Three Basic Rules: Dilution, Dilution, Dilution

Take a sample of 100 venture-backed companies successful enough to undertake an initial public offering. In a high percentage of the transactions, the prospectus discloses that the earliest stage investors (founders and angels) wind up with close to trivial equity percentages and thus, puny returns on their investment in the company. One would think that these investors are entitled to the lushest rewards because of the high degree of risk accompanying their early stage investments, cash and/or sweat. The problem, however, is dilution. Most early stage companies go through multiple rounds of private financing, and one or more of those rounds is often a “down round,” which entails a disappointing price per share and, therefore, significant dilution to those shareholders who are not in a position to play in the later rounds.

The problem of dilution is serious because it has a dampening impact on angels and others who are thinking of financing, joining or otherwise contributing to a start up. Estimates put the relationship of angel capital to early stage investments by professional VCs at five dollars of angel capital going into promising start ups for every one dollar of VC investment. But if angels are increasingly discouraged by the threat of dilution, particularly since the meltdown, we don’t have much of an industry; there is no one to start the engines. [1]

There are a variety of fixes for the dilution issue open to founders and angels.

  • Make sure you enjoy pre-emptive rights, the ability to participate in any and all future rounds of financing and to protect your percentage interest. Pre-emptive rights can be, of course, lost if you don’t have the money as founders and angels often do not to play in subsequent rounds.
  • Try to get a negative covenant; this gives you a veto over the subsequent round and particularly the pricing of the terms.

You don’t want to kill the goose of course, meaning veto a dilutive round and then once the Company fails for lack of cash; however, a veto right at least will you the opportunity to make sure the round is fairly prices; that the board casts a wide enough net so that the round is not an inside trade; meaning that the investors in control of the Company, go over in the corner and do a deal with themselves. Those rounds can be highly toxic to the existing shareholders (cram downs, as they are called). Finally, if you don’t have cash try to upgrade your percentage interest with derivative securities, options and warrants (a warrant is another word for option, they are the same security, a call on the Company’s stock at a fixed price but options are if the call was labeled if an employee is the beneficiary is the holder and the warrants are for everyone else). If you are the founding entrepreneur therefore, make sure you are a participant in the employee option program. Often the founder will start off with a sufficient significant percentage of the Company’s equity that she doesn’t feel necessary to declare herself eligible for employee options. This is a major mistake. In fact, I am likely to suggest founder client consider a piece of financial engineering I claim to have invented; the issuance of warrants in favor of the founders and angels at significant step-ups from the current valuation, which I call ‘up-the-ladder warrants.’ To see how the structure works, consider the following example:

Let’s say the angels are investing $1,000,000 in 100,000 shares ($10 per share) at a pre-money valuation of $3 million, resulting in a post money valuation of $4 million ($1 million going into the Company). We suggest angels also obtain 100 percent warrant coverage, meaning they can acquire three warrants, totaling calls on another 100,000 shares of the Company’s stock; however not to scare off subsequent venture capitalists or, more importantly, cause the VCs to require the warrants be eliminated as a price for future investments. The exercise prices of the warrants will be based on pre-money valuations which are relatively heroic win/win valuations, if you like. For the sake of argument, the exercise prices could be set at $30, $40 and $50 a share (33,333 shares in each case).

Let’s use a hypothetical example to see how this regime could work. Since the angels have invested $1 million at a post-money valuation of $4 million, they therefore own 25 percent of the Company–100,000 shares out of a total of 400,000 outstanding. The three warrants, as stated, are each a call on 33,333 shares. Subsequent down rounds raise $2,000,000 and dilute the angels’ share of the Company’s equity from 25 percent to, say, 5 percent–their 100,000 shares now represent 5 percent of 2,000,000 shares (cost basis still $10 per share) and the down round investors own 1,900,000 shares at a cost of $1.05 per share. Assume only one down round. Finally, assume the Company climbs out of the cellar and is sold for $100 million in cash, or $50 per share.

Absent ‘up-the-ladder warrants,’ the proceeds to the angels would be $5 million–not a bad return (5x) on their investment but, nonetheless, arguably inconsistent with the fact that the angels took the earliest risk. The ‘up-the-ladder warrants‘ add to the angels’ ultimate outcome (and we assume cashless exercise or an SAR technique, and ignore the effect of taxes) as follows: 33,333 warrants at $20/share are in the money by $666,660 and 33,333 warrants at $10 a share are in the money by $333,330. While the number of shares to be sold rises to 2,066,666, let’s say, for sake of simplicity, the buy-out price per share remains at $50, meaning the angels get another $999,999–call it $1 million. The angels’ total gross returns have increased 20 percent while the VCs’ returns have stayed at $95,000,000. Even if the $1,000,000 to the angels comes out of the VC’s share, that’s trivial slippage … a gross payback of 47.5 times their investment, vs. 47 times. If the company sells for just $30 a share, the angels get nothing and the VCs still make out.


For more information about raising Private Equity & Venture Capital, please visit VC Experts

What Not To Say In a Business Plan

Guest Post by: Barry Moltz

The following is an excerpt from his e-book entitled, Growing Through Rants and Raves. Barry Moltz is also the writer of a book entitled You Have to Be a Little Crazy, which delivers irreverent, straight talk about the complex intersection of start-up business, financial health, physical well-being, spiritual wholeness and family life. This title and other publications by Barry can be viewed at his website, http://www.barrymoltz.com.

Sometimes I find that the company’s founder is so far ‘outside the box’ that they ‘stretch the envelope.’ As an angel investor, I review more than 500 business plans each year. Unfortunately, many are so riddled with economy lingo, business jargon and clichés, that they do not communicate any real business value. In my opinion, terminology, such as disintermediation, sweet spot, ASP, best of breed, and win-win should be outlawed for the next 100 years. For building a real business, these terms are meaningless. Another challenge when reviewing business plans is that the introductory sentences sometimes stretch for an entire paragraph as the entrepreneur looks for that all-encompassing way to describe their business. Forget it! There isn’t one. Many times I want to strangle the writer to simply tell me what they do in five words or less. Poor choice of words: This business makes mechanical gasoline fueled devices, used for transportation, more efficient by periodically sending them through an applied for patent machine to loosen the terra firma from these vehicles to make them more conducive at performing their task. Solid choice of words: We run a car wash. Another frequently used practice is to create a business plan using template software or by working from an existing plan. I do not recommend this practice and like to refer to William Sahlman in his Harvard Business case study “Some Thoughts on Business Plans.” This case study has continuously inspired me to see beyond clichés and catchphrases and better interpret misleading statements within business plans.

If the plan says: “Our numbers are conservative.” I read: “I know I better show a growing profitable company. This is my best-case scenario. Is it good enough?” Since all numbers are based on assumptions, projections in business plans are by their very nature a guess and are not conservative.

If the plan says: “We’ll give you a 100 percent internal rate of return on your money.” I read: “If everything goes perfectly right, the planets align, and we get lucky, you might get your money back. Actually, we have no idea if this idea will even work.” No one can predict what an investor’s return will be. Let them decide.

If the plan says: “We project a 10 percent margin.” I read: “We kept the same assumptions that the business plan software template came with and did not change a thing. Should we make any changes?” Ensure you have developed your financial projections from the ground up.

If the plan says: “We only need a 5 percent market share to make our conservative projections.” I read: “We were too lazy to figure out exactly how our business will ramp up.” Know what it will cost to acquire customers. Gaining 5 percent market share is not an easy task in a large market.

If the plan says: “Customers really need our product.” I read: ” We haven’t yet asked anyone to pay for it.” or “All our current customers are our relatives” or “We paid for an expensive survey and the people we interviewed said they needed our product.” The definition of a business is when people pay you money to solve their problems. This is the only way to prove people “need it.”

If the plan says: “We have no competition.” I read: Actually … I stop reading the plan. Always beware of entrepreneurs that claim they have no competitors. If they are right, it’s a problem and if they are wrong, it is also a problem. Every business has competitors or else there is a current solution to this customer need. If there are no competitors for what the entrepreneur wants to do, there is a good chance there also is no business. So what should an entrepreneur do? Write the plan in plain and proper English. Please understand that the reader comes to the plan with no knowledge of your business. No fancy words, clichés or graphs will make them want to invest. Understand every part of your plan and be able to defend it. Use your own passion to describe your plan. Make your plan your own.

The 11 things that matter in a business plan:

  • What problem exists that your business is trying to solve. Where is the pain?
  • What does it cost to solve that problem now? How deep and compelling is the pain?
  • What solutions does your business have that solve this problem?
  • What will the customer pay you to solve this problem? How solving this problem will make the company a lot of money.
  • What alliances can you leverage with other companies to help your company?
  • How big can this business get if given the right capital?
  • How much cash do you need to find a path to profitability?
  • How the skills of your management team, their domain knowledge, and track record of execution will make this happen.

Please remember, the business plan is basically an “argument” where you need to state the problem and pain, then provide your solution with supporting data and analogies.

What Will VC’s Want For A Security: Common Stock? Preferred Stock? Debt? Warrants?

Written by: Joseph W. Bartlett/VC Experts Founder

As one programs any financing, as in corporate finance generally, the objective is to make 2 + 2 = 5; that is to obtain added value for the issuer. In the course of a financing, the insiders are attempting to raise the maximum amount of money for the minimum amount of equity (“equity” meaning claims on the residual values of the firm after its creditors have been satisfied). A corporation will issue at least one class of common stock because it must; many firms stop there; they pursue the simplest capital structure possible in accordance with the KISS principle (“Keep it Simple, Stupid”). However, in so doing, the corporation may close down its chances to pursue the added-value equation (2 + 2 = 5) because that equation involves matching a custom-tailored security to the taste of a given investor. The top line of the term sheet will ordinarily specify the security the VCs opt to own; the following discussion takes up the most common possibilities.

Different investors have differing appetites for various combinations of risk and reward. If a given investor has a special liking for upside potential leavened with some downside protection, the investor may “pay up” for a convertible debt instrument. An investor indifferent to current returns prefers common stock. The tax law drives some preferences, since corporate investors must pay tax at full rates on interest but almost no tax on dividends. On the other hand, the issuer of the security can deduct interest payments for tax purposes–interest is paid in pre-tax dollars–but not dividends. The sum of varying preferences, according to the plan, should be such that the issuer will get more for less–more money for less equity–by playing to the varying tastes of the investing population, and, in the process, putting together specially crafted instruments, custom made as it were. A potential investor interested in “locking in” a return will want a fixed rate on debt securities instead of a variable rate; the ultimate “lock-in” occurs in a zero coupon bond, which pays, albeit not until maturity, not only interest at a fixed rate but interest on interest at a fixed rate.

As the practice of tailoring or “hybridizing” securities has become more familiar and frequent, the traditional categories can become homogenized. Preferred stock may come to look very much like common stock and debt resembles equity. In fact, the draftsmen of the Revised Model Business Corporation Act no longer distinguish between common and preferred stock. Moreover, it may be advantageous (again with a view to making 2 + 2 = 5) to work with units or bundles of securities, meaning that an investor will be offered a group of securities, one share of preferred, one debenture, one share of common, and a warrant, all in one package.

Indeed, creativity by sponsors has spawned a variety of novel “securities,” equity and debt, which have played a role in venture capital, the underlying notion being to maximize values by crafting instruments to fit the tastes of each buyer and to capture current fashions in the market. The use of “junk” or “fluffy debt has been the focus of popular attention of late; however, junk bonds debt securities which are less than investment grade and, therefore, unrated are only one species of the complex phyla of hybrid securities invented by imaginative planners. Thus, a given issuer‘s financial structure can perhaps be best envisioned by thinking in terms of layers of securities. The top layer is the most senior: usually secured debt, “true” debt in the sense that the holder is opting for security of investment and “buying” that security by accepting a conservative rate of return, a fixed interest rate, or a variable rate tied to an objective index. The bottom layer is the most junior: common stock (and if the common stock is divided into different series, the most junior series); on occasion, this level is referred to as the “high-speed equity.” The risk of a total wipeout is the greatest, but, because of the effects of leverage, so is the reward. In between are hybrids, layers of securities with differing positions, meaning differing claims on Newco‘s current cash flows and the proceeds of a sale or liquidation of the entire enterprise.

The variables open to the planners include the following:

  • a security can be denominated either debt or equity with different tax consequences to both the issuer and the holders;
  • a security may be senior, or subordinated, or both, as in senior to one level and subordinate to another (the term “subordinated” opens, in and of itself, a variety of possibilities);
  • a security may be convertible into another at a fixed or variable rate of exchange (and convertible over again, as in debt convertible into preferred stock, in turn convertible into common);
  • an equity security may contemplate some form of fixed recoupment of principal, perhaps expressed in terms of a redemption right;

Redemption can be at the option of the issuer, the holder, or both; and the issuer‘s obligations to make periodic payments with respect to a debt security can range from the simple to the exotic–monthly interest payments at a fixed rate to so-called PIK payments (payment in kind, meaning in stock versus cash) tied to the performance of a particular business segment (as in “alphabet stock”). The utility of this structure is that it gives Newco time to fulfill the promises in its pitch book.

All that said, in today’s universe, the market standard is common stock to the founder founders, plus the friends and family. The next round, with the exception noted, is convertible preferred stock. The jump balls are participating versus non-participating, cumulative dividends, etc. But the security is convertible preferred, even in the angel round, which used to be common. The exception is a convertible note in the bridge round, next round pricing. See the Buzz article, The Next Round Pricing Strategy.

For more information on Venture Capital and Private Equity, please visit VC Experts.

Ten Tips to Magnetize Your Business Plan

It is a rare entrepreneur who can raise money beyond the seed round without a well prepared, thoroughly research business plan. It maps out the road to success. The business plan must convince investors that you know the best route to get there and that if there are twists and turns in the road, as there inevitably will be, you can navigate them. Typically, venture capitalists (VCs) and angels focus primarily on the management team, the idea, market opportunity, and the financials, but other factors play into the final decision of an investor to fund a business. Here are ten tips that will magnetize your business plan making it more attractive to investors.

1. Hook them Immediately

Investors are deluged with business plans, rejecting most within a few minutes of beginning to read them. How do you stand out from the rest? Open with a couple of sentences that grab the attention and imagination of investors and entice them to want to read more. These first few sentences must tell the reader what you do, why you are unique, the size of the market, and the share of market you expect to capture and when.

2. Project Solid Management Expertise

The strength of your start-up’s management team is absolutely critical to your success and your ability to raise venture and angel financing. A start-up doesn’t need to have a complete team to raise funding, but it should, at the least, have key players on board who have the experience and the vision to make the company a success. VCs and angels invest in people, not just ideas on paper, and they want to make sure that your team can deliver. Investors look for an effective management team that:

  • Has successfully started and run other companies
  • Works cooperatively
  • Consists of members selected to provide a range of industry knowledge and functional skills
  • Has integrity, passion, flexibility and reliability

Corporate and advisory board members can help enhance the expertise, experience, and network of the managers of a start-up. Marquis names impress investors. Choosing well-represented professional resources such as accountants and lawyers will not only expand your network but also increase your credibility with investors.

3. Develop Captivating and Believable Financials

Investors will want to know how you arrived at your projections. These assumptions should be clearly spelled out. If you have an existing business, you have a pretty good sense of how much things will cost, how much staff you’ll need, and the sales, you’re likely to make. But when you’re just starting out, these projections are difficult to make. Instead, develop your financials from the bottom up.

  • Examine different distribution channels and the opportunities and costs in each
  • Source manufacturers and suppliers
  • Project staffing needs with salaries and start dates

Investors will expect numbers to be more or less aggressive depending on the stage, level of risk of the company and whether they are a VC or an angel. Angels tend to have less aggressive goals than VCs.

Know your numbers and be ready to explain how each item in your projections has been calculated, because any serious investor is likely to grill you on the detail. You’ll also be expected to know your brake event point, burn rate, when you are going to run out of money and what the investor’s exit strategy is (buyout, IPO, merger/acquisition).

4. Target a Significant Market With Opportunity

VCs in particular are looking for big opportunities – they want to know that your business will serve a large market (at least $1 billion) and possibly become a market leader. They want to understand what the market situation is that needs to be addressed and how you plan to exploit it. Is the consumer frustrated, perhaps the industry is plagued by poor quality control? Is it an untapped market niche? Are you consolidating a fragmented market? Have you developed a technological or medical breakthrough?

5. Include a Well-Researched Market Analysis

Part of targeting a significant market opportunity is knowing everything about the market, not just is size and opportunity. Provide a full analysis of the market, its characteristics, growth potential and all relevant trends. Include a competitive analysis, which describes the strengths and weaknesses of the competitors within your market and your competitive advantage.

6. Create Competitive Barriers

You must have a sustainable competitive advantage. Do you have patents, copyrights, a proprietary process or technology, exclusive licenses or agreements? Are you the first to market? How long can you protect that lead if a big company enters the market? Do you have the best people or the best strategic partners?

7. Forge Strategic Alliances

Securing strategic alliances with key players in the industry, distributors, vendors, etc., shows venture capitalists and angels that others trust you, want to work with you and establishes proof of concept, which is particularly important for a start-up. This definitely increases an investor’s confidence in you.

8. Set Realistic and Achievable Milestones

Investors don’t give a large sum of money in one chunk. You’ll need to address how much will be needed, when each contribution will be made and what the goals are to be accomplished in that period. If you don’t achieve your goals you may not get the next contribution so make your milestones realistic.

9. Show Management’s Commitment

For start-ups, a personal investment on the part of the entrepreneur demonstrates his or her seriousness and willingness to take on part of the risk and shows investors the entrepreneur’s commitment to the project.

10. Attend to the Details

VCs and angels don’t have a lot of time or patience. The business plan should be:

  • Concise – about 30 pages
  • Consistent – numbers in particular need to be consistent throughout the text of the plan, the
  • Financials and the assumptions
  • Well documented – footnote where appropriate
  • Accurate – don’t make things up
  • Easy to read
  • Well laid out
  • Written in an acceptable business plan style
  • Handsome – use of color on the cover and graphics can be beneficial

Be sure the cover page has the name of your company, logo, its address, phone and fax numbers and company URL, plus the name and title of the contact with email address. Include a table of contents that provides a logical arrangement of the sections of your business plan, with page numbers. Believe it or not entrepreneurs sometimes overlook these small details.

Final Points

Getting funding is no easy task. Hard work, persistence and following these tips will improve your chances of success.

How to Use and Protect Your Trademark without a Registration

Guest Post by:  Kristin Cornuelle /Senior Associate at Orrick

Many companies are interested in protecting their brands, but are sometimes unclear about how to protect a trademark, and most importantly, how to use it properly.  Trademarks do not have to be registered with the U.S. Patent and Trademark Office (USPTO) in order for the owner to have rights.  Even if you do not have a state or federal trademark registration, you may have common law trademark rights – at least with respect to the geographical area you are operating in – if you are using your mark in connection with your product or service and providing it in commerce.

Although you cannot use the circle R symbol ® until the trademark is registered with the USPTO, you can use a TM or SM superscript to indicate that you are claiming common law rights in your mark.  When you are using a trademark in your advertising material or on your website, consider using the TM or SM superscript in the upper right hand corner.  Try to use the TM or SM superscript in the first or most prominent use of the mark on the web page or collateral. In other words, the first time the trademark appears in the collateral, advertisement or web page.  No need to use it every time, but the most prominent usage will put viewers or readers on notice that you are claiming common law rights to that mark.  The TM or SM superscript can be a great deterrent to other individuals or entities who are considering the same or similar mark for their product or services.

It is also important to highlight your trademark in some way to set it apart from the rest of your advertising language.  You do not need to capitalize the trademark, but it is a good idea to highlight it in some way to pull it out from general text, either through bold, underline or italics or a different font or stylization.  You can also use it consistently on each webpage in a prominent location, such as the header or footer, in a different size than your other web content.

Another common mistake many make is using a trademark as a noun or a verb.  Make sure that you only use the trademark as an adjective, not as a noun or verb, or as a plural or possessive.  For example, “Our ORRICK legal services support start-up companies who are looking to….”

Of course, you can always file a trademark application with the USPTO and obtain some wonderful benefits, and you should definitely consider this option.  In the meantime, these tips should give you a start on protecting your brand without one!

Trademarks

If you have questions about trademarks and how to protect or enforce them, please contact Kristin Cornuelle at kcornuelle@orrick.com

For more information as presented in our August 24th Trademarks session, please click the image to the left.


Kristin Cornuelle, a senior associate in the Portland office, is a member of the Intellectual Property Group and the Trademark, Copyright and False Advertising Group. Kristin has experience with both intellectual property and general commercial litigation matters.

Regulation Crowdfunding: A Six-Month Update

Guest Post By: Samuel Asher Effron, Associate with Mintz Levin

It has been almost seven months since issuers across the country began raising money through Regulation Crowdfunding (“Reg CF”), which went into effect on May 16, 2016. In the six months since Reg CF went into effect, 160 initial filings for crowdfunding offerings on Form C were made with the SEC. The following summary of the highlights and trends are based on data collected from those Form C filings through November 16, 2016.

The General Landscape

First, the good news – despite the naysayers (including this author), a surprising, but still relatively small, number of issuers took advantage of Reg CF to launch 160 crowdfunded offerings, including six issuers who have launched two campaigns each. Of those campaigns, a total of approximately $13.5 million has been pledged or funded, with nearly $8 million raised in 32 successfully funded campaigns. Unfortunately, all of this is also the bad news – the success rate for Reg CF offerings so far is only 20%; that’s not great. And the total amount raised in Reg CF offerings in this six-month period compares very unfavorably to the amount raised in Regulation D offerings during the same period, which is close to $30 billion. Further, of the nearly $8 million raised to date, over half represents just five issuers, with three of those hitting the maximum Reg CF offering amount of $3 million. That said, this is just a start, and the data from the first six months reveal some interesting trends that could give us a glimpse into how Reg CF will be used in the future.

Industry Focus

One of the big surprises about the types of companies utilizing Reg CF has been the high participation by, and success of, companies in the food and beverage industry, especially small breweries, distilleries and restaurants. Food and beverage companies comprised a total of 17.5% of all campaigns in the first six months of Reg CF, 28.13% of funded campaigns, by far the largest successful general industry category (with the closest trailing category being “Apps”, representing 9% of all funded campaigns). It’s possible that the affinity groups associated with food and beverage producers create a built-in audience for crowdfunding.  Compare food and beverage’s success with the experience of “tech” companies, including apps, online platforms and other technology-related businesses, which have fared particularly poorly with Reg CF – “tech” companies represent 25% of all launched campaigns, but only 12.5% of successfully funded campaigns. The most successful campaign so far, based on both amount raised ($1 million) and number of investors (a whopping 1,396 individuals) was fledgling movie studio Legion M.

Issuers

For a fundraising mechanism designed to assist small private companies to raise small amounts of capital, it is not surprising to discover that most of the companies utilizing Reg CF are relatively young. The median age of a Reg CF issuer is about two years, and with almost 62% of all issuers formed since January 2015, and about 28% formed just since Reg CF went into effect! That said, there are some older companies utilizing this new method – about 20% are older than four years, and one issuer has been in business since 2003. The companies’ geographic diversity is impressive – campaigns have been launched in 32 states and the District of Columbia. California represents the state with the most campaigns (30%), with Florida (10.6%), Texas (8.1%) and New York (7.5%) trailing a bit further behind. Interestingly, even though only 8.1% of all campaigns were launched in Texas, that state performed disproportionately well, with almost 22% of successful campaigns.

Investors

Participation levels in the campaigns so far have been varied. While the average number of investors across the 122 campaigns that have disclosed their participation numbers is 79 (excluding two large outliers, including Legion M) and the median number of investors is 20 (same caveat), of that number, 20% have had zero investors, and 32% have had 10 or fewer. That said, the number of investors in a campaign does not correlate to its success – one successfully funded issuer raised its funds from just a single investor. Average investment amounts per investor across all campaigns and all successfully funded campaigns is about $950 and $1,200, respectively.

Platforms

To date, FINRA had approved 21 funding portals to host crowdfunding offerings, with 20 having hosted campaigns during Reg CF’s first six month. Of those that have hosted campaigns, WeFunder is far and above the most prolific and successful so far, measured both by number of campaigns (nearly 38% of all campaigns are hosted on WeFunder’s platform) and number of successfully funded campaigns (nearly 60%). This could possibly be first mover advantage, as WeFunder was one of the first portals up and running from Day 1 of Reg CF. It could also possibly be a result of competitive pricing – WeFunder generally charges a 3% commission on successful campaigns, whereas the vast majority of other platforms charge between 5% and up to 12%. About 16% of platforms, in addition to a commission based on a successful fundraising, also take some form of equity compensation. Other prominent platforms include StartEngine Capital (13.75% of all campaigns, but only 6.25% of funded campaigns), NextSeed US (4.4% of all campaigns, but a staggering 22% of funded campaigns and a 100% success rate), and uFunding Portal (11.25% of all campaigns, but 0% of funded campaigns), the last of which now has the dubious distinction of being the first Reg CF funding platform to be removed and banned from the FINRA list of approved platforms for failing to screen for potential fraud by companies using its services.

Offering Details

So, what are investors actually investing in? The three principal categories are equity (common and preferred), which account for over 50% of all campaigns, debt (straight debt, convertible debt and revenue sharing), which accounts for just under 25%, and SAFEs (simple agreement for future equity – a convertible note-like instrument gaining acceptance in recent years), which were offered in 25% of offerings. What is interesting, though, is that SAFEs were sold in over 40% of successful campaigns, whereas equity was offered in only 25% (comprised of 6.25% preferred stock, and 18.75% common). Further, it is somewhat unusual for SAFEs to be the preferred “security” of choice, both because many of the companies offering them may never actually reach a “qualified financing” in which the principal amount of the SAFE converts into equity, and also because many of the SAFEs have a built in redemption feature which permits the issuers to repurchase any equity securities into which the instruments are convertible. Neither of these are investor-friendly features. Of the debt securities offered in successful campaigns, only one campaign offered a convertible note – the rest were split evenly between revenue sharing arrangements and straight debt.

Looking Forward

So, what do the six-month numbers tell us about Reg CF so far, and what we can expect in the future? There certainly seems to be an audience for food and beverage offerings, which is promising for small breweries, restaurants and distilleries hoping to make a go of it. And companies with low capital needs may be well served by a Reg CF campaign so long as the expenses are not disproportionate to the amount raised. On the other hand, for tech-based companies that have traditionally relied on venture capital and angel investors, the data suggest that it is still easier, less expensive (proportionate to amounts raised) and less burdensome from a public disclosure and reporting perspective to continue to raise money through Regulation D private placements. On the platform side, WeFunder appears to have a strong, early lead over competitors, but SeedInvest (an established private placement platform) and IndieGoGo (a brand name in the awards-based crowdfunding space) have both entered the arena and could be formidable challengers to WeFunder’s supremacy. For now, Reg CF offers another, potentially limited, tool in the fundraising toolbox. With a new incoming administration and SEC Chairperson, changes to the Rules might also adjust the regulation in a way that will make it more useful to companies, and more accessible to investors.


Bio for Samuel Asher Effron

Sam’s practice focuses on venture capital, private equity and other securities transactions, counseling start-ups and emerging growth companies, funds and crowdfunding platforms. Sam is heavily involved in the start-up community in New York and regularly advises and mentors young companies and entrepreneurs regarding the legal and business issues that they face, and speaks at many of the local accelerators, incubators and co-working spaces. He is also a key contributor to MintzEdge, an online resource for entrepreneurs that includes useful tools and information for starting and growing a company, and is the co-editor of TechConnect, Mintz’s periodic newsletter on “all things technology” in the legal and business world.

mintzedge