Step 6: Commit to purchasing shares
Published on March 30, 2016
Remind yourself once more that angel investing is risky, and private securities can be illiquid for several years. Then, if you’re sure, click on “Invest Now,” and send money to an escrow account. If the issuer meets its funding goal, the deal closes and (congratulations) you’re an owner; if not, you’ll get a refund from escrow.
If you are investing in startups and early-stage companies in a systematic way, with your objectives being portfolio diversification and maximum return on investment, then you will complete steps 1 through 5 before you commit to an equity crowdfunding deal.
When you make the decision to invest in a private company, you have done most of the hard work. The transaction—transferring money into escrow to purchase equity shares—is easy, thanks to e-commerce technology. But your work is not quite finished. Assuming the issuer reaches its funding goal and the equity crowdfunding round closes, you still need to monitor your equity crowdfunding investments and possibly take action in the event of a liquidation (including dissolution or bankruptcy), subsequent equity financing rounds (e.g., more equity crowdfunding or venture capital), and exit opportunities (such as acquisitions and IPOs). You also might have an opportunity to sell your shares back to the issuer or, after a 12-month holding period, to another investor on a secondary market.
Below we will discuss details of the investment transaction, your rights and obligations as a shareholder, and how to monitor and manage your equity crowdfunding portfolio over the years.
What Happens When You Commit?
On most equity crowdfunding sites, the first step to making an investment is clicking on a button on the issuer’s offering page that says something like “Invest Now.” This is the beginning of a process that ends with transfer of funds into escrow. After committing to invest, you may have to wait hours, days, or weeks to see if the issuer reaches its all-or-nothing funding goal by the stated deadline; if it does, then the round closes and your status changes from a commitment to a transaction. Following are details about the steps in this process:
- By clicking on “Invest Now” and entering the dollar amount of your investment on a commitment form, you are making a promise to invest that amount in the issuer if the funding round closes. Refund policies may vary from one crowdfunding site to another, but once the funding round closes you will not be able to get a refund unless the issuer has violated the law or failed to comply with securities regulations.
- You will be required to “e-sign” the relevant offering documents, including the term sheet. Crowdfunding sites typically use secure, third-party services such as DocuSign to ensure that signatures are legal and enforceable in court.
- Having registered as an investor on the crowdfunding site, you must now “self-certify” that you are qualified to make the investment you are committing to, based on your income and net worth. We summarized the annual investment limits in Step 1. If the SEC later discovers that you have exceeded your annual limit, your investment transaction may be canceled; it is unlikely (but not impossible) that you will be criminally prosecuted, since the regulations are, after all, there to protect investors.
- On some sites, you will have an option to purchase an insurance-like policy (from independent providers) that covers your investment in the event of dissolution or bankruptcy of the issuer, for a limited period—typically up to 18 months after closing. This service is integrated into some crowdfunding sites seamlessly; you do not have to visit the insurer’s website unless you want to check it out. We covered this option more thoroughly in Step 4.
- The portal or platform will provide instructions for securely transferring your funds (the investment amount plus insurance premium, if any) into escrow. You may have an option to mail in a check, use PayPal, or make a wire transfer, for example. If the crowdfunding site is a broker-dealer platform, then the broker-dealer can act as escrow agent and charge a fee to the issuer (at no cost to investors). If the site is a non-broker-dealer crowdfunding portal, then investors transfer funds to an independent escrow agent. The escrow agent’s fee comes out of the issuer’s funds. Crowdfunding portals do not earn any portion of the escrow agent’s fees.
- At this point, some crowdfunding sites will provide a “sharing tool” that lets you notify your off-platform social network (via LinkedIn, Twitter, or Facebook, for example) that you just invested in [name of issuer here] on the [name and URL of portal], and encourage your friends and colleagues to explore the same opportunity. This little marketing ploy promotes the crowdfunding site, attracts more potential investors to the offering that you invested in, and helps ensure that the issuer reaches its funding goal. You have to decide whether you want to involve your social networking contacts in your investment life. (There is no way you can earn referral fees for steering new investors to an offering, as it is illegal under Title III of the JOBS Act.)
Did the Issuer Achieve its Funding Goal?
If the issuer’s funding goal is not achieved by the stated deadline, then the escrow agent returns all funds to the investors; the issuer walks (or perhaps limps) away with nothing, and the crowdfunding site receives no fee.
If the issuer achieves its funding goal by the deadline, then the funding round closes. The escrow agent disburses investors’ funds to the issuer (and to the insurer if applicable) and takes a fee from the proceeds, and the crowdfunding site earns compensation from the issuer: either a fee for listing the offering, an equivalent amount of equity in the deal, or a percentage of the capital raised, typically around 6 to 10 percent. Then the issuer countersigns the offering documents and makes them available in PDF format through each investor’s dashboard. You should copy and store these executed documents on a computer hard drive or another memory device and/or print and file them away for future reference. The crowdfunding site promises to maintain document archives indefinitely, but there is no guarantee of that.
Finally, you might receive a certificate of stock ownership or LLC membership from an SEC-approved stock transfer agent, another outside party contracted by the crowdfunding site. The SEC does not require issuers or platforms to provide such certificates, however. It requires only that shareholder records be kept by issuers, and in some cases that will be evidenced only by a “book entry,” which eliminates the need to issue paper certificates.
After a deal closes, most crowdfunding sites leave a private, secure communication channel open between the issuer and its investors. The crowdfunding site’s staff does not interact with either party via that channel, and it’s not accessible by anyone except the issuer and its investors. Issuers can disseminate reports, newsletters, updates, and other information to investors through this channel. Investors can seek to have discussions with the issuer, and with each other, through the same channel, which each investor can access through his or her dashboard on the crowdfunding site. This channel is to be left open indefinitely by the site, or until the issuer decides it would rather maintain communication channels with investors through its own website.
Issuers have business incentives, as well as legal obligations, to keep lines of communication open with investors. A community of investors can come to the aid of a company that needs help spreading the word about a new product or job openings, for example, or sharing company news via social media. And if the company needs to raise a second round of equity capital, its first-round investors are the logical place to start soliciting funds. A smart company will harness the power of its investor base, and to do that it must keep investors engaged. Likewise, by supporting the company and helping it succeed, you have an opportunity to boost your return on investment. Of course, you also have the right to be a passive investor and not respond to requests for help or input.
Your Rights as a Shareholder
Companies that raise capital via equity crowdfunding must file annual reports with the SEC and make those reports available to investors, in compliance with Title III. Annual reports should include financial statements—profit-and-loss, balance sheet, and cash flow, at a minimum—as well as a discussion of next year’s opportunities and challenges, and how the company plans to reach its near-term goals.
The annual reports do not have to be audited or reviewed by outside accountants. Annual filing requirements under Title III continue until one of the following occurs:
- The issuer goes public.The issuer has filed at least one annual report and has no more than 300 shareholders of record.
- The issuer has filed at least three annual reports and has no more than $10 million in assets.
- The issuer or another party purchases or repurchases all the securities sold in the Title III deal.
- The issuer stops doing business.
In addition to Title III requirements, corporate law requires that companies notify equity investors of annual shareholder meetings, certain kinds of legal proceedings that affect shareholder rights, and any liquidation (dissolution, bankruptcy, merger, or acquisition) or IPO.
Any additional rights of investors would be spelled out in the terms of each deal. Your company (yes, it is your company, as you are now an owner) may be required to provide quarterly reports or progress updates, for example, and/or notify shareholders when their approval is required, whether by majority vote or by absence of a veto, to take certain action such as changing the bylaws or incurring debt above a certain dollar amount. The deal terms might also require the company to notify shareholders of subsequent equity funding rounds (whether via crowdfunding or in traditional Regulation D angel deals) and give early investors the opportunity to participate in later rounds at favorable prices. You may have the right to convert your preferred stock to common stock at any time—which you would not want to do until (1) the company is consistently profitable; (2) the company is about to experience a major liquidity event, such as being acquired; or (3) you want fuller voting rights.
The terms of an investment in preferred stock may entitle you to quarterly or annual dividends based on a percentage of the share price that you paid, even if the company is not profitable. If the company does not have the cash flow to pay such dividends, they would be deferred until the company could pay them cumulatively—if ever. You should keep track of those accumulated dividends if you are entitled to them.
We recommend that you review your term sheet for each investment at least yearly (and study each company’s annual report), as a reminder of the options you may have as your company develops and changes.
As a company owner, you have a right (along with the company’s customers and everyone else in the world) to contact the founders and executives and ask questions, express concerns, or offer advice. Keep in mind they do not have a legal obligation to respond to you, although most companies want to maintain good relations with their investors.
About the Authors
David M. Freedman and Matthew R. Nutting are coauthors of Equity Crowdfunding for Investors (Wiley & Sons, 2015).