clear safe harbors for different kinds of private offerings.
[v] JOBS Act, Title I-Reopening American Capital Markets to Emerging Growth Companies, Pub. L. 112-106, 126 Stat. 306, 307-308 (2012).
[vi] JOBS Act, Title V-Private Company Flexibility and Growth.
[vii] JOBS Act, Title II-Access to Capital for Job Creators, 126 Stat. 306, 313-315. The SEC has promulgated the final rules authorizing this new ß 506 general solicitation. 78 Fed. Reg. 44771 (Jul. 24, 2013). Regulation D can be found at 17 C.F.R. Sec. 230.500 et seq. Importantly, the new Rule 506 general solicitation permission is limited to offerings where sales will only be made to “accredited investors” (as defined in 17 C.F.R. Sec. 230.501(a)).
[viii] JOBS Act, Title IV-Small Company Capital Formation. “Regulation A+” is based on Regulation A, which can be found at 17 C.F.R. Secs. 230.251-230.263.
[ix] See, e.g., Thomas Lee Hazen, Crowdfunding or Fraudfunding? Social Networks and the Securities Laws: Why the Specially Tailored Exemption Must be Conditioned on Meaningful Disclosure, 90 N.C. L. Rev. 1735 (2012); Alan R. Palmiter, Pricing Disclosure: Crowdfunding’s Curious Conundrum, 7 Ohio St. Entre. Bus. L.J. 373 (2012).
[x] See John S. (Jack) Wroldsen, The Social Network and the Crowdfund Act: Zuckerberg, Saverin, and Venture Capitalists’ Dilution of the Crowd, 15 Vanderbilt J. of Ent. and Tech. Law 583 (2013).
[xi] See Stuart R. Cohn, The New Crowdfunding Registration Exemption: Good Idea, Bad Execution, 64 Florida L. Rev. 1433 (2012); C. Steven Bradford, The New Federal Crowdfunding Exemption: Promise Unfulfilled, Sec. Reg. L.J. 195 (Fall 2012).
[xii] JOBS Act, Sec. 302. In more detail, the exemption is limited to offers and sales that:
* raise no more than US$1MM in the aggregate with all such similarly exempt offerings in a 12 month period;
* do not exceed US$2,000 or 5% of any particular investor’s net worth or annual income (where the net worth or annual income is less than US$100,000) aggregated with all purchases by the investor of the issuerís stock in a 12 month period;
* do not exceed 10%, with a maximum cap of US$100,000, of any particular investorís annual income or net worth where the investors annual income or net worth are equal or greater to $100,000; and
* are conducted through a broker or funding portal complying with a new Sec. 4A added to the Securities Act, and the issuer complies with the provisions of Sec. 4A as well.
[xiii] JOBS Act, Sec. 302; SEC, Crowdfunding, Sec. II(B)(1), 78 Fed. Reg. 66437-66449.
[xiv] Pub. L. 107-204, 116 Stat. 745 (Jul. 30, 2002).
[xv] Pub. L. 111-203, 1245 Stat. 1376 (Jul. 21, 2010).
[xvi] SEC, Crowdfunding, Sec. II(B)(1)-(3), 78 Fed. Reg. 66437-66454 (Nov. 5, 2013).Sec.
[xvii] Id. at Sec. I(C), 66430.
[xix] Besides regular periodic reporting, the SEC is contemplating requiring material event reporting, similar to Form 8-K filings under the Exchange Act. See SEC, Crowdfunding, Sec. II(B)(2), 66450-52. This will put even more time pressure and distraction on inexperienced start-ups, increasing the likelihood of accidental disclosure of sensitive information.
[xx] Id. at Sec. II(B), 66437-44. Because the SEC at this time is not mandating the form of the business and financial condition disclosure reports, issuers may well over report to stay on the safe side of an indeterminate line for compliance with Regulation Crowdfunding.
[xxi] Id. at Sec. II(B)(3), 66452-54.
[xxii] This could be limited through use of non-voting stock with mandatory buy-out provisions allowing the company to later reduce the cap table. But the crowdfunding shareholders would have to agree to buy shares under these conditions. It remains to be seen whether a crowdfunding market could develop around such terms.