Will Deal Costs Kill Retail Equity Crowdfunding?

As the SEC prepares to finalize rules governing what companies must do qualify equity private placement offerings for sale to unaccredited investors under Title III of the JOBS Act, more and more would-be players in the nascent “equity crowdfunding” market are coming around to the view that statutory deal costs may prevent it from ever becoming a viable channel for raising significant capital. The SEC, in its own analysis of expected costs of raising capital via Title III sanctioned public or retail crowdfunding included in the 585-page Title III rule proposal released last October, suggested that fixed costs of accounting audits, legal work and offering commissions could consume up to 39% of proceeds from crowdfunding raises of less than $100,000, and up to 15% of raises between $100,000 and $1 million. Crowd Capital Associates, a Berkeley, Calif., research group founded by crowdfunding evangelist Sherwood Neiss, estimates that Title III equity offerings of $100,000 to $1 million, the annual statutory limit for companies, will spend between 10% and 40% of their proceeds on deal costs and compliance. Those costs include ongoing annual audits for companies raising $500,000 or more that could eat up 25% of the proceeds of a $500,000 offering. Which may mean entrepreneurs will need to crowdfund the deal costs of a crowdfunding round before they can actually raise money for their businesses.

Mark Cuban

Maverick Justice

Mark Cuban

If there are any lessons to be learned from this week’s not guilty verdict in the SEC vs. Mark Cuban insider trading case, it must be that it’s good to be king. Or at least a billionaire, a celebrity, and a Texan. Mark Cuban, brash dot-com billionaire, professional sports team owner, reality TV show celebrity, and sometime microcap company investor, was acquitted of insider trading charges in Dallas federal district court last week. The verdict was reached by a hometown jury which took three and a half hours to decide that taking a call from the CEO of a public company in which he was the largest single investor, to be told about an impending and unannounced private placement which would dilute his holdings and almost certainly lower the value of his investment, to which he did not dispute that he replied, “Now I’m screwed.

APO Redux: New Solicitation Rules Open the Door for Direct Public Offerings

No sooner had the ink begun to dry on the SEC’s recently adopted amendment to Rule 506 of Regulation D allowing the public promotion of equity private placements, and free-thinking securities attorneys and investment bankers began pondering the possibilities of their new-found freedom to hawk their wares from the mountaintops. Ever the innovators never willing to accept the well-trodden path when a cleverly engineered shortcut is available, in no time the cleverest among them began to imagine what was only recently regarded as unthinkable: the rebirth of the APO market. APOs, or “alternative public offerings,” are generally referred to a combination of a public shell company with a private operating business that is concurrent with an equity private placement by the public company, which results in a capitalized public company which owns the private operating business. APOs first became popular in the middle of the past decade, when a perfect financial storm of greed, demand and opportunity came together. The greed came from the surfeit of PIPE deal makers – fund managers, placement agents and deal attorneys – that had grown around the PIPE market during its heyday of 2000-2006, when a public offerings market in disarray and a whole generation of newly public internet companies in financial chaos combined to bring PIPEs issuers into the market by the bushel, offering fat discounts to investors who could lock in their returns with a quick call to their options broker.

Don’t Confuse Growth Capital Investment and PIPE Financing

Last month’s Growth Capital Investor webinar on negotiating with hedge funds for financing included a discussion by the program’s panelists, Joe Smith of Ellenoff Grossman and Schole, and Adam Epstein of Third Creek Advisors, over the differences between most hedge fund-originated investments in emerging growth companies and those made by other types of investors such as private equity, venture and mutual funds. The primary difference being that most hedge fund investments should not be considered investments at all. As Smith noted, hedge funds using PIPE structures to invest in small cap companies are better characterized as financiers rather than investors – a critical distinction that company management and boards too frequently fail to grasp, or choose to disregard. Epstein makes the same point in his recent book on small cap corporate governance, “The Perfect Corporate Board”:

“Even seasoned directors and investors sometimes fail to appreciate that in the small-cap ecosystem there are investors and there are financiers….The routine failure of small-cap companies to make that distinction is significant because officers and directors wrongfully assume that any party that invests capital directly into the company is a “partner.” Financiers, though, are not in the partnering business….”

Hedge funds exist in a place in the financial markets which allows them to raise ungodly sums of capital from other investors so long as they deliver to them on two primary objectives: uncorrelated risk-adjusted returns; and near-complete liquidity. These mandates engineer hedge funds to go where the profits come hot and fast.