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BRIDGEFUNDING: CROWDFUNDING AND THE MARKET FOR ENTREPRENEURIAL FINANCE
Seth C. Oranburg*
Title III o --- the Jumpstart Our Business Startups Act o --- 2012 (Regu- lation Crowd --- unding) should encourage entrepreneurship by allowing startups and small businesses to sell stock online. Un --- ortunately, that law applied Depression-era securities law concepts to peer-to-peer --- i- nancing in the Internet era; as a result, it implemented Internet-investor protection ine ---
ectively. Using Regulation Crowd — unding requires star- tups to comply with costly and unnecessary anti — raud requirements. Even a — ter making disclosures, registering with a — unding portal, and producing audited — inancial statements, startups still cannot raise enough money via Regulation Crowd — unding to deploy high-growth strategies without needing more — unds — rom pro — essional angel and ven- ture investors. This Article explores the business environment o — entrepreneurial
inance through the lens o — securities regulations. It — inds that regulators should be more concerned with protecting investors — rom startup — ailure than — rom crowd — unding — raud. It recommends an amendment to Regula- tion Crowd — unding that may enable startup success: the limit on — un- draising should be raised — rom $1 to $5 million. Bridge — unding theory begins with the observation that historically low percentages o — startups are “bridging” — rom angel to venture — inanc- ing; the rest o — ten — ail. Legal and economic analyses demonstrate that this growing gap is the result o — regulations and market — orces. Bridge — unding recognizes that peer-to-peer Internet — inancing is inher- ently di —
erent than securities issuances o — yore. It posits that crowd — und- ing could bridge the — unding gap and theorizes why bridge — unding may be sa — er — or investors and better — or startups.
INTRODUCTION . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 398 R I. STARTUP INVESTMENT . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 402 R A. The Startup Private Equity Market . . . . . . . . . . . . . . . . . . 403 R 1. Private Equity Market Participants . . . . . . . . . . . . . . 404 R
* Visiting Assistant Pro --- essor o --- Law, Chicago-Kent College o --- Law; J.D., University o --- Chicago Law School, cum laude. I thank Douglas Baird, Lisa Bernstein, Richard Epstein, Manuel Utset, Jay Kesten, Shawn Bayern, Jake Lin --- ord, Sam Wiseman, Hannah Wiseman, Mark Spottswood, Andrew Verstein, Cathy Hwang, Richard Benham, Peter Gruskin, Eli Elias, and Jason Del Rosso --- or their valuable comments and suggestions.
397
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a. Startups . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 405 R
b. Angel Investors . . . . . . . . . . . . . . . . . . . . . . . . . . . . 407 R
c. Venture Capital Investors . . . . . . . . . . . . . . . . . . . 408 R
2. The Startup Private Equity Financing Cycle . . . . . 410 R
3. The Series A Gap in the Private Equity Market . . 412 R
B. The Market --- or Entrepreneurial Finance . . . . . . . . . . . . 416 R II. BRIDGEFUNDING . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 419 R
A. The Bridge --- unding Proposal . . . . . . . . . . . . . . . . . . . . . . . . 419 R
B. Why Bridge --- unding Works . . . . . . . . . . . . . . . . . . . . . . . . . . 422 R
1. Bridge --- unding Can Fill the Private Equity Gap . . 422 R
2. Crowds Are Suited --- or Bridge --- unding . . . . . . . . . . . 423 R
3. Bridge --- unding Addresses Fraud . . . . . . . . . . . . . . . . . 425 R
4. Bridge --- unding Addresses Cost . . . . . . . . . . . . . . . . . . 428 R
5. Bridge --- unding Addresses Business Risk . . . . . . . . . 430 R
6. Bridge --- unding Addresses Price Uncertainty . . . . . . 431 R
7. Bridge --- unding Opens New Business Models . . . . . 434 R III. WHY CURRENT REGULATIONS FAIL . . . . . . . . . . . . . . . . . . . . . . 435 R
A. Law and Economics o --- the Private Equity Gap . . . . . . 435 R
1. Economic Theory Explains the Gap . . . . . . . . . . . . . 436 R
2. Venture Capital Success Widens the Gap . . . . . . . . 440 R
3. Angel Technology Heightens the Gap . . . . . . . . . . . 441 R
B. Existing Exemptions Do Not Fill the Gap . . . . . . . . . . . 444 R
1. Regulation D . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 446 R
2. Rule 504 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 446 R
3. Rule 505 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 448 R
4. Rule 506 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 449 R
5. Regulation A . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 450 R
6. Regulation A+ . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 451 R CONCLUSION . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 452 R
INTRODUCTION
Wittlebee was a success --- ul startup that --- ailed --- or surprising reasons. In 2011, --- ormer Myspace Vice President Sean Percival --- ounded Wit- tlebee, a children’s clothing club.1 Subscription business models in tech- nology companies like Net --- lix and Amazon Prime were booming.2 Wittlebee extended that model to the retail clothing market in an exciting new way. Each month, busy parents would receive high-quality clothing
1 See Sean Percival, Introducing Wittlebee, http://seanpercival.com/2012/02/13/intro- ducing-wittlebee/ (last visited Dec. 21, 2014) (describing Wittlebee as “a new way to keep up with your kids’ basic clothing needs.”).
2 See Dan Rayburn, Amazon’s Prime Streaming with De --- initely Disrupt Net --- lix, BUSI- NESS INSIDER (Feb. 23, 2011), http://www.businessinsider.com/amazon-prime-streaming-dis- rupt-net --- lix-2011-2.
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or a low price.3 At — irst it seemed like a runaway success. Initial inves- tors contributed a shocking $2.5 million, — ive times what startups usually raise.4 Wittlebee deployed the capital to grow quickly. It developed a user- — riendly website, poached success — ul customer acquisition guru Chris Nella — rom ShoeDazzle, and even purchased another startup called Cottonseed Clothing.5 Revenues grew quickly—but not quickly enough. Like most early stage startups, Wittlebee was not designed to be sel —
su
icient. Startups — ocus on growth, not pro — itability, and are dependent on raising outside — unding to sustain that growth or even to continue operations. New money had usually been there — or good startups like Wittlebee.6 But in 2012, the money disappeared, and it has not returned. One thousand startups were “orphaned” that year,7 including Wittlebee, which eventually sold its business to FabKids — or pennies on the dollar in November 2013.8 Wittlebee’s business model succeeded when — inanced by its new parent company.9 Its children’s clothing subscription model was clearly a success, but its — ounders — ailed because the capital market
or startup investment has a gap, where money is in short supply.10 Other entrepreneurs, seeing that good startups like Wittlebee can be
orced to liquidate even when employing a success — ul business model, may be discouraged — rom — ounding startups. This Article is the — irst in legal literature to explore this gap as a market — ailure and whether that — ailure is an unintended consequence o —
certain legal regulations. Many assume that capital markets are
ree mar-
3 Id. (explaining that Wittlebee is a new concept in the “subscription commerce” space).
4 See Wittlebee, CRUNCHBASE, http://www.crunchbase.com/organization/wittlebee (last visited Dec. 22, 2014).
5 Michael Carney, Duck, Duck, Acquisition: Wittlebee Taps Kids Clothing Company Cottonseed, PANDODAILY (Aug. 28, 2012), http://pando.com/2012/08/28/duck-duck-acqui- sition-wittlebee-taps-childrens-clothing-company-cottonseed/.
6 In 2008, 225 companies received seed --- unding --- rom angels and 118 o --- angel- --- unded companies received additional --- inancing --- rom venture capital investors. PITCHBOOK, 2013 ANNUAL VENTURE CAPITAL RUNDOWN 9 (2013), http:// --- iles.pitchbook.com/pd --- /PitchBook_VC _Rundown_Y2013.pd --- . In 2012, angels --- unded 814 companies while venture capitalist in- vested in only 244 o --- them. Id. There --- ore the ratio o --- seed- --- unded to VC- --- unded companies dropped --- rom about 2:1 to about 4:1 in the period --- rom 2008 to 2012.
7 Will Oremus, Tech Startups Are About to Start Dropping Like Flies, SLATE (Dec. 20, 2012), http://www.slate.com/blogs/ --- uture_tense/2012/12/20/series_a_crunch_tech_startups_ are_about_to_start_dropping_like_ --- lies.html (“One thousand startups will be orphaned; many will die. One billion dollars will have gone --- or naught. Bright young minds across the country will be out o --- work.”).
8 Michael Carney, Mother and Child Reunion: JustFabs Buys FabKids, PANDO (Jan. 18, 2013), http://pando.com/2013/01/18/mother-and-child-reunion-just --- ab-buys- --- abkids/.
9 See Sarah Perez, FabKids Launches Subscription-based Kids Clothing Service, Ac- tress Christina Applegate Partners, TECHCRUNCH (Aug. 2, 2012), http://techcrunch.com/2012/ 08/02/ --- abkids-launches-subscription-based-kids-clothing-service-actress-christina-applegate- partners/.
10 See, e.g., Ross S. Weinstein, Crowd --- unding in the U.S. and Abroad: What to Expect When You’re Expecting, 46 CORNELL INT’L L.J. 427, 452 (2013).
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kets, but in
act they are heavily regulated. Only “accredited investors” can purchase large amounts o — private equity.11 The two types o — accred- ited investors who participate in the private equity market, angels and venture capitalists, are driven by market dynamics to use di —
erent strate- gies. Most angel groups invest about $400,000 per company, while most venture capitalist — irms invest about $7 million per company.12 This leads to “lumpy” startup investment. It is well documented that startups have trouble raising between $1 and $5 million, a range that has become commonly known as the “Series A gap.”13 Many claim that this gap results — rom a liquidity problem, which is o — ten re — erred to as the “Se- ries A crunch.”14 This Article is the — irst to use game theory—in particu- lar, concepts o — hold-out and — ree rider problems—to show how this private equity gap may also result — rom a market — ailure. In 2012, Congress amended securities law to enable a new way to
inance startups. The Jumpstart Our Business Startups (JOBS) Act o —
2012 is a law that creates a new exemption to securities laws.15 It ex- empts “crowd — unding” — rom the Securities Act o — 1933, allowing startups to sell $1 million o — private equity to the general public.16 Crowd — unding will introduce a new participant, “crowds,” into the private equity mar- ket, which consist o — members o — the general public who do not necessa- rily have any particular accreditation or sophistication about investing. Crowds invest pursuant to a di —
erent set o — dynamics than either angels or venture capitalists.17 Crowds could provide the liquidity needed to avoid the Series A crunch. Un — ortunately, the JOBS Act only allows startups to raise $1 million per year through crowd — unding, which does not address the Series A gap.18 Instead, it merely allows the general public to compete with pro-
essional angel investors to make the — irst investment in startup compa-
11 See 17 C.F.R. § 230.501(a) (2015) (de --- ining “accredited investor” as that term is used in Regulation D).
12 Seed Investing Report—Startup Orphans and the Series A Crunch, CB INSIGHTS (Dec. 19, 2012), https://www.cbinsights.com/blog/seed-investing-report/.
13 See, e.g., John Pletz, Lightbank Looks to Plug the Series A Gap, CRAIN’S CHICAGO B US . (Mar. 26, 2013), http://www.chicagobusiness.com/article/20130326/BLOGS11/ 130329828/lightbank-looks-to-plug-the-series-a-gap (“There are a lot o --- quality seed-stage companies that have done well but not well enough to get over the hump.”).
14 See Rebecca Grant, Watch Out --- or Big --- oot! ‘Series A Crunch’ Sighting Reported in Silicon Valley, VENTUREBEAT (Mar. 25, 2013), http://venturebeat.com/2013/03/25/watch-out-
or-big — oot-series-a-crunch-sighting-reported-in-silicon-valley/ (“The Series A crunch has le — t the realm o — Big — oot and Nessie and is entering the realm o — truth, at least according to Fen- wick & West.”). 15 See Jumpstart Our Business Startups Act, Pub. L. No. 112-106, 126 Stat. 306 (2012). 16 See id. 17 See, e.g., Laura M. Hughes, Crowd — unding: Putting a Cap on the Risks — or Unsophisti- cated Investors, 8 CHARLESTON L. REV. 483 (2014). 18 See id.
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nies.19 316,600 angels seed-
unded 73,400 U.S. startup companies in 2014, when they invested $24.1 billion at an average o — $328,300 per company.20 There is already a substantial contributor to sub-million-dol- lar startup capitalization. The JOBS Act pits crowd — unding investors di- rectly against the more established, sophisticated, and connected angels. As designed by the dra — ters o — the JOBS Act, the $1 million cap is intended to protect the general public — rom investment — raud or — rom sim- ply making outright poor investment decisions.21 Instead, it makes crowd — unding expensive, complicated, ine —
icient, and risky — or unso- phisticated investors. For example, the JOBS Act requires startups to spend up to $150,000 (e.g., to obtain independent audits, disclosure doc- uments, — iling — ees, and legal — ees) be — ore selling equity via crowd — und- ing.22 Raising money — rom angel investors is not only up to six times cheaper than crowd — unding, but angel investment costs are mostly in- curred a — ter — inancing is assured, whereas startups have to sink costs up
ront in order to try crowd — unding.23 Under current regulations, there-
ore, it seems that only startups that are unable to get angel — unding will seek crowd — unding. This Article presents a new solution that uses crowd — unding to solve the Series A gap. The JOBS Act — undamentally misunderstood crowd — unding.24 However, i — existing crowd — unding limitations were in- verted—such that startups had a $1 million — loor and a $5 million ceil- ing—it would become rational — or high-quality startups to seek crowd — unding — or gap — inancing. This Article coins the term “bridge — unding” to describe such a regulatory regime. Bridge — unding ac- complishes more than providing capital to — ill a gap in the private equity market. Bridge — unding also leverages the ability o — crowds to enhance the startup — inancing cycle. Bridge — unding allows crowd — unding to become cost e —
ective with- out reducing — raud protections such as disclosure requirements. It is harder to commit bridge — unding — raud because angels have already vetted
19 See id.
20 Je ---
rey Sohl, The Angel Investor Market in 2014: A Market Correction in Deal Size, CTR. FOR VENTURE RESEARCH (May 14, 2015), https://paulcollege.unh.edu/sites/paulcollege .unh.edu/ — iles/web — orm/2014%20Analysis%20Report.pd — . 21 See, e.g., Van S. Wiltz, Will the JOBS Act Jump-Start the Video Game Industry? Crowd — unding Start-Up Capital, 16 TUL. J. TECH. & INTELL. PROP. 141, 164 (2013). 22 Sherwood Neiss, It Might Cost You $39k to Crowd — und $100k Under the SEC’s New Rules, VENTUREBEAT (Jan. 2, 2014), http://venturebeat.com/2014/01/02/it-might-cost-you- 39k-to-crowd — und-100k-under-the-secs-new-rules/ (explaining a recent SEC cost–bene — it re- port that looked at success — ees, compliance costs, and costs o — CPA review or audit). 23 As o — the date o — this publication, the SEC has not — inalized and promulgated its crowd — unding regulations, so analysis here is based on the proposed — inal rules. For the pro- posed rule, see Crowd — unding, 78 Fed. Reg. 66,427 (Nov. 5, 2013) (to be codi — ied at 17 C.F.R. pts. 200, 227, 232, 239, 240 & 249). 24 See in — ra Part II.
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and continue to monitor the startup when crowds invest. Portals could
urther reduce crowd — unding investor risk by encouraging individuals to diversi — y their investments; as the central nexus — or investment, portals can make it easier to invest small amounts in multiple companies by aggregating, synthesizing, and analyzing in — ormation about investment opportunities. Additionally, bridge — unding introduces a valuable new signal to the private equity market. Bridge — unding could signal to ven- ture capitalists that consumers are likely to desire a product. This may create a positive — eedback loop where crowd — unded companies are more likely to obtain venture capital, thus making crowd — unding more success — ul. Part I o — this Article explains the startup — unding li — ecycle. It exam- ines the investor dynamics that continue to perpetuate the Series A gap, examines data evidencing a private equity liquidity crunch, and in- troduces crowd — unding. Part II introduces “bridge — unding,” a new way that securities regulation can solve the private equity gap and leverage the wisdom o — crowds. Part II also addresses criticisms o — crowd — unding, considers whether bridge — unding alleviates or aggravates those criti- cisms, and suggests some costs and bene — its o — bridge — unding that have not yet been addressed in the crowd — unding literature. Part III delves deeper into the theory o — bridge — unding. This Part uses game theory to explain why there is a gap in the private equity market and also explores why alternative exemptions — ail to — ill the gap. This Article concludes by reviewing the competitive advantage o — crowds to — und the gap.
I. STARTUP INVESTMENT
Equity is the --- inancial --- uel o --- the innovation economy. There are two main types o --- purchasers who --- uel startup development through their investment in equity securities: angel investors and venture capitalists.25 The di ---
erences between these two players in the private equity market have led to a gap in startup — inancing.26 Section A o — this Part reviews how startup private equity works by discussing both angel and venture investment in the private equity market, describing how private equity investments drive what is called the startup — inancing cycle, and explain- ing a gap in this cycle where — undraising is especially di —
icult. Section B introduces crowd — unding, a new regulatory regime that will allow a third type o — investor, the general public, to invest in the private equity market by buying startup stock online.
25 Abraham J.B. Cable, Fending --- or Themselves: Why Securities Regulations Should En- courage Angel Groups, 13 U. PA. J. BUS. L. 107, 111 (2010).
26 See Seth Oranburg, The Law & Economics o --- the Series A Gap, CLS BLUE SKY BLOG (Apr. 6, 2015), http://clsbluesky.law.columbia.edu/2015/04/06/the-law-economics-o --- -the-se- ries-a-gap/.
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A. The Startup Private Equity Market
Startups raise money --- rom “angels” and “venture capitalists” (or “VCs”) primarily by selling pre --- erred stock to these two types o --- inves- tors.27 Startups are generally corporations,28 which is one type o --- com- pany that separates ownership and control. The stockholders technically own the corporation, but the board o --- directors (who are appointed by the stockholders) has authority and controls the corporation’s actions.29 Shareholders have limited rights under corporate law to control a corpo- ration that they own, but shareholders can negotiate --- or contract rights o ---
control. Contractual control rights (like the right o
shareholders to pre- vent the company — rom issuing more stock, to obtain — inancial in — orma- tion about the corporation, to prevent other shareholders — rom selling the corporation’s stock, or to have a representative on the board o — directors) are o — ten — ound in pre — erred stock purchase agreements. The key point is that raising money by selling stock is di —
erent than taking out a loan because a startup gives up a percentage o — the company along with some measure o — control when it sells equity.30 The relation- ship between the company and its equity investors can last the com- pany’s entire li — etime. Startup equity investment is o — ten a long-term commitment. Central to understanding the startup private equity market is realizing that such investments are rarely passive. Angels and VCs compete — or startups by providing guidance and services. They are “more than money,”31 but they are also the only source o — money. This creates the unique dynamic called the startup — inancing cycle.
27 See, e.g., What Are Some Basics to Know About Startup Investing?, FUNDERSCLUB, https:// --- undersclub.com/learn/startup-investing/getting-started/basics-to-know-about-startup- investing/ (last visited Feb. 28, 2016) (“Individuals who invest in startups are called angel investors . . . whereas --- irms that are set up to invest in startups are called Venture Capi- tal --- irms . . . .”). Stock is a type o --- equity, and equity re --- lects an ownership right in a company.
28 See Kyle Hulten, Why C Corporations Are the Pre --- erred Entity --- or Tech Startups, INVIGOR LAW (Feb. 24, 2014), https://www.invigorlaw.com/corporations-best-entities-tech- startups/ (explaining that the C corporation is ideal --- or startups because investors do not have to worry about pass-through tax or daily corporate decision-making, it is easy to grant equity to employees in the --- orm o --- stock options, it is easy to grant pre --- erential rights to investors as compared to --- ounders and employees, investors pay capital gains rates on dividends instead o ---
ordinary income rates on partnership distributions, and because the C corporation structure is
amiliar to — ounders, investors, employees and their counsel and accountants). 29 See, e.g., Jesse M. Fried & Mira Ganor, Agency Costs o — Venture Capitalist Control in Startups, 81 N.Y.U. L. REV. 967, 969 (2006). 30 Id. 31 See Joseph Menn, Andreessen Expands Venture Capital Business, FIN. TIMES (Nov. 3, 2010), http://www. — t.com/cms/s/0/a — 5c1a7c-e717-11d — -880d-00144 — eab49a.html#axzz3MHe3l njx.
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1. Private Equity Market Participants
As discussed, there are two main types o --- investors in the private equity market: angels and VCs.32 These investors are purchasers o --- pri- vate equity.33 In 2014, 316,600 individual angels invested $24.1 billion in 73,400 startups34—an average o --- $328,300 per angel investment— while 803 VC --- irms invested $49.3 billion in 4,361 companies35—an average o --- $11.3 million per VC investment. In other words, despite investing a similar total amount, the average VC investment per round is thirty- --- ive times that o --- the average angel investment. Accordingly, an- gel and VC investment strategies are quite di ---
erent. Angels — orm groups to invest small amounts o — their own money in brand new startups.36 VCs — orm — unds to invest large amounts o — other people’s money in more mature startups.37 While the angels and VCs currently provide the vast majority o — traditional startup investment, the JOBS Act may allow a new type o — investor to enter the marketplace: the general public.
Figure 1: Angels and VCs historically invested a similar total amount per year (about $25B).38
32 See supra Part I.A.
33 See Venture Capital, U.S. SMALL BUS. ADMIN., https://www.sba.gov/content/venture- capital (last visited Oct. 7, 2015).
34 Sohl, supra note 20. R
35 NAT’L VENTURE CAPITAL ASS’N, YEARBOOK 2015, at 38 --- igs.3.10 & 3.11 (2015), http://nvca.org/research/stats-studies/.
36 See George Deeb, How to Find Angel Investors --- or Your Startup, FORBES (Sept. 19, 2014), http://www. --- orbes.com/sites/georgedeeb/2014/09/19/how-to- --- ind-angel-investors- --- or- your-startup/.
37 See Dan Primack, VC Deals Are Down, but VC Deal Sizes Are WAY Up, FORTUNE (July 3, 2014), http:// --- ortune.com/2014/07/03/vc-deals-are-down-but-vc-deal-sizes-are-way- up/.
38 Data aggregated --- rom CVR Analysis Reports, UNIV. OF N.H., https://paulcollege.unh .edu/research/center-venture-research/cvr-analysis-reports (last visited Feb. 28, 2016); NAT’L VENTURE CAPITAL ASS’N, supra note 35, at 38 --- ig.3.10. R
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Average Angel and VC Deal Size
11.3
7.1 7.6 7.2 7.4
6.9 7.1 7.0 7.0 7.1
6.5 6.4 6.4
0.4 0.4 0.5 0.5 0.5 0.5 0.3 0.3 0.3 0.3 0.3 0.4 0.3
2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014
Average Angel Deal ($M) Average VC Deal ($M)
Figure 2: On average, angels invest three or
our hundred thousand dollars in each star- tup, whereas VCs invest several million dollars in each round.39
a. Startups
The main seller o --- private equity in the startup private equity market is, unsurprisingly, the startup. But, it is important --- rom the outset to distinguish startups --- rom small business, as it is common to con --- late these very di ---
erent types o — business entities.40 Distinguishing between the two is important because private equity investment works — or star- tups, not — or small businesses. The angel and venture capital investment model is to purchase re- stricted stock—which cannot be easily resold—to hold — or a limited number o — years.41 This investment is very risky, so the objective is to obtain geometric returns when an investment is success — ul.42 A startup is the sort o — high-growth, high-risk enterprise that appeals to this invest- ment model. Startups are designed to grow quickly.43
39 Data aggregated --- rom CVR Analysis Reports, supra note 38; NAT’L VENTURE CAPITAL ASS’N, supra note 35, at 38 --- igs.3.10 & 3.11.
40 See, e.g., President Barack Obama, Remarks by the President at JOBS Act Bill Sign- ing (Apr. 5, 2012), http://www.whitehouse.gov/the-press-o ---
ice/2012/04/05/remarks-president- jobs-act-bill-signing (describing President Barack Obama as proclaiming when he signed the JOBS Act into law, “startups and small business will now have access to a big, new pool o —
potential investors—namely, the American people”). 41 JACK S. LEVIN ET AL., STRUCTURING VENTURE CAPITAL, PRIVATE EQUITY, AND EN- TREPRENEURIAL TRANSACTIONS ¶ 103 (2009). 42 Id. 43 See Startups & High Growth Busineses, U.S. SMALL BUS. ASS’N., https://www.sba .gov/content/startups-high-growth-businesses (last visited Jan. 30, 2015) (“In the world o — bus- iness, the word ‘startup’ goes beyond a company just getting o —
the ground. The term startup is also associated with a business that is typically technology oriented and has high growth potential. Startups have some unique struggles, especially in regard to — inancing. That’s be- cause investors are looking — or the highest potential return on investment, while balancing the
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A small business, on the other hand—like a bike store, cobbler’s shop, deli, espresso ca --- e, or --- ood truck44—is designed to grow sustain- ably. Small businesses are wonder --- ul and vital --- or the American econ- omy. They provide employment opportunities --- or millions o ---
Americans. But they generally make terrible equity investments.45 Hal
o
small businesses — ail in their — irst — ive years.46 Although this is similar to the 52% — ailure rate o — startups,47 small businesses do not grow expo- nentially as startups do, so equity investors who invest in small busi- nesses would get the same risk as with investing in startups but with — ar lower returns. That is why small businesses are mostly — inanced with owner investment and an average o — $80,000 a year in bank credit.48 It is unrealistic, there — ore, that private equity markets will provide a signi — i- cant source o —
inancing — or small businesses. While a small business might be able to use a small bank loan to become sel — su —
icient, startups require millions o — dollars to grow quickly be — ore they are pro — itable as a stand-alone business. High- growth startups use money to scale quickly, which is important to win the race to register a patent or build a two-sided network.49 For example, consider a — amous startup story. Facebook was — irst — unded on Septem- ber 1, 2004 by two angels who invested $500,000, which Facebook used to build a basic web application that the — ounders deployed at Harvard University.50 Less than a year later, Facebook received $12.7 million in a Series A — inancing — rom the venture — irm, Accel Partners, in May 1, 2005, which it used to develop core social in — rastructure and expand to more U.S. universities and international student networks.51 Facebook
associated risks.”); see also Candice Landau, What’s the Di
erence Between a Small Business Venture and a Startup?, BPLANS, http://articles.bplans.com/whats-di —
erence-small-business- venture-startup/ (last visited Jan. 30, 2015). 44 All o — these are examples — rom Inc. Magazine’s article, 10 Inspiring Success Stories, INC., http://www.inc.com/ss/10-inspiring-small-business-success-stories (last visited Jan. 30, 2015). 45 In — uture work, the author o — this Article will discuss how crowdlending might be an excellent source o —
unding — or small business. 46 See Frequently Asked Questions, U.S. SMALL BUS. ASS’N OFFICE OF ADVOCACY, https://www.sba.gov/sites/de — ault/ — iles/sb — aq.pd — (last visited Jan. 30, 2015). 47 See generally ROBERT WILTBANK & WARREN BOEKER, RETURNS TO ANGEL INVES- TORS IN GROUPS (2007), http://sites.kau —
man.org/pd — /angel_groups_111207.pd — . 48 Id. 49 See Thomas R. Eisenmann et al., Strategies — or Two-Sided Markets, HARV. BUS. REV., Oct. 2006 (stating that competition lucrative — or two-sided networks such as PC operating systems, credit card networks, and internet advertisements have a winner-take-all dynamic that requires operating on razor-thin margins or even giving subsidies to build the network). 50 See Brian Caul — ield & Nicole Perlroth, Li — e A — ter Facebook, FORBES (Jan. 26, 2011), http://www. — orbes.com/ — orbes/2011/0214/ — eatures-peter-thiel-social-media-li — e-a — ter- — acebook .html. 51 Facebook, CRUNCHBASE, https://www.crunchbase.com/organization/ — acebook/ — und- ing-rounds (last visited Jan. 30, 2015).
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needed a huge in
usion o — cash to expand rapidly, illustrating that $1 mil- lion is not a lot o — money — or a startup. Many startups raise millions o —
dollars throughout the startup
inancing cycle.52 Accordingly, this Arti- cle — ocuses on the startups, not small business.
b. Angel Investors
Angels are pro --- essionals who invest their own money in startups.53 Traditionally, angels were hard to --- ind. Throughout the late 1980s, these wealthy gurus connected with startups through in --- ormal and even secre- tive channels.54 In the early 1990s, angels began to --- orm groups and publicize their activities.55 The --- irst prominent angel investment group
ormed in 1994.56 Silicon Valley’s “Band o — Angels” began with twelve members and grew to 110 members by 1998.57 From then on, angel groups sprouted up throughout the United States. The number o — regis- tered angel groups has tripled since 1999.58 The Angel Capital Associa- tion estimates that there are between 10,000 and 15,000 angel groups operating in the United States today, with an average o — 42 members per group.59 Many o — these angel groups now have a prominent website that contains a contract — orm, public membership list, and even a list o — port-
olio companies.60 Not all angels invest in groups. Some o — the most popular angels continue to invest in the traditional, solitary, and secretive way. Many o —
these traditional angels—like Peter Thiel (who seeded Facebook) and Naval Ravikant (who — unded Twitter and Uber)—are — amous — or build- ing groundbreaking startups or investing early in hugely success — ul ventures. Not everyone can be an angel. Legally, an angel must be an “ac- credited investor,” someone with at least $1 million in net wealth or
52 See Brian Solomon, These 11 Startups Raised Over $1 Billion Be --- ore They Had a Product, FORBES (June 11, 2015), http://www. --- orbes.com/sites/briansolomon/2015/06/11/ these-11-startups-raised-over-1-billion-combined-be --- ore-launching/.
53 What Is an Angel Investor?, ANGEL CAPITAL ASS’N, http://www.angelcapitalassocia- tion.org/ --- aqs/#What_is_an_angel_investor_ (last visited Oct. 6, 2015).
54 Darian M. Ibrahim, The (Not So) Puzzling Behavior o --- Angel Investors, 61 VAND. L. REV. 1405, 1443 (2008) (explaining how the investment contract design o --- angel stock purchase agreements can be understood through a historical shi --- t --- rom in --- ormal modes o ---
secretive operations to
ormal mechanisms and public group operations). 55 John May, Structured Angel Groups in the USA: The Dinner Club Experience, 4 VEN- TURE CAPITAL 337, 339 (2002). 56 Id. 57 Id. 58 FAQs About Angel Groups, ANGEL CAPITAL ASS’N, http://www.angelcapitalassocia- tion.org/press-center/angel-group- — aq/ (last visited Feb. 28, 2016). 59 Id. 60 See, e.g., HYDE PARK ANGELS, http://www.hydeparkangels.com/ (last visited Feb. 28, 2016).
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$200,000 in annual income.61 The U.S. census counts household wealth, not individual wealth, so estimates — or the number o — potential angels varies, but 9.63 million American households had a net worth o — $1 mil- lion or more in 2013,62 which is about 3% o — the U.S. population.63 The Angel Capital Association estimates that about 4 million potential angels reside in the United States.64 Despite the large number o — potential angels, only about 300,000 Americans made an angel investment in the past two years.65 This is partially because an angel should have a solid understanding o — business planning, corporate — inance, pre — erred stock investment, and market con- ditions, plus a risk-seeking constitution.66 Angel investment is not — or everyone.
c. Venture Capital Investors
Venture capitalists are pro --- essional, institutional money managers o --- risk capital. VCs create --- unds in which large institutional investors (such as pension --- unds and university endowments) invest. VCs then “deploy” that capital primarily by purchasing startup equities. The na- ture o --- venture capital investment is quite di ---
erent — rom angel invest- ment because VCs manage other people’s money, whereas angels invest their own money. Venture — unds raise sums o — money — ar in excess o —
most angels’ personal net wealth,67 and VCs have to deploy this money very quickly because the — unds typically have eight to twelve year li — e spans.68 When the — und’s li — e is over, the capital must be returned. Venture capital — unds have grown dramatically since 1985, both in terms o — the number o — VC — unds and the average amount that each VC
und manages. From 1985 to 2014, 2,054 VC — irms were — ounded.69 These — irms raised 5,062 — unds totaling over $599 billion.70 While the number o — VC — unds has increased dramatically, the number o — VC — und
61 17 C.F.R. § 230.501(a)(5)–(6) (2013).
62 Number o --- U.S. Millionaires Hits New High, CNN MONEY (Mar. 14, 2014), http:// money.cnn.com/2014/03/14/news/economy/us-millionaires-households/.
63 Robert Schlesinger, The 2014 U.S. and World Populations, U.S. NEWS & WORLD REPORT (Dec. 31, 2013), http://www.usnews.com/opinion/blogs/robert-schlesinger/2013/12/ 31/us-population-2014-317-million-and-71-billion-in-the-world.
64 See FAQs About Angel Groups, supra note 58.
65 Id.
66 See WILTBANK & BOEKER, supra note 47 (asserting that due diligence, experience, and participation are the three largest --- actors impacting the outcome o --- angel investments).
67 See, e.g., Dan Primack, NEA Raising Largest VC Fund o --- All Time, FORTUNE (Oct. 27, 2014), http:// --- ortune.com/2014/10/27/exclusive-nea-raising-largest-vc- --- und-o --- -all-time/. The VC --- irm NEA recently raised a --- und with nearly $3 billion in capital.
68 Allen Wagner, The Venture Capital Li --- ecycle, PITCHBOOK (May 14, 2014), http:// blog.pitchbook.com/the-venture-capital-li --- ecycle/.
69 See NAT’L VENTURE CAPITAL ASS’N, supra note 35, at 20 --- ig.1.04. R
70 Id.
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managers has not. In 1994, there were 3,735 VC pro
essionals managing $33.2 billion—about $9 million per manager.71 In 2014, there were 5,680 VC pro — essionals managing $156.5 billion—about $28 million per manager, more than a three- — old increase in money under management per manager.72 Put simply, there is a similar number o — people managing a — ar larger amount o — money, so they will tend to make larger investments.73 VC — unds — ocus on high technology investments. These — unds in- vested $5.2 billion in the in — ormation technology industry in 2014,74 which accounted — or 72% o — total investments that year.75 VCs increas- ingly — ocus on — ollow-on investment. In other words, VCs — requently
und the same company several di —
erent times throughout the startup
inancing li — ecycle. In — act, over 85% o — VC investments in 2014 were
ollow-on investments.76 Despite making 4,361 investments in 2014, VCs only invested in 404 new non-high-technology companies that year.77
Figure 3: VC investors increased dramatically both in size and number around the year 2000, and the average capital managed by a single investor almost tripled, although there have been corrections since the Great Recession in the mid-2000s.78
Like angel investment, venture --- und investment is not --- or everyone. Only “quali --- ied purchasers”—those individuals who are natural persons owning $5 million or more in investments, or --- unds owning $25 million
71 Id. at 9 --- ig.1.0.
72 Id.
73 See id.
74 Id. at 32 --- ig.3.02.
75 See id.
76 See id. at 56 --- ig.3.19.
77 Id. at 12 --- ig.5.0. 78 Data aggregated --- rom NAT’L VENTURE CAPITAL ASS’N, supra note 35, at 19 --- ig.1.02 & 21 --- ig.1.05.
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or more in investments79—can invest in venture capital
unds. This means that many angels cannot invest in venture capital — unds. The only way such angels can get involved in the startup private equity market is by making investments be — ore VCs do. Accordingly, angels and venture capitalists play supporting roles by investing in di —
erent stages o — startup development. This model o — staged investment is called the startup — i- nancing cycle.
2. The Startup Private Equity Financing Cycle
Startups generally do not raise money only once, so it is very impor- tant to understand the entire startup --- undraising cycle in order to under- stand the startup private equity market. The startup --- undraising cycle is a multi-step process through which startups raise money at distinct periods.80
“Seed --- unding” is the beginning o --- the startup --- inancing cycle. Star- tups use seed --- unding to research, assess, and develop an initial concept.81 “[F]riends, --- amily, and ‘ --- ools’” ( --- ools re --- erring to the high risk associ- ated with investment in nascent startups) provide a small amount o --- seed-
unding,82 although angel investors provide most seed — unding capital.83 Once a startup receives seed — unding, the company begins operations and enters the “seed valley o — death,” where companies require signi — i- cant capital in — lows but have little or no revenue.84 Startups begin to leave the perilous seed valley o — death when their revenue increases enough to cover all monthly — ixed and variable costs. This is called the “break even.”85 A — ter the break even, a startup enters an “early stage,” where ven- ture capital — irms become substantially more interested in investing in that startup.86 Startups decidedly exit the seed valley o — death when a venture capital — irm makes its — irst early stage investment, called “Se- ries A.”87 A — ter this point, venture capital investors — requently reinvest in the startup in Series B, C, D and so on, so the startup can a —
ord to
79 15 U.S.C. § 80a-2(51)(A) (2012).
80 Oranburg, supra note 26. R
81 DOUGLAS J. CUMMING & SOFIA A. JOHAN, VENTURE CAPITAL AND PRIVATE EQUITY CONTRACTING: AN INTERNATIONAL PERSPECTIVE 5 (2d ed. 2014).
82 Id. at 6.
83 Id. (citing Andrew W. Wong, Angel Finance: The ‘Other’ Venture Capital, (Univer- sity o --- Chicago, Working Paper, (2002)); see also Laura Entis, Where Startup Funding Really Comes From, ENTREPRENEUR (Nov. 20, 2013), http://www.entrepreneur.com/article/230011.
84 CUMMING & JOHAN, supra note 81.
85 Id. at 7.
86 Id.
87 See id.
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invest in growth even i
doing so causes net pro — its to become negative again.88 Small venture capital — irms may only make early stage investments. Large venture capital — irms make “later stage” investments all the way up to the end o — the startup — inancing cycle, when a startup ceases to be a startup. The cycle ends badly when the startup goes broke and liquidates or sells the — ledgling operations at a discount. The cycle ends well when the startup is sold to another company through a pro — itable acquisition or a merger. The ultimate conclusion to a startup is when the startup goes public and accesses the public capital markets through an initial public o —
ering (IPO). The IPO is the pre — erred mode o — exit—the ideal end o —
the startup
inancing cycle— — or most investors to divest their investments.89 This Article examines newer data that indicates the Series A gap has become greater, meaning that more companies who receive seed — unding will not receive Series A — unding, as illustrated by the chart below.
Figure 4: The Startup Financing Cycle
The above chart illustrates that, --- rom 2008 to 2014, angel seed in- vestment has increased while VC seed investment has decreased. This substantially contributes to the Series A gap and Series A crunch. Dur- ing the relevant period, annual angel investment steadily rose --- rom 55,480 deals to 73,400 deals.90 Meanwhile, VC investments --- ell --- rom 1966 to 740.91
88 See id.
89 Id. at 596.
90 See CVR Analysis Reports, supra note 38.
91 NAT’L VENTURE CAPITAL ASS’N, supra note 35, at 38 --- ig.3.10.
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3. The Series A Gap in the Private Equity Market
Seed --- unding is only the --- irst step in the startup --- inancing cycle, and startups rarely survive on seed --- unding alone. As Pro --- essor Darian M. Ibrahim writes:
Venture capital is crucial to a start-up’s success, but it is
not immediately available to most start-ups. Most ven-
ture capitalists --- und start-ups that have survived their
earliest stages and are expanding, --- or instance by deliv-
ering products and services to customers, or are prepar-
ing --- or an IPO or private sale. Nor is venture capital
readily available in the smaller amounts that might be
appropriate --- or very young companies. A typical ven-
ture round averages between $2 million and $10 million,
although it can be much higher. There --- ore, venture capi-
talists leave a critical --- unding gap that has both time and
capital components. The time gap is present during the
earliest stage o --- a start-up’s li --- e, which commonly lasts
at least one year.92
In other words, between the seed --- unding relative maxima o ---
$350,801 and the Series A relative maxima o
$4.87 million, there is a minimum o — startup investment. Success — ul angel investor, Bill Payne, has studied these maxima and minima. In 2011, he produced what he termed the “Funding Gap”: Let’s look at some numbers: Hundreds o — thousands o —
riends and — amily invest an estimated $50 billion or more in startup companies every year in the US. It is estimated that more than 200,000 angel investors — und 50,000 companies with $20 billion annually. And, the 1,000 or so VC — irms also invest about $20 billion in 1,000 new companies every year. But, I estimate that less than 200 (and probably less than 100) investors pro- vide — unding in the gap between angels and VCs, that is, rounds o — investment between $1 million and $4 million. Finding investors is always di —
icult, but — inding capital in The Funding Gap is like seeking a needle in the pro- verbial haystack.93
92 Ibrahim, supra note 54, at 1416. R
93 The Funding Gap, BILL PAYNE & ASSOCIATES, (Jan. 20, 2011). http://billpayne.com/ 2011/01/20/the- --- unding-gap-2.html.
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Figure 5: The Funding Gap © 2011 Bill Payne
The chart above shows that startup investment is lumpy. It tends to happen in speci --- ic times and in speci --- ic amounts. Angels typically invest less than $1 million at the Series Seed stage.94 Venture --- irms typically invest more than $5 million at the Series A stage.95 The result is that it is virtually impossible --- or an entrepreneur who needs $3.5 million to --- ind investors.96
Since Pro --- essor Ibrahim’s article --- rom 2008 and Mr. Payne’s article
rom 2011, the typical venture round has grown while the typical angel round has shrunk. As such, this Article argues that the gap has increased. The leading venture law — irm, Fenwick & West LLP, has empiri- cally demonstrated that the gap is a persistent and growing phenome- non.97 Fenwick’s 2012 study o — seed — unding — ound that there is an increasing institutionalization o — seed — inancing.98 In other words, there are — ewer traditional (solo, secretive) angels out there. Angels are — orm- ing more visible groups that use technology to connect with potential investments. In 2014, angels invested $24.1 billion in a total o — 73,400 startups (an average o — $328,300 per angel deal).99 Venture capital — irms—on whom angels and crowd — unding investors rely to provide additional
unding — rom Series A to IPO—invested $49.3 billion in a total o — 4,361 deals (an average o — $11.3 million per venture deal).100 O — these venture capital deals, venture capital — irms invested $9.896 billion in 2,031 early stage deals (an average o — $4.87 million per early stage deal).101 Be-
94 David H. Freedman, The Great Funding Flameout, 35 INC. 78, 82 (2013).
95 Id.
96 The Funding Gap, supra note 93. R
97 Barry J. Kramer & Steven S. Levine, Seed Finance Survey 2012, FENWICK & WEST LLP (Mar. 25, 2013), http://www. --- enwick.com/FenwickDocuments/2012_Seed_Survey_Re port.pd --- .
98 Id.
99 Sohl, supra note 20. R 100 NAT’L VENTURE CAPITAL ASS’N, supra note 35, at --- igs.3.10 & 3.11. 101 Id.
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tween these two peaks o
investment at $0.3 million and $11.3 million is a valley where — unding is increasingly hard to — ind.102 The valley reaches a critical low point—a gap—between about $1 to $5 million, where startups — ail because — unds are in such short supply.
4. Gap Problems --- or Startups and Investors
The Series A gap causes problems --- or many startups. Angel inves- tor Mason Myers o --- Greybull Stewardship has observed that “traditional Series A does not --- it many companies.”103 Amar Bhidé,104 in his article, Bootstrap Finance: The Art o --- Start-ups,105 summarily explains, “belie ---
in a ‘big money’ model o
entrepreneurship . . . has little in common with the traditional low-budget start-up.”106 Venture capital investors look — or high growth starters — ounded by success — ul entrepreneurship experi- ence.107 As a result, there are endless startups that build iPhone applica- tions and similar products. But companies that design hardware or biotechnology—and the entire li — e science startup — ield in general— struggle to access capital.108 Lately there has been a remarkable increase in seed — unded startup
ailures. These — ailures have occurred as a result o — a phenomenon known as the “Series A crunch.”109 Companies that obtain seed — unding but — ail to receive Series A — unding be — ore they run out o — capital get “crunched.” The crunch threatens the success o — the startup revolution. Slate Magazine reports, “[o]ne thousand startups will be orphaned; many will die. One billion dollars will have gone — or naught. Bright young minds across the country will be out o — work.”110 Startup- — ocused web- site, Launch, published a “Series A Crunch Survivor’s Guide.”111 More pessimistic observers such as Richard Meyer o — the Capital Formation Institute called this the “Start-Up Enterprise Valley o — Death” and re-
102 See FAQs About Angel Groups, supra note 58 (noting that angel groups may invest in R the gap between individual angels and venture capitalists).
103 Mason Myers, We’re In Seed-Stage Boom, Not a Series A Crunch, MASON MYERS BLOG (Apr. 6, 2014), http://masonmyers.com/seed-stage-boom-times-not-series-a-crunch/.
104 Thomas Schmidheiny Pro --- essor o --- International Business, Tu --- ts University.
105 Amar Bhidé, Bootstrap Finance: The Art o --- Start-ups, 60 HARV. BUS. REV. 109 (1992).
106 Id.
107 Id. at 111.
108 Laura Lorek, More Venture Capital Needed --- or Li --- e Science Startups, SILICON HILLS (Dec. 4, 2014), http://www.siliconhillsnews.com/2014/12/04/more-venture-capital-needed- --- or- li --- e-science-startups/.
109 See, e.g., Grant, supra note 14. R
110 Will Oremus, Tech Startups Are about to Start Dropping like Flies, SLATE (Dec. 20, 2012), http://www.slate.com/blogs/ --- uture_tense/2012/12/20/series_a_crunch_tech_startups_ are_about_to_start_dropping_like_ --- lies.html.
111 The Series A Crunch Survivor’s Guide, LAUNCH (Jan. 2, 2013), http://blog.launch.co/ blog/the-series-a-crunch-survivors-guide.html.
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marked that “[i]ts width ranges
rom $2,000,000 to $10,000,000, dictated by the minimum investment that VC — irms pre — er to invest to match their costs o — management.”112 Data show that the Series A crunch is a serious problem. Fenwick’s 2012 Seed Financing Survey reported that the “number o — seed — inanc- ings increased — rom 472 in 2009 to 1749 in 2012, while the number o —
Series A rounds only increased
rom 418 to 692 during the same pe- riod.”113 This indicates that the Series A gap has become greater, mean- ing that more companies who receive seed — unding will not receive Series A — unding, as illustrated by the chart below.
Figure 6: While angels continue to make more seed-stage investments each year, VC seed — unding has dropped to less than hal — o — 2008 levels.114
GeekWire reported warnings o --- a Series A crunch in early 2013. The above chart illustrates the ratio o --- companies that received seed --- und- ing to the number o --- seed --- unded companies that received Series A --- und- ing.115 CB Insights, which maintains the Venture Capital Database,116 reported in late 2012 that only about 40% o --- seed- --- unded companies will
112 Richard Meyer, The Start-Up Enterprise Valley o --- Death, CAPITAL FORMATION INST., http://www.c --- i-institute.org/VP - The Start-Up Enterprise Valley o --- Death - Meyer.html (last visited Dec. 21, 2014).
113 Kramer & Levine, supra note 97, at 3. R
114 Data aggregated --- rom CVR Analysis Reports, supra note 38; NAT’L VENTURE CAPITAL ASS’N, supra note 35, at 38 --- ig.3.10.
115 John Cook, The Series A Crunch Is Alive and Well, GEEKWIRE (Jan. 18, 2013), http:// www.geekwire.com/2013/chart-series-crunch-real/. The ratio increased --- rom 1.9:1 in 2009 to 3.3:1 in 2012.
116 Seed Investing Report—Startup Orphans and the Series A Crunch, CB INSIGHTS, https://www.cbinsights.com/blog/seed-investing-report/ (last visited Dec. 21, 2014).
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raise a Series A round.117 This dramatically increases the risk associated with — orming, joining, or investing in a startup company, and thus chills those desirable behaviors.
B. The Market
or Entrepreneurial Finance
The JOBS Act o --- 2012 created the possibility o --- a new entrant into the private equity market. In addition to the established investors—an- gels and VCs—the JOBS Act will permit the general public to invest in the market --- or entrepreneurial --- inance through “crowd --- unding.”118 This Article re --- ers to that general investing public as “crowds.”
Crowd --- unding has a general and speci --- ic meaning in the context o ---
this Article. Crowd
unding can be generally understood as “the practice o —
unding a project or venture by raising many small amounts o — money
rom a large number o — people, typically via the Internet.”119 Crowd — unding in this sense has been occurring at least since 2005 with the — ounding o — Kiva.120 Since Kiva began in 2005, over a million people have made interest-
ree crowd — unded microloans to impoverished entrepreneurs through Kiva.121 Now, crowd — unding is popular on Kickstarter.com, where, — or example, an initiative called the Pebble Smartwatch project raised $10 million by pre-selling the — inished project.122 Small businesses start and grow with — or-pro — it crowd — unded loans — rom InvestNextDoor.com123 and Lending Club.124 The Oceti Sakowin Indian tribe o —
ered a thank you reward to everyone who contributed $20 to save the Black Hills and
117 See id.
118 See, e.g., Press Release, Sec. & Exch. Comm’n, SEC Issues Proposal on Crowd --- und- ing (Oct. 23, 2013), http://www.sec.gov/News/PressRelease/Detail/PressRelease/13705400176 77.
119 Tanya Prive, What Is Crowd --- unding and How Does It Bene --- it the Economy, FORBES (Nov. 27, 2012), http://www. --- orbes.com/sites/tanyaprive/2012/11/27/what-is-crowd --- unding- and-how-does-it-bene --- it-the-economy/.
120 Terry Waghorn, Premal Shah: Loans that Change Lives, FORBES (Nov. 4, 2013), http:/ /www. --- orbes.com/sites/terrywaghorn/2013/11/04/premal-shah-loans-that-change-lives/ (noting that Kiva is “a global micro --- inance organization that connects borrowers who need --- unding to launch poverty-trans --- orming businesses with socially minded lenders who have as little as $25 to invest in their success”).
121 About Us, KIVA, http://www.kiva.org/about (last visited Jan. 12, 2015).
122 Angela Moscaritolo, Pebble Smartwatch Sells Out, Collects $10 Million on Kick- starter, PC MAGAZINE (May 10, 2012), http://www.pcmag.com/article2/0,2817,2404295,00 .asp.
123 See generally Pre-Launch Guide --- or Your Small Business Crowdlending Campaign, INVESTNEXTDOOR (Nov. 7, 2014), https://www.investnextdoor.com/blog/guide-preparing- small-business-crowdlending-campaign/.
124 See generally LENDINGCLUB, https://www.lendingclub.com/business/ (last visited Jan. 12, 2015).
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other Sioux sacred land on Indiegogo.125 These are examples o
the don- ative, pre-ordering, rewards, and lending models o — crowd — unding. On the other hand, equity crowd — unding—which is selling a small amount o — stock to a large number o — people via web sites called — unding portals—was illegal until the JOBS Act created a new exemption to the Securities Act o — 1933.126 A more speci — ic de — inition o — crowd — unding
or present purposes relates expressly to equity crowd — unding as permit- ted by the JOBS Act and SEC rules: Regulation Crowd — unding would prescribe rules gov- erning the o —
er and sale o — securities under new Section 4(a)(6) o — the Securities Act o —
- The proposal also would provide a — ramework — or the regulation o — regis- tered — unding portals and brokers that issuers are re- quired to use as intermediaries in the o —
er and sale o —
securities in reliance on Section 4(a)(6). In addition, the
proposal would exempt securities sold pursuant to Sec-
tion 4(a)(6) --- rom the registration requirements o --- Section
12(g) o --- the Securities Exchange Act o --- 1934.127
The JOBS Act amends Section 4(a)(6) o --- the Securities Act o --- 1933 (the Securities Act)128 to allow a private corporation to o ---
er and sell up to $1 million worth o — equity securities (stock) in a twelve-month period to the general public without registering the securities with the SEC.129 This new exemption to registration under the Securities Act is generally called “crowd — unding,” although it is more speci — ically called “equity crowd — unding.”130 Equity crowd — unding will be allowed when the SEC promulgates its
inal rules131—which at the time o — this publication are overdue132—al- though some o — the crowd — unding rules are provided in the JOBS Act itsel — . Individuals who have between $100,000 and $1 million in annual income or net worth may invest 10% o — it each year in startups through
125 See generally Pe’ Sla: Help Save Lakota Sioux Sacred Land!, INDIEGOGO, https://www .indiegogo.com/projects/pe-sla-help-save-lakota-sioux-sacred-land (last visited Jan. 12, 2015).
126 See generally 15 U.S.C. § 77 (2012).
127 Crowd --- unding, 78 Fed. Reg. 66,427 (Nov. 5, 2013) (to be codi --- ied at 17 C.F.R. pts. 200, 227, 232, 239, 240 & 249).
128 See 15 U.S.C. § 77d(a)(6).
129 See id.
130 See, e.g., Jumpstart Our Business Startups Act Frequently Asked Questions About Crowd --- unding Intermediaries, SEC. & EXCH. COMM’N (May 7, 2012), https://www.sec.gov/ divisions/marketreg/tmjobsact-crowd --- undingintermediaries --- aq.htm.
131 Jumpstart Our Business Startups Act, Pub. L. No. 112-106, § 303(b), 126 Stat. 306, 321 (2012).
132 See id. Rulemaking was due “not later than 270 days a --- ter the date o --- enactment o ---
this Act,” which was signed into law on April 5, 2012. Id.
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crowd
unding.133 Individuals who have or annually earn less than $100,000 may invest the greater o — $2,000 or 5% o — their annual income each year in startups.134 The JOBS Act also creates the new term “ — unding portal,” which is a — inancial intermediary that can sell startup stock online to non-accred- ited investors.135 A private company raising capital under the crowd — unding exemption — rom the Securities Act must sell the stock through either a registered broker-dealer or a — unding portal.136 Any bro- ker-dealer or — unding portal that engages in crowd — unding must register with the SEC and the Financial Industry Regulatory Authority (FINRA).137 The — unding portal may not solicit transactions — or securi- ties displayed on its website or portal, compensate anyone — or soliciting investors, pay compensation based on the sale o — securities on its website or portal, hold customer — unds or securities, or o —
er investment advice or recommendations.138 All o — these regulations come at a price. The SEC estimates that raising $100,000 may cost up to $39,000 in portal and compliance
ees.139 Raising $1,000,000 may cost up to $151,660.140 In comparison, raising a similar amount o — money — rom angels through series seed pre-
erred stock — inancing pursuant to Regulation D Rule 506141 costs be- tween $10,000 and $30,000 in legal — ees.142 This huge cost di —
erence dis — avoring crowd — unding begs the question: Why would startups choose to use this vastly more expensive — undraising method when equity — un- draising alternatives are widely available?
133 15 U.S.C. § 77d(a)(6)(B)(ii).
134 15 U.S.C. § 77d(a)(6)(B)(i).
135 15 U.S.C. § 78c(a)(80).
136 Id.
137 See generally Funding Portals, FINRA, http://www. --- inra.org/industry/issues/ --- unding- portals (last visited Jan. 12, 2014).
138 Id.
139 See Neiss, supra note 22. R
140 Id.
141 See in --- ra Part III.B. Equity --- undraising involves the sale o --- unregistered securities, so it must be done under an exemption --- rom the Securities Act. Regulation D (or Reg D) con- tains three rules (Rules 504, 505, and 506) providing exemption --- rom registration, and they will be discussed in greater depth later on in this Article. Rule 504 allows startups to sell up to $1 million o --- securities in one o --- three ways: (1) in a general solicitation to non-accredited investors with a disclosure document, (2) in a general solicitation to accredited investors with- out a disclosure document, and (3) in a general solicitation to non-accredited investors without a disclosure document. Rule 505 o --- Regulation D allows the issuer to sell up to $5 million o ---
its securities in a 12-month period to an unlimited number o
accredited investors and up to 35 other persons. Rule 506 o — Regulation D is the only “unlimited” exemption — rom the Securi- ties Act, meaning that only under Rule 506 can issuers raise an unlimited amount o — money
rom issuing unregistered securities. This makes Rule 506 a popular exemption. 142 Scott Edward Walker, Everything You Ever Wanted to Know About Convertible Note Seed Financings (But Were A — raid to Ask), TECHCRUNCH (Apr. 7, 2012), http://techcrunch .com/2012/04/07/convertible-note-seed- — inancings/.
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II. BRIDGEFUNDING
This Article argues that crowd --- unding regulations are backwards. Instead o --- limiting investment to $1 million per startup,143 crowd --- unding should require startups to raise at least $1 million and up to $5 million annually. The Article uses the term “bridge --- unding” to describe its new theory o --- an inverted crowd --- unding regulation.
This Article proposes that bridge --- unding may be an e ---
ective way to allow crowds to participate in the private equity market while limiting
raud and providing a valuable new source o — capital — or startups. This Article’s theory o — bridge — unding is based on three main points: (1) star- tups need capital in the private equity gap o — about $1 to $5 million; (2) crowds are better at making second-period (gap) investment instead o —
irst-period (seed) investment; and (3) — raud concerns about crowd — unding can be su —
iciently addressed without a $1 million limit. The policy implications o — these observations are a recommendation
or the JOBS Act to invert the $1 million limit — or crowd — unding. Instead o — a ceiling, that should become a — loor. Startups should be required to raise at least $1 million — rom crowd — unding, and the ceiling should rise to at least $5 million.
A. The Bridge
unding Proposal Bridge — unding means creating a regulatory regime whereby the gen- eral public can invest in early stage startups. Early stage startups are distinguished — rom seed stage startups in that early stage startups have already received some seed capital — rom angels or other pro — essional in- vestors.144 There are two regulatory mechanisms that can be employed to ensure that bridge — unding is directed to early stage, not seed stage, startups. First, regulators can set a $1 million — loor on bridge — unding invest- ment. This will do little to harm crowd — unding because crowd — unding is already — ar too expensive — or sub-million-dollar investment rounds. As discussed later in this Part, rational startups will not seek crowd — unding i —
they can obtain seed
unding — rom angels, as angel investment is more e —
icient. Angel investment is generally not available — or startups that are very low quality or that need more than $1 million.145 A $1 million — loor bars low quality startups — rom seeking bridge — unding while allowing high quality startups to obtain bridge — unding in the more-than-million- dollar range where angel — unding is not readily available.
143 15 U.S.C. § 77d(a)(6)(A) (2012).
144 Alternative Investments—The Stages in Venture Capital Investing, INVESTOPEDIA, http://www.investopedia.com/exam-guide/c --- a-level-1/alternative-investments/venture-capital- investing-stages.asp (last visited Oct. 8, 2015).
145 See FAQs About Angel Groups, supra note 58. R
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Second, regulators can require that a startup must have at least one signi --- icant, independent stockholder be --- ore that startup may raise money through bridge --- unding. The purpose o --- this requirement is to bring an angel or other pro --- essional investor into the startup be --- ore allowing crowds to invest. That pro --- essional investor provides diligence and over- sight while in --- luencing pricing --- unctions that make crowd --- unding less risky and more e ---
icient. The particular threshold — or who quali — ies as a “signi — icant investor” merits — urther study, but this Article proposes the — ollowing — ramework predicated on diligence, oversight, and in — luence. First, the independent pro — essional investor must make an investment large enough to compel a reasonable pro — essional investor to per — orm thorough due diligence o — the startup. Due diligence includes tasks like making sure the company is duly incorporated, con — irming that all stock grants have been authorized by the board, checking the capitalization table — or accuracy, considering the e —
icacy o — the business model, evaluating the competitive landscape, and determining the viability o — the proposed product. Second, the independent pro — essional investor must acquire rights to review the startup’s books and records and to attend board meetings. These oversight rights are commonly — ound in management rights letters in venture capital contracts. Third, the independent pro — essional investor must own enough stock to in — luence corporate decision making. In — lu- ence by minority stockholders is o — ten bargained — or in the private equity contracting process. In — luential rights include protective provisions, whereby the investor can veto — undamental corporate transactions such as a liquidation or another stock issuance; rights o —
irst re — usal and co- sale, whereby the investor can e —
ectively prevent the — ounders — rom sell- ing their shares; and board participation rights, whereby the investor is guaranteed a number o — seats on the board o — directors. The pro — essional investor must be independent in order — or the dili- gence, oversight, and in — luence roles to be meaning — ully carried out. In- dependence has a di —
erent meaning in securities law. In public corporations, the requirement — or an “independent director” means the company must have a director on the board who is not a shareholder.146 In the context o — bridge — unding, however, the requirement — or an “inde- pendent investor” means an individual who is not related or beholden to the — ounders o — the startup. This would disquali — y — amily members and close — riends — rom playing the role o — an independent investor. While the requirements o — a $1 million — loor and a prior signi — icant independent pro — essional investor ensure that bridge — unding is not used
146 Je
rey N. Gordon, The Rise o — Independent Directors in the United States, 1950–2005: O — Shareholder Value and Stock Market Prices, 59 STAN. L. REV. 1465, 1482 (2007).
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or seed — unding, a $5 million cap on bridge — unding also — ocuses invest- ment on early stage startups. Startups that require substantially more than $5 million have access to a venture capital investment that can — uel the startup to reach its later stages.147 Startups o — this size do not — ace a liquidity crunch, so there does not seem to be any immediate need — or crowds to — und these companies. Moreover, additional risks o — startup investment emerge in the later stages. For example, startups may need to make acquisitions to grow in later stages. The general public may be in a poor position to understand whether to — unnel money into Startup X so it can use that capital to purchase Startup Y. The decentralized nature o —
crowds mean they cannot give the same sort o
speci — ic advice that ven- ture capital managers provide to their port — olio companies. The $5 mil- lion cap balances the need — or startup capital with the need — or investor protection. Moreover, as discussed in detail below, — ocusing bridge — und- ing on the $1 to $5 million range encourages crowds to invest where they have unique advantages over other participants in the private equity market. Bridge — unding can be made more e —
icient through de — ault provi- sions in the investment contracts. Crowds are large heterogeneous groups o — unsophisticated, inexperienced investors.148 They may not know how to protect their rights through speci — ic provisions in venture capital contracts. The law can protect these investors by creating de — ault or mandatory rules. These rules can be rigid or — lexible. For example, a
lexible rule about crowd — unding investment agreements may require that crowds get the same rights that the independent pre — erred angel investor received. It is typical that a later stage investor receives the same or greater rights than an earlier stage investor does,149 so this regulation would normalize investment contracts with crowds in the private equity market. Crowds might also be protected by rigid de — ault rules. For ex- ample, laws may require that crowds receive anti-dilution protections, rights to veto a sale o — company or a later — inancing round, rights to inspect books and records, or even the right to have a crowd representa- tive installed on the board o — directors. In summary, the bridge — unding proposal has — our main components: (1) a $1 million — loor to keep low quality startups — rom obtaining seed
inancing — rom bridge — unding, (2) a $5 million ceiling to prevent crowds
rom overinvesting in mature startups, (3) a prior independent pro — es-
147 See FAQs About Angel Groups, supra note 58. R
148 See Thomas Lee Hazen, Crowd --- unding or Fraud --- unding? Social Networks and the Securities Laws—Why the Specially Tailored Exemption Must Be Conditioned on Meaning --- ul Disclosure, 90 N.C. L. REV. 1735, 1766 (2012). 149 Ibrahim, supra note 54, at 1430–31. R
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sional investor to vet and monitor the startup, and (4) de
ault terms that make crowd — unding equity contracts more e —
icient.
B. Why Bridge
unding Works The pragmatic thrust o — this Article is that bridge — unding works, even though crowd — unding — ails. The remainder o — this section reviews the criticisms o — crowd — unding to demonstrate many o — the reasons why bridge — unding can succeed.
1. Bridge --- unding Can Fill the Private Equity Gap
The Series A crunch demonstrated that it is getting harder --- or star- tups with Series Seed --- unding to attract Series A investment.150 There’s a gap between an average o --- $1 million invested by angels and an aver- age o --- $5 million invested by venture --- unds that relatively --- ew investors seem willing to --- ill.151 Even companies like Wittlebee—which received an unusually large $2.5 million investment in the Series Seed round152— may require more investment be --- ore it is able to demonstrate pro --- itability and thus secure venture investment.
Crowd --- unding could potentially bridge the gap. But where does crowd --- unding --- it in the startup li --- e cycle? Crowd --- unding, as designed by the JOBS Act, largely aims to take the place o --- angel investment. Crowd --- unding and angel investment occupy the same space in the startup ecosystem.153 Both provide small to average Series Seed rounds o ---
about $1 million.154 Un
ortunately, therein lies the problem. Creating another source o — seed-stage capital around the $1 million mark is not what the market needs. The market needs a gap investment that can pro- vide — unding between angel investment and venture investment. The $1 million dollar investment limit also seems to be inherently counterintuitive, preventing startups — rom wanting to use crowd — unding. Instead o — relying on the crowd — unding exemption, startups can rely on Regulation A+ or Regulation D Rule 506,155 which will be discussed in depth later. Those exemptions allow startups to raise at least $50 mil- lion.156 Regulation D, in particular, might be pre — erred by startups that want to avoid extra disclosure liability imposed by the crowd — unding ex-
150 See Grant, supra note 14. R
151 This may be in part because the 100-investor limit prevents angels --- rom --- orming large enough syndicates to --- und companies through this gap.
152 See Wittlebee, supra note 4. R
153 See Ibrahim, supra note 54, at 1416 (noting that angel investment is usually available R in smaller amounts than venture capital).
154 15 U.S.C. § 77d(a)(6)(A); see also supra Part I.A.1.
155 15 U.S.C. § 77c(a)(2)(2012); 17 C.F.R. § 230.506 (2014).
156 15 U.S.C. § 77c(a)(2); 17 C.F.R. § 230.506.
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emption.157 Put simply, crowd
unding has to compete not only with an- gel investment, but also with other statutory exemptions, both o — which are attractive alternatives to crowd — unding. I — there are superior strate- gies or better alternatives, crowd — unding simply won’t work. Crowd — unding needs some sort o — competitive advantage in order — or it to be popular, e —
ective, and pro — itable — or investors and startups. Increasing the maximum amount startups can receive — rom crowd — unding would allow crowd — unding to — ill a valuable niche. The Series A crunch showed that there is a problem with investing between Series Seed and Series A, creating an opportunity — or investors. Bridge — unding would capitalize on this opportunity and establish the crowd — unding exemption as an attractive, innovative source o — capital.
2. Crowds Are Suited --- or Bridge --- unding
Crowd --- unding, as currently regulated, presumes that crowds will be able to take the place o --- angels—those investors who --- ind, --- und, and guide nascent startup corporations.158 This Article challenges that as- sumption and suggests instead that angels are a unique player in the mar- ket with whom crowds cannot compete. Angels are o --- ten wealthy market leaders, industry experts, and visionaries.159 They are ideally suited to help a brand new venture realize its latent potential. Crowds, on the other hand, re --- lect the general wisdom and consensus o --- the popu- lation at large.160 Crowds are, by de --- inition, less wealthy than angels, and the sheer number o --- crowd --- unding investors creates a bell curve dy- namic where crowds will tend to --- und popular companies.
These initial di ---
erences show that treating crowd — unding and angel investment as i — they were competitors is ill — ounded. Startups require staged, multi-period investment.161 Angel investment alone is not su —
i- cient to — ully grow a startup.162 Crowd — unding alone is equally unlikely to create a viable, long-term company.163 These groups typically invest once at the beginning o — a startup’s li — ecycle, so the startup can grow large enough to attract venture investment.164 Venture investment, un- like crowd — unding or angel investment, can sustain a company through-
157 Deborah L. Jacobs, The Trouble with Crowd
unding, FORBES (Apr. 17, 2013), http:// www. — orbes.com/sites/deborahljacobs/2013/04/17/the-trouble-with-crowd — unding/. 158 See supra Part I and accompanying text. 159 See FAQs About Angel Groups, supra note 58. R 160 Tom Kalil & Doug Rand, Crowd — unding: Democratizing Investment — or Entrepre- neurs, WHITE HOUSE (Nov. 4, 2011), https://www.whitehouse.gov/blog/2011/11/04/crowd — und ing-democratizing-investment-entrepreneurs. 161 Oranburg, supra note 26. R 162 Id. 163 See Prive, supra note 119 (noting that crowd — unding can help an established business R expand its product range). 164 See Ibrahim, supra note 54, at 1416–17. R
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out its li
ecycle.165 Venture — unds have access to hundreds o — millions or billions o — dollars.166 Once a venture investor has a vested interest in a company, the investor may singlehandedly ensure that the startup sur- vives unpro — itable periods. In order to propel startups through the Series A gap and allow them to secure this much sought a — ter venture capital, crowd — unding should be regulated in a way that allows it to operate alongside angel investment, not in competition with it. As it stands, the $1 million crowd — unding limit means crowd — unding and angel investment occupy the same space in the startup ecosystem—that is, the Series Seed, sub $1 million invest- ment.167 Data evidencing the Series A crunch has shown that this niche in the ecosystem is already overcrowded.168 The imposition o — a $1 mil- lion hard cap on investment bars crowds — rom — ul — illing their unique po- tential and establishes unnecessary competition in a saturated market. There — ore, criticism that crowd — unding is too limited, expensive, risky, and complex to be an e —
ective substitute — or alternative — irst-period — i- nancing — or startups is well — ounded. It should not be operating as such. What critics are missing is that crowd — unding—reengineered as bridge — unding—has the potential to sa — ely inject capital into the second investment period, when startups need cash desperately and when none o — the current investors is likely to — inance post-seed, pre-revenue invest- ments. Bridge — unding would allow crowds to immediately step in and play a valuable role in startup — inancing. Crowds have proven their willingness to invest $1 to $5 million or more in promising early stage projects. Nomad raised several million dollars via several campaigns — or three novel USB accessories.169 The Dash raised almost $3.4 million to produce a wireless in-ear headphone and — itness tracker.170 Pono Music ( — ounded by Neil Young) raised al- most $6.3 million to create a high — idelity portable music player.171
165 Id. at 1411–12.
166 See NAT’L VENTURE CAPITAL ASS’N, supra note 35. R
167 See Ibrahim, supra note 54, at 1416; 15 U.S.C. § 77d(a)(6)(A) (2012); see also supra R Part I.A.1.
168 See, e.g., Grant, supra note 14. R
169 Erin Hobey, Crowd --- unding on CircleUp, Nomad Connects with Fluxmob: Grows Smartphone Accessory Brand to over $2 Million in Sales, CROWDFUND INSIDER (July 14, 2014), http://www.crowd --- undinsider.com/2014/07/44021-crowd --- unding-circleup-nomad-con- nects- --- luxmob-grows-smartphone-accessory-brand-2-million-sales/.
170 The Dash—Wireless Smart In Ear Headphones, KICKSTARTER, https://www.kick- starter.com/projects/hellobragi/the-dash-wireless-smart-in-ear-headphones (last visited Jan. 17, 2015).
171 Pono Music—Where Your Soul Rediscovers Music, KICKSTARTER, https://www.kick- starter.com/projects/1003614822/ponomusic-where-your-soul-rediscovers-music (last visited Jan. 17, 2015).
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OUYA raised $8.5 million to create an open source video game console that is powered by Android OS and plays on a television.172
3. Bridge --- unding Addresses Fraud
Crowd --- unding, understandably, raises concerns about investor pro- tections. Scholars such as Pro --- essor Thomas Lee Hazen caution, “[i] ---
history teaches us anything, the lesson is that social media technologies increase rather than decrease the potential — or — raud.”173 I disagree with the premise that social media enhances — raud—in other works I argue that Twitter and other social media enhance collective shareholder activ- ism.174 Rather, it seems that — raud concerns are overblown, and those concerns can be diminished when crowd — unding is used as gap — inancing. The concerns underlying claims — or more anti — raud regulations are out o —
touch with how crowd
unding and startup investment actually work. For example, Pro — essor Hazen writes: The Internet and social networking o —
er — ertile ground
or scammers. Scammers and securities — raudsters have
or nearly a century — ound ways to adapt their scams to new technologies. Consider, — or example, high-pressure boiler room sales operations or the promotion o —
icti- tious or worthless securities to build Ponzi schemes. The Internet has also proven to be — ertile ground — or pump and dump schemes. Boiler room tactics have adapted to new technologies. For example, telephonic cold calling has been supplemented or superseded by spam emails.175 None o — these concerns has anything to do with social media. In
act, the most recent case cited in support o — “pump and dump opera- tions” was resolved in 2006—when social media barely existed. Fast
orward to 2013, when spam emails (like phishing scams) are actually declining.176 Other crowd — unding securities can be advertised online, but there are scant reports o — spam scams — rom LendingClub, Prosper, RealtyMogul, or any other debt crowd — unding portals.177 I — anything,
172 OUYA: A New Kind o
Video Game Console, KICKSTARTER, https://www.kickstarter .com/projects/ouya/ouya-a-new-kind-o — -video-game-console?re — =sidebar (last visited Jan. 17, 2015). 173 Hazen, supra note 148, at 1769. R 174 Seth C. Oranburg, A Little Birdie Said: How Twitter Is Disrupting Shareholder Activ- ism, 20 FORDHAM J. CORP. & FIN. L. 695, 695 (2015). 175 Hazen, supra note 148, at 1767–68 (citations omitted). R 176 Victoria Lund-Funkhouser, Top 7 Phishing Scams o — 2013, RETURN PATH (Dec. 26, 2013), http://blog.returnpath.com/blog/tori- — unkhouser/top-7-phishing-scams-o — -2013. 177 See, e.g., LendingClub Corporation, BETTER BUS. BUREAU, http://www.bbb.org/ greater-san- — rancisco/business-reviews/ — inancial-services/lendingclub-corporation-in-san- — ran-
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social media makes crowd
unding sa — er. Investors can share in — orma- tion, — orm groups, build trust, and establish rapport despite geographic boundaries, all thanks to social media.178 Crowd — unding happens in- stantly online, making transactions transparent. Monitoring is easy and in — ormation — lows — reely. Ordinary Americans are savvy to online scams.179 Other articles state that “the risk — or — raud against such well-inten- tioned people and their potential backers is very real,”180 but why is this
raud more worrisome than other investment risks? Public Citizen, a D.C. think tank, uses similar rhetoric: “[T]he public will be outraged i — . . . Congress approves legislation that — urther deregulates Wall Street and — acilitates more — inancial — raud. The House should reject H.R. 3606.”181 Putting aside the — act that crowd — unding has almost nothing to do with Wall Street—this is more o — a Silicon Valley kind o — regula- tion—more claims o —
raud with no speci — icity should be understood as sound and — ury, signi — ying nothing. The truth is, crowd — unding is not more prone to — raud than other
orms o — investment. Merely being on the Internet does not make it worse. Social media does not hurt investors; it helps them collaborate. But Congress watered down Regulation Crowd — unding—perhaps to en- sure that the JOBS Act would quickly pass182—in response to anti — raud (and, bizarrely, anti-Wall Street) rhetoric. The result is a regulation that is too complicated and expensive to be use — ul. Merely because something takes place on the Internet does not make it per se more — raudulent. For instance, the Internet prevents — raud by giving investors the ability to instantly discuss concerns with each other. But some — raud concerns are actually supported by real-world in- stances, which can happen online or o —
line, like pump-and-dump schemes. And even without — raud, startup investment is very risky. But the literature seems to overlook a very power — ul anti — raud device built
cisco-ca-361746 (last visited Oct. 9, 2015) (giving LendingClub an A+ rating, but noting that the company’s name has been used in an online lending scam). 178 Oranburg, supra note 174, at 707. R 179 See, e.g., OH Attorney General: Watch Out — or These Scams in 2015, CINCINNATI.COM (Jan. 10, 2015), http://www.cincinnati.com/story/news/2015/01/10/oh-attorney-general-watch- scams/21582267/ (noting Ohio Attorney General Mike DeWine’s advice on how not to — all — or internet scams). 180 Jacques F. Baritot, Increasing Protection — or Crowd — unding Investors Under the JOBS Act, 13 U.C. DAVIS BUS. L.J. 259, 281 (2013) (concluding that “the risk — or — raud against [unsophisticated investors]” is very real, without providing any examples or support). 181 Vote NO on JOBS Act, PUBLIC CITIZEN, http://www.citizen.org/documents/vote-no- on-jobs-act.pd — (last visited Jan. 26, 2015). 182 See generally Joan MacLeod Heminway, How Congress Killed Investment Crowd — unding: A Tale o — Political Pressure, Hasty Decisions, and Inexpert Judgments that Begs — or a Happy Ending, 102 KY. L.J. 865 (2014) (explaining how — ear o — crowd — unding combined with the political necessity to vote — or the JOBS Act led to a watered down rule).
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into Regulation Crowd
unding: personal liability o — the — ounder and other parties related to the issuer — or — raud. Moreover, bridge — unding happens a — ter seed — unding, when angels invest. Angels provide a — ront line o — de — ense against — raud that crowd — unders can enjoy. Regulation Crowd — unding imposes personal liability on the — oun- ders and other parties related to the issuer. These additional liabilities make crowd — unding even more costly and less attractive. Alternative
undraising modalities, like Regulation D, are subject to — ewer causes o —
action
or — raud. These additional — raud liabilities should, however, quell the — raud concerns discussed above. All securities issuances are subject to — raud liability under § 17 o —
the Securities Act, which makes it unlaw
ul to conduct — raudulent inter- state securities transactions,183 and Rule 10b-5 o — the Exchange Act, which imposes liability — or “any untrue statement o — a material — act or [omission o — ] a material — act necessary in order to make the statements made.”184 In addition, Regulation Crowd — unding imposes liability on is- suers — or omission o — “a material — act required to be stated,” even i — that
act is not necessary in order to make the statement made.185 Regulation Crowd — unding also imposes liability on “any person who is a director or partner o — the issuer, and the principal executive o —
icer or o —
icers, principal — inancial o —
icer, and controller or principal accounting o —
icer o — the issuer (and any person occupying a similar sta- tus or per — orming a similar — unction).”186 To win an award o — damages
rom — raud under Regulation Crowd — unding, plainti —
s do not have to prove that the de — endant’s — raud caused the plainti —
’s loss,187 nor must plainti —
s prove that de — endants acted will — ully.188 The triple threat o — personal liability — or the executive o —
icers, a lower standard — or proving — raud and a broader de — inition o —
raud by omission, greatly increases the liability o — issuers who use Regulation Crowd — unding vis-à-vis those who use Regulation D. All else being equal, issuers will pre — er to sell stock under another exemption (such as Regulation D) that imposes less liability on the company and its agents. This added anti — raud protection helps Regulation Crowd — unding discour- age — raudulent issuers — rom using crowd — unding. Moreover, it is much easier to set up a nascent shell corporation than it is to operate a company — or a year, obtain angel seed — unding in- vestment, and develop a product (not just a promise). Due to the costs o —
183 Securities Act o --- 1933 § 17(a), 15 U.S.C. § 77q(a) (2012).
184 Exchange Act Rule 10b-5, 17 C.F.R. § 240.10b-5 (2012).
185 15 U.S.C. § 77d-1(c)(2)(A).
186 15 U.S.C. § 77d-1(c)(3).
187 15 U.S.C. § 77d-1(c)(1)(B).
188 15 U.S.C. § 77d-1(c)(2)(B).
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committing such
raud on bridge — unding investors—who are not the — irst investors in a company—it seems unlikely that bridge — unding would be used — or naked — raud in a way that seed — unding scams could exist. However, there are simple regulatory solutions that could quell whatever marginal — raud concerns arise — rom allowing a startup to raise $5 million instead o — $1 million. For example, Regulation Crowd — unding already limits investors to 10% o — their annual income or net worth to invest in crowd — unding each year. This could simply be extended to limit any particular investor to investing 10% o — his or her annual income or net worth in any particular startup. Finally, it is worth pointing out that i — a scammer wants to steal $5 million via crowd — unding, he can do so under Regulation Crowd — und- ing as it is currently dra — ted almost as easily as i — the limit were higher. The scammer could simply set up — ive separate pseudo-startups. There is nothing in the law, nor any rules, which prohibit such a parallel o —
ering. Simply put, the $1 million limit does not protect investors, and it pre- vents good companies — rom genuinely bene — itting — rom crowd — unding.
4. Bridge --- unding Addresses Cost
Scholars such as Pro --- essor C. Steven Brad --- ord189 recognize that “[t]o be use --- ul to small business issuers, a crowd --- unding exemption needs to be relatively simple and inexpensive.”190 To quali --- y --- or the exemption, startups and portals must strictly comply with all the require- ments o --- Regulation Crowd --- unding—there is no “substantial compli- ance” rule as is --- ound in other securities exemptions.191 Regulation Crowd --- unding requires startups to --- ile with the SEC and make available to the public disclosures about the company’s --- inancial in --- ormation, ownership, capital structure, business plan, and risk --- actors.192 Comply- ing with these complex regulations requires startups to retain the services o --- lawyers and accountants, thus adding cost through complexity.193
Portals must register with the SEC as a broker or a “ --- unding por- tal.”194 Registering as a --- unding portal is expensive, and portals can be disquali --- ied in several ways:
189 Earl Dunlap Distinguished Pro --- essor o --- Law, University o --- Nebraska-Lincoln College o --- Law. 190 C. Steven Brad --- ord, The New Federal Crowd --- unding Exemption: Promise Un --- ul --- illed, 40 SEC. REG. L.J. 195 (2012). 191 See id. 192 Id. 193 Id. 194 Id.
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The term “ --- unding portal” means any person acting as an
intermediary in a transaction involving the o ---
er or sale o — securities — or the account o — others . . . that does not— (A) o —
er investment advice or recommendations; (B) solicit purchases, sales, or o —
ers to buy the securi- ties o —
ered or displayed on its website or portal; (C) compensate employees, agents, or other persons — or such solicitation or based on the sale o — securities dis- played or re — erenced on its website or portal; (D) hold, manage, possess, or otherwise handle investor
unds or securities; or (E) engage in such other activities as the Commission, by rule, determines appropriate.195 Strict compliance with Regulation Crowd — unding is di —
icult, and any noncompliance by a crowd — unding issuer can disquali — y its portal
rom making any crowd — unding o —
erings.196 This is problematic be- cause crowd — unding needs a crowd to congregate on a portal and make crowdsourced decisions. The high risk o — total, across-the-board portal disquali — ication — or minor, technical noncompliance by an issuer on that portal makes becoming a portal less attractive. And, as i — being a portal were not dis — avored enough, the JOBS Act also — orbids portals — rom compensating its employees or agents based on sales. This seems to dis- advantage portals vis-à-vis registered brokers, who are not subject to this restriction.197 Portals will have to pass these costs to crowd — unding issuers. Startups can raise only $1 million pursuant to Regulation Crowd — unding, and doing so costs up to $151,660.198 As discussed ear- lier, using Regulation D costs about $25,000,199 and in 2014 angel inves- tors invested $24.1 billion, with an average deal size o — $328,300.200 About 70,000 startups obtain initial angel investment annually. Crowd — unding is so expensive that its investors are likely to be privy only to the 70,001st best startup that year. That is why many commenta- tors have thrown in the towel and declared that crowd — unding will — ail. One o — the primary purposes o — bridge — unding is to avoid this un — or- tunate result. Recall that the costs associated with crowd — unding are
195 15 U.S.C. § 78c(a)(80) (2012).
196 See Brad --- ord, supra note 190. R
197 Id.
198 Neiss, supra note 22. R
199 See Series Seed—Term Sheet, SERIES SEED, www.seriesseed.com (last visited Feb. 22, 2015) (describing that the standard --- orm o --- Series Seed Term Sheet speci --- ies that a company will reimburse purchaser’s counsel with a --- lat --- ee o --- $10,000). It is generally understood that the company’s counsel usually bills about 1.5 times what a purchaser’s counsel does. 200 Sohl, supra note 20. R
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mostly
ixed costs; they do not increase very much as the amount o —
money raised increases. As a result, the cost per dollar raised decreases when a startup raises $5 million instead o — $1 million. Somewhere in the range o — $3 to $5 million, bridge — unding becomes about as expensive— on a per-dollar-raised basis—as raising money — rom angel investors. This solves much o — the cost issue. The issue o — complication is directly tied in with the cost. Compli- cation is something that can be dealt with given su —
icient resources. Startups can hire lawyers, accountants, and other pro — essionals to resolve some o — the JOBS Act’s complicated requirements i — the startup raises enough money to pay the associated — ees, with enough money le — t over to actually operate.
5. Bridge --- unding Addresses Business Risk
Startup investment is risky business, but crowd --- unding may attract the riskiest startups. Scholars such as Pro --- essor Michael B. Dor ---
argue that “[t]he problem [with crowd — unding] is that the companies that par- ticipate will be terrible prospects . . . . [S]tart-ups with real potential will continue to use other programs . . . .”201 He then raises concerns that series seed angel investments may be unpro — itable,202 which may also be true about venture capital — unds — or certain periods.203 I am concerned that crowd — unding is even worse than angel investment in this regard, but do not doubt the necessity o — series seed — unding — or startups to continue innovating. Nevertheless, Pro — essor Dor —
and I arrive at virtually the same conclusion: “The most promising companies—that small percent- age o — start-up companies that account — or the bulk o — angel investors’ gains—will seek their — inancing — ar — rom the costly crowd.”204 That is the extent o — our agreement, however. I do not agree that “the SEC’s best option is to kill retail crowd — unding with excessive regulation.”205 Instead, regulators should revive crowd — unding through the concept o —
bridge
unding so it will attract some o — the best companies. Pro — essor Darian M. Ibrahim argues that crowd — unding might actu- ally attract some high-quality entrepreneurs and investors.206 “First, Ti- tle III should appeal to high-quality startups that are too young — or
201 Michael B. Dor
, The Siren Call o — Equity Crowd — unding, 39 IOWA J. CORP. L. 492, 492 (2014). 202 Id. at 509–20. 203 See Robert S. Harris, et al., Private Equity Per — ormance: What Do We Know?, 69 J. Fin. 1851 (2014) (studying the per — ormance o — nearly 1,400 buyout and venture capital — unds and concluding that such — unds per — ormed below the S&P 500 average in the 2000s). 204 Dor —
, supra note 201, at 519. R 205 Id. at 522. 206 See Darian M., Ibrahim, Equity Crowd — unding: A Market — or Lemons? 100 MINN. L. REV. 561, 604 (2015).
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‘pro
essional’ — inancing . . . . Second, . . . Title III would appeal to that subset o — startups that need cash but do not need value-added services
rom investors.”207 I disagree with both possibilities. Title III cannot possibly appeal to “startups [that] are too early stage — or even a $100,000 angel investment to be on the table”208 because complying with regula- tions could cost more than the startup would raise. Raising $100,000 through crowd — unding could cost $39,000, most o — which are — ixed costs that do not drop much as the amount raised decreases.209 And while I agree that startups who need money—but not services—could pre — er crowd — unding over venture capital, that argument assumes incorrectly that crowd — unding is cheaper than venture capital and that crowd — unding and venture capital — undraising overlap. Crowd — unding simply is not a substitute — or venture capital, although it could become a good alterna- tive to venture capital i — the crowd — unding limit were raised to at least $5 million, a solution this Article proposes.
6. Bridge --- unding Addresses Price Uncertainty
How does the general public determine what a brand new startup security is worth? How do investors know whether startup securities are being sold --- or the right price? Pro --- essor Alan Palmiter210 pinpoints a critical non- --- raud problem in crowd --- unding.211 His recent paper, Pricing Disclosure: Crowd --- unding’s Curious Conundrum, asks: How do inexpe- rienced, small, casual investors know they are buying startup securities
or the “right” price?212 Pro — essor Palmiter suggests that startups should be responsible — or proposing the price and methodology behind that pro- posal.213 Pro — essor Palmiter also recognizes that the SEC cannot police every tiny o —
ering, so he proposes a new sel — -help scheme — or de — rauded crowd — unding investors.214 The — ailure o — a crowd — unding issuer to disclose clear assumptions underlying the chosen method — or determining the price o — o —
ered secur- ities would be materially — alse and misleading.215 But en — orcing the an- ti — raud Rule 10b-5 requires either public or private action.216 The plainti —
’s recovery in a private en — orcement action against a crowd — und- ing issuer pursuant to Rule 10b-5 — or — ailure to disclose pricing method-
207 Id. at 589–90.
208 Id. at 589.
209 See Neiss, supra note 22. R
210 Howard L. Oleck Pro --- essor o --- Business Law, Wake Forest University School o --- Law. 211 See generally Alan R. Palmiter, Pricing Disclosure: Crowd --- unding’s Curious Conun- drum, 7 ENTREPREN. BUS. L.J. 373 (2012). 212 See id. at 374. 213 See id. 214 See id. at 375. 215 See id. at 415. 216 See id. at 418.
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ology is limited to the amount invested, so damage awards can be at most $1 million.217 Plainti —
s’ attorneys’ — ees, which are on average between twenty and thirty percent o — the settlement amount,218 would be too small to justi — y commencing the action.219 Will the public authorities step in where it is economically un — easi- ble — or private lawyers to take action? The SEC prioritizes its limited resources — or en — orcement action based on “(1) the message delivered to the industry and public; (2) the amount o — investors harm done; (3) the deterrent value o — the action; and (4) the SEC’s visibility in certain areas . . . .”220 The SEC’s investigations department very rarely re — ers Regula- tion D violations (which re — lect greater harm — rom a more — requent and visible type o — transaction than crowd — unding) to the SEC’s en — orcement division, so it is highly unlikely that the SEC will prosecute crowd — und- ing violations.221 Arbitration could be a — aster and cheaper alternative to public or private action — or the policing o — 10b-5 ( — raud) violations in crowd — unding disclosures.222 But the JOBS Act currently lacks any mandate — or arbitration, so issuers do not have to agree to arbitrate claims.223 Arbitration is also problematic because arbiters are not re- quired to produce any written explanation behind their award o — dam- ages.224 Arbitration decisions in securities law also have no precedential value.225 Pro — essor Palmiter presents a novel alternative in both public and private litigation and arbitration. Price insurance would be a new way to ensure that crowd — unding investors are not bamboozled.226 The insur-
217 See id. at 416. 218 See id. at 417–18 (citing John C. Co ---
ee, Jr., The Regulation o — Entrepreneurial Liti- gation: Balancing Fairness and E —
iciency in the Large Class Action, 54 U. CHI. L. REV. 877, 889–90 (1987)); see also Frequently Asked Questions About Class Actions, BERNSTEIN LIEBHARD LLP, http://www.bernlieb.com/FAQs/index.html (last visited Feb. 28, 2016). 219 Palmiter, supra note 211, at 417. R 220 Id. at 418–19 (citing James D. Cox et al., SEC En — orcement Heuristics: An Empirical Inquiry, 53 DUKE L.J. 737, 751 (2003) (explaining that SEC en — orcement is used as a beacon showing what the SEC considers important to preserving — inancial market integrity)). 221 See id. at 420 (citing OFFICE OF INSPECTOR GENERAL, U.S. SEC. & EXCH. COMM’N, REGULATION D EXEMPTION PROCESS 13, 18–20 (2009) (explaining that, despite discovering multiple violations in a sample o —
orty-one Regulation D — ilings, in the — i — teen-month period ending in December 2008, the Division o — Corporate Finance’s O —
ice o — Small Business Pol- icy only re — erred one Regulation D issue to the En — orcement division). 222 See id. at 422–21. 223 See id. at 422. 224 See id. at 424. 225 See id. at 425 (citing Barbara Black & Jill I. Gross, Making It Up as They Go Along: The Role o — Law in Securities Arbitration, 23 CARDOZO L. REV. 991, 1001 (2002)) (pointing out that because most cases are now heard by an arbitration panel, as opposed to a judge or jury, law in the — ield has matured only slightly since Shearson/Am. Express v. McMahon, 482 U.S. 220 (1987)). 226 See Palmiter, supra note 211, at 426. R
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ance provider would be incentivized to investigate startups issuing crowd — unding securities on behal — o — all the small investors, thus solving a collective action problem where no small investors — ind it worth their while to thoroughly investigate risks.227 Fortunately, the concern o — mis- pricing is diminished when a startup has operated — or a period o — time and has completed at least one priced equity — undraising round — rom an- gel investors. Raising the crowd — unding limit thus alleviates some pric- ing uncertainty. Moreover, bridge — unding requires prior equity investment by pro-
essional angel investors. That means a priced round o — stock has been sold. Stock re — lects a percentage ownership o — a company.228 For exam- ple, someone who owns 1 million out o — 10 million shares owns 10% o —
StartX. How much he or she paid
or that percentage o — shares translates into an objective valuation o — StartX. I — she paid $1 million to end up with 10% o — StartX, the enterprise as a whole is worth $10 million. Val- uation is inherent in a priced round o — stock. In contrast to a priced round, startups can sell convertible securities. There are several types o — convertible securities. A common type is con- vertible debt. These are loans which can automatically convert the prin- cipal owed (and sometimes the interest accrued) into an amount o — stock based on a per-share stock value. The amount o — stock can be — ixed at the time the convertible debt is issued. More commonly, however, the stock value is determined when the next — inancing occurs. Debt holders o — ten get a discount at that time.229 For example, StartX sells $1 million o — convertible debt to Angela. The debt agreement provides — or a 1% simple annual interest. Angela’s debt converts to pre — erred stock when- ever the next investor buys Series Seed pre — erred stock o — StartX, say — or $1 per share. Angela bargained — or a discount o — 80% o — the per share price o — the next investor. At the closing o — the pre — erred stock sale, Angela’s debt automatically converts into 1,262,500 shares o — StartX pre — erred stock. Convertible securities—which also come in more exotic — lavors like a “simple agreement — or — uture equity” and “convertible equity”—de — er the valuation o — a startup until the next — inancing.230 Such transactions are not use — ul in valuing bridge — unding stock. That is why such transac-
227 See id. 228 See Stock, INVESTOPEDIA, http://www.investopedia.com/terms/s/stock.asp (last visited Oct. 8, 2015). 229 Peter Werner, Primer on Convertible Debt, COOLEY LLP, https://www.cooleygo.com/ convertible-debt/ (last visited Oct. 8, 2015). 230 Melody Peng, Using Convertible Equity: What Startups Need to Know, LIGHTER CAPI- TAL (May 1, 2015), https://www.lightercapital.com/blog/using-convertible-equity-what-start ups-need-to-know/.
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tions do not quali
y as a prior independent pro — essional investment as described in Part II.A above.
7. Bridge --- unding Opens New Business Models
As demonstrated above, VCs primarily invest in high-tech compa- nies and secondarily in li --- e science companies.231 Bridge --- unding creates a new source o ---
unding that may inspire entrepreneurs to build alterna- tive business models. Furthermore, the data show that VCs strongly pre-
er to invest in local startups.232 That means, — or many entrepreneurs, moving to Silicon Valley. The Bay Area is one o — the most expensive places in the world to live, and the attraction o — venture capital there continues to draw residents and increase prices. Other regions have at- tempted to create their own, local “Silicon Valley,” but they have been met with limited success.233 Venture capital — irms pre — er to invest in high technology. So — tware
irms are especially popular targets — or VC investment. Intellectual prop- erty is highly scalable. Once good code is developed—whether an iPhone application, an encryption algorithm, or database management tools—spending money on marketing can have a direct e —
ect on making lucrative sales.234 Some readers may recall when Internet advertising was the business model o — most startups. Now many startups rely on in- app purchases. So — tware is clearly important, but it is not the only innovation we need. Li — e sciences, biotechnology, and apparel are le — t out o — the mix.235 It gets worse than that. Women are disadvantaged when seeking venture capital.236 Individuals located outside o — Silicon Valley are over-
231 See supra Part I.
232 See Merrill F. Hoopengardner, Nontraditional Venture Capital: An Economic Devel- opment Strategy --- or Alaska, 20 ALASKA L. REV. 357, 368 (2003) (“Thus, in addition to eco- nomic considerations, the hand-holding nature o --- the venture capital business is compromised i --- the venture capital --- irm is geographically removed --- rom the business in which it is investing.”).
233 Vivek Wadhwa, Silicon Valley Can’t Be Copied, MIT TECH. REV. (July 3, 2013), http://www.technologyreview.com/news/516506/silicon-valley-cant-be-copied/.
234 Dragana Mendel, Is Your Startup a High Growth Venture Capital Type? (Feb. 2, 2015), http://www.anagard.com/blog/2015/02/02/is-your-startup-a-high-growth-venture-capi- tal-type/.
235 See Bruce Booth, Debunking Myths About Biotech Venture Capital, FORBES (May 22, 2013), http://www. --- orbes.com/sites/brucebooth/2013/05/22/debunking-myths-about-biotech- venture-capital/.
236 See Tom Kaneshige, Why Venture Capitalists Don’t Fund Women-Led Startups, CIO (Feb. 12, 2015), http://www.cio.com/article/2882826/venture-capital/why-venture-capitalists- dont- --- und-women-led-startups.html. Tom Kaneshige --- rom CIO argues that there seems to be two main reasons why --- emale-led startups struggle to secure venture capital. First, venture
irms like to invest in leaders, not just great ideas. As it presently stands, almost all venture managing partners are men, and they seem to be more com — ortable investing in startups led by
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looked or ignored.237 Startup investment’s diversity problem is so pro- nounced that Mirror Digital’s CEO, Sheila Marmon, launched the Venture Capital Access Program to help women and minority-led busi- nesses to raise capital.238 Bridge — unding can democratize startup investment. Whereas today the pre — erences o — venture capital — irms dictate how angels invest and which startups succeed, in the — uture, a crowdsourced approach to equity
inancing may allow the general public to pick the next Facebook.
III. WHY CURRENT REGULATIONS FAIL
Bridge --- unding is supported and in --- ormed by theories in the litera- tures o --- business innovation, law, and economics. This Part addresses and incorporates those into the literature regarding securities law, while explaining why existing regulations are insu ---
icient to bridge the private equity gap.
A. Law and Economics o
the Private Equity Gap The Series A gap appears to be a — ailure in the private equity mar- ket, but economic theory suggests that well- — unctioning markets should not su —
er — ailures in equilibrium.239 Ascribing to this theory leads to three possible conclusions. The — irst possible conclusion is that the gap is not a market — ailure, but an arti — act o — a well- — unctioning market. Per- haps the gap simply re — lects that an increasing quantity o — untenable star- tups were — ounded this decade. This Article cannot explore a counter — actual world, where all — ailed startups actually received — unding, and measure the per — ormance o — that private equity market against the real world. But this Article does present evidence that startups — ailed largely and without any correlation to their long term potential — or suc- cess. Wittlebee—as mentioned earlier— — ailed to get — unding, was sold to another company in a — ire sale liquidation (where investors got pennies on the dollar — or their investment), and went on to thrive as a subsidiary o — its new parent organization.240 These — acts, at least, sew reasonable doubt that the gap is desirable.
male entrepreneurs. Second, and interrelated, there is a dearth o
women venture capitalists generally, and they are o — ten negatively stereotyped by their male counterparts in the industry. 237 Alicia Purdy & Kaja Kwasneiewska, The Fine Print on Investing in Venture Capital, FIN. POISE (Sept. 30, 2013), https://www. — inancialpoise.com/accreditedinvestormarkets/print/ 3018/ (noting that angels and VC — unds normally “will not invest in companies outside their geographic area (usually 100–150 miles — rom the VC’s o —
ice)”). 238 David Teten, Helping Women and Minorities Raise Angel Capital, DAVID TETEN, http://teten.com/blog/2014/04/18/helping-women-and-minorities-raise-angel-capital/ (last vis- ited Jan. 30, 2015). 239 See JEFFREY M. PERLOFF, MICROECONOMICS 24–26 (5th ed. 2009). 240 See supra notes 1–10 and accompanying text.
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The second possible conclusion is that the private equity market is not in equilibrium, but is responding to some sort o --- shock.241 Perhaps a crash in public stock markets temporarily changed investor behavior in the private equity market. I --- the gap exists only in disequilibrium, it will go away when the shock has --- inished rippling through the market. Only time will tell i --- the gap exists in disequilibrium or is persistent, but data show that the gap has existed, and has been expanding, since at least 2011.242 The expansion o --- the gap --- or --- our years appears to be prima
acie evidence that it is not merely a disequilibrium state. The third possible conclusion is that the gap is the result o — a market
ailure, which can possibly be addressed by law. This Article argues that there is good evidence o — market — ailure in the private equity market.
1. Economic Theory Explains the Gap
It is not the aim o --- this Article to prove that there is a market --- ailure in the private equity market through economic modeling. Rather, the intention is to show that there are several reasonable bases --- or conclud- ing that the gap is not merely a positive market characteristic or a tempo- rary glitch.
Market --- ailure can result --- rom a number o --- situations, including reg- ulations, monopoly power, transaction costs, lack o --- in --- ormation, and ir- rational actors. Some o --- these situations can be quickly ruled out. For example, there is no evidence o --- any monopoly or even market power in the private equity market. Rather, the private equity market has tens o ---
thousands o
participants. The largest participant, NEA, which raised $3 billion, re — lects only 0.5% o — the cumulative amounts that VC — unds have raised since 1985 and only 1.5% o — the money under management by VC
unds in 2013.243 It also appears unlikely that the gap is the result o — irrational actors. While it is true that angel investors o — ten speak o — caring about more than money and giving back to the start-up community, in general these inves- tors are sophisticated pro — essionals who are looking to make a pro — it.244 Some might claim that venture — und managers make decisions that bene-
it the managers to the detriment o — the — und. That may occur at the margins, but — und managers have to raise money — rom investors every seven to ten years.245 VC managers simply cannot expect to usurp — und opportunities or pro — it themselves at the expense o — the — und and con- tinue to be able to raise money.
241 PERLOFF, supra note 239, at 24–31. R
242 See Kramer & Levine, supra note 97. R
243 Primack, supra note 67. R
244 FAQs About Angel Groups, supra note 58.
245 See NAT’L VENTURE CAPITAL ASS’N, supra note 35. R
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Transaction costs in the private equity market are higher than in public stock markets, and this --- actor does, in --- act, seem to have a ---
ected behavior in the private equity market. Raising money by selling stock costs at least $25,000 in legal — ees.246 There — ore, it would be irrational to raise less than $25,000 by selling stock in all instances. Transaction costs increase as the amount raised increases, so larger transactions tend to have lower transaction costs on a per-dollar-raised basis than smaller transactions. This may be one reason why angels invest in groups. An- gel groups share transaction costs among all the investors, so each inves- tor can contribute a small amount, yet the aggregate amount contributed is enough to outweigh the transaction costs. Transaction costs become less o — a — actor in VC transactions. Spending $100,000 in legal — ees to secure an investment o — $10,000,000 is well within the range o — transac- tion costs that allow proper market — unctioning. Moreover, i — angels wish to invest in startups without purchasing equity, they can make simi- lar investments with convertible notes,247 simple agreements — or — uture equity,248 or other instruments that require spending only a — ew thousand dollars in transaction costs. While there does not seem to be any obvious externalities in the private equity market, the group dynamics o — angel investment may prove otherwise. An externality is a cost or bene — it imposed on individu- als not participating in the trade.249 It seems, at — irst, that only the startup and the investor gain or lose — rom the purchase o — equity. However, it is critical to remember that startup investment is a multi-period strategy.250 In order — or a — irst-period (seed) investment to pay o —
, someone else must make a second-period investment as well. In — act, many startups require several stages o —
unding be — ore that startup can be pro — itably sold in a merger event or made liquid through an initial public o —
er- ing.251 In the private equity market, an angel in the — irst period enjoys a positive externality when a di —
erent investor invests in the company in the second period. Angels invest in groups, but the entire group does not need to rein- vest in order — or the startup to survive. I — an angel joins a group that makes a startup investment, the group as a whole may want to reinvest in that startup to prevent it — rom — ailing, but an individual angel in the group may pre — er to let the rest o — the group save the startup. This is called a
246 See supra note 199. R
247 Are Sa --- e Investment Docs Sa --- er than Convertible Notes?, START UP LAW PROF. BLOG (July 8, 2014), https://startuplawpro --- .wordpress.com/2014/07/08/are-sa --- e-investment-docs- sa --- er-than-convertible-notes/. 248 Id. 249 See PERLOFF, supra note 239, at 605–07. R 250 See supra Part I.A.2. 251 See supra Part I.A.
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hold-out problem, which can lead to angel underinvestment in the private equity market.252 Angels can also seek a positive externality by — ree riding on another investor’s e —
orts.253 Diligence, also called due diligence, is the process by which an investor and his counsel review a potential investment.254 This involves obtaining stage agency — ilings to ensure that the company was properly created and is up to date on its tax payments. This con-
irms that no creditors have a lien on the company or its assets, veri — ying that the capitalization table accurately re — lects who owns how much o —
the startup. In turn, this ensures that the startup actually owns its intel- lectual property, checking whether the startup’s board o — directors prop- erly authorized any corporate actions, reviewing the — inancial statements, investigating the history o — the — ounders and the key employees, assess- ing the business risks o — the startup, and evaluating the competitive land- scape — or that business model.255 Then the angel has to negotiate the terms o — the pre — erred stock purchase agreement, review the documents to ensure they comply with the terms, execute a wire trans — er, and ensure that the stock certi — icate has been received and stored. In addition, an angel may continue to oversee the startup a — ter the investment is consum- mated by sitting on the board o — directors, reviewing — inancial in — orma- tion, advising the leadership team, or physically inspecting the prototype or product.256 Angels can avoid these costs by — ollowing a “lead” angel. A lead angel is a member o — an angel group who bears the costs o — the diligence, negotiations, and oversight. Recall that angel groups can be organized or ad hoc. Organized angel groups such as the Hyde Park Angels may have a — ormal process by which members alternate responsibility — or diligence tasks and get reimbursed by the group — or associated — ees. Ad hoc angel groups, on the other hand, may be — ormed solely — or the purpose o — mak- ing a single investment. In such groups, angels pre — er to avoid the costs associated with diligence by allowing another to bear those costs, then interpreting that other investor’s willingness to invest as a signal that the diligence turned out — avorably. In this way, an angel can derive a posi- tive externality by — ree riding on another’s e —
orts. Angel — ree riding problems can be — ormalized in a game called the prisoner’s dilemma.257 In this game, two co-conspirators who cannot
252 See Oranburg, supra note 26. R
253 Id.
254 Due Diligence, INVESTOPEDIA, http://www.investopedia.com/terms/d/duediligence.asp (last visited Oct. 9, 2015).
255 See The Due Diligence Process in Venture Capital (VC), MARS (Dec. 6, 2013), http:// www.marsdd.com/mars-library/the-due-diligence-process-in-venture-capital/.
256 See Ibrahim, supra note 54, at 1432–33. R
257 See PERLOFF, supra note 239, at 481–82. R
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communicate are charged with arson and murder,
or which there is evi- dence — or arson, but not murder. A con — ession by either conspirator, however, would be su —
icient — or a murder conviction. The prosecutor o —
ers the — ollowing plea bargain: I — neither con — esses, both will serve two years in prison — or arson. I — one con — esses and the other does not, the con — essor will walk — ree and the other will serve ten years — or murder. I — they both con — ess, they will both be charged with murder but receive a lesser sentence o — six years — or their cooperation. The best outcome — or both is that both remain silent (resulting in a total sentence o —
our years), but they cannot communicate and agree to be silent.258 Accordingly, both will con — ess, resulting in a total sentence o — twelve years. This is a sub-optimal outcome. The prisoner’s dilemma applies to angel investment in the — ollowing way. Two angels want to invest in the same startup, but they are not aware o — each other’s existence, so they cannot communicate. There is a lack o — in — ormation in the market about other investors’ interest in a star- tup. Each angel will decide to undergo the cost o — diligence, similar to how both conspirators decided to con — ess, even though this is a sub-opti- mal outcome — or the angels. Accordingly, angel investment costs more than it would in an optimal environment, so certain angel investments that are socially desirable do not get made. This result, again, is underinvestment. Yet another reason — or a — ailure in the startup private equity market is regulation, which leads to a lack o — liquidity. As mentioned earlier, the Securities Act o — 1933 requires that only accredited investors make angel investments and only quali — ied purchasers make venture capital invest- ments.259 In other words, regulations limit who may participate in the private equity market. Regulations also impose various disclosure re- quirements and — raud liabilities on market participants. The e —
ect is to shrink the pool o — entities — or whom it is possible and economically ra- tional to participate in this market. Regulations can there — ore lead to a liquidity crunch. It may seem that there is endless capital in the private equity mar- ket. But in context, it becomes apparent that capital is somewhat limited. In 2013, angels and VC — irms together invested almost $55 billion.260
258 See id.
259 The term “accredited investor” is de --- ined in 17 C.F.R. § 230.501(a). The term “quali-
ied purchaser” mirrors the accredited investor term. De — ining the Term “Quali — ied Purchaser” Under the Securities Act o — 1933, 66 Fed. Reg. 66,839 (Dec. 27, 2001) (to be codi — ied at 17 C.F.R. pt. 230). 260 NAT’L VENTURE CAPITAL ASS’N, supra note 35; Sohl, supra note 20. VCs invested R much more—$49.1 billion—in 2014, but seems to be an outlier, especially since 85% o — those investments were — ollow-on investments. See NAT’L VENTURE CAPITAL ASS’N, supra note 35, R at 56 — ig.3.19.
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This is roughly equal to the amount o
investment in initial public o —
er- ings that year,261 and about the same amount that gold mining corpora- tions invested on projects and acquisitions in 2010.262 In contrast, shareholders in public stock markets received $1,167 billion o — income in dividends alone in 2014.263 This section has taken a law and economics approach to the ques- tion o — why there is a Series A gap and a Series A crunch. The next section will attempt to explain the gap based on market — undamentals. There are two dynamics that drive the Series A gap to become wider and taller, thus creating a larger gap, which leads to more companies — ailing in the Series A crunch. The — irst dynamic, which makes the gap wider, is inherent in the nature o — success — ul venture — irms making larger invest- ments. The second dynamic, which makes the gap taller, results — rom new technology that allows more angels to better diversi — y by making more small investments. The wider gap is harder to cross and extends the range o — startups whose business models are un — undable even though they may otherwise be ultimately pro — itable.
2. Venture Capital Success Widens the Gap
As venture --- irms succeed, they receive more money under manage- ment, so they need to either make more investments or larger invest- ments. Making venture capital investments is costly—venture --- irms spend signi --- icant resources considering a potential investment, venture
inancing involves a lot o — legal costs, and — irms provide many value- added services to their port — olio companies—but those costs do not in- crease much as the amount invested increases.264 In other words, venture capital investments have economies o — scale.265 Data support this claim. The average venture capital investment in early stage startup — inancing has increased steadily (except — or a huge increase during the dot-com bubble)266 — rom $1.76 million in 1985 to $7.32 million in 2014.
261 Ben Rooney, Stocks: 2013 Is One --- or the Record Books, CNN MONEY (Dec. 31, 2013), http://buzz.money.cnn.com/2013/12/31/stocks-record-bull-market/ (noting that 222 companies went public in 2013, raising nearly $55 billion).
262 Nathan Vardi, How Gold Miners Became A Terrible Investment, FORBES (July 1, 2013), http://www. --- orbes.com/sites/nathanvardi/2013/07/01/how-gold-miners-became-a-terri- ble-investment-2/ (determining that gold mining operations invested $60 billion in 2010).
263 Global Dividend Income Hits New Record o --- $1.167 Trillion, BBC NEWS (Feb. 16, 2015), http://www.bbc.com/news/business-31485930.
264 See PERLOFF, supra note 239, at 208. R
265 Id.
266 See, e.g., William W. Bratton & Michael L. Wachter, A Theory o --- Pre --- erred Stock, 161 U. PA. L. REV. 1815, 1865 (2013) (explaining venture capital investment during the peak o --- the dot-com bubble in 2000).
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Figure 7: While the number o
VC early-stage deals has increased, the amount invested per early-stage VC deal has also increased.267
From the third quarter o
2013 to the second quarter o — 2014, venture capital investment increased — rom $12 to $22 billion,268 while the num- ber o — deals steadily dropped — rom 1,944 to 1,590.269 Yet to become success — ul, top venture — irms like Andreessen Horowitz distinguish themselves by o —
ering services and distinction to startups in their investment port — olios.270 For venture — irms to generate an appropriate return on their investment, time, and ancillary services spent on port — olio companies, they need to make relatively large invest- ments in relatively mature companies.
3. Angel Technology Heightens the Gap
Angels are individuals who invest their own money directly in early-stage startups. Who are these angels and how do they make invest- ments? Not everyone can be an angel. Legally, an angel must have at least $1 million in net wealth or $200,000 in annual income,271 which is approximately 3% o --- the U.S. population.272 Practically, an angel should have a solid understanding o --- business planning, corporate --- inance, pre-
erred stock investment and market conditions, plus a risk-seeking con-
267 Data aggregated --- rom NAT’L VENTURE CAPITAL ASS’N, supra note 35, at 38 --- igs.3.10 & 3.11.
268 Primack, supra note 37. R
269 Id.
270 See Menn, supra note 31. R
271 17 C.F.R. § 230.501(a)(5)–(6) (2013).
272 Schlesinger, supra note 63. R
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stitution. 273 Approximately 300,000 Americans made an angel investment in the past two years.274 Angels invest in groups called “syndicates.” A syndicate makes an angel investment more e —
icient because only one angel needs to source, review, or negotiate a seed — unding investment opportunity.275 Syndi- cates can be quite large. One o — the largest established syndicates, Ohio TechAngel Funds, has over 300 angels.276 But only 100 angels can in- vest in a single company,277 so many syndicates, such as Seattle’s Alli- ance o — Angels, Southern Cali — ornia’s Pasadena Angels, and New York Angels each have 100 members.278 Recently, angel online investing became hugely popular thanks to websites such as AngelList, which was — ounded in January 2010 as an online — unding portal where companies can solicit investment — rom over 2,500 registered angels.279 There are two kinds o — angels on AngelList: “leads” and “ — ollowers.” A lead on AngelList per — orms many o — the sourcing, diligence, and negotiations tasks. I — the lead does not take a management — ee—thus allowing other angels to — ree ride on those e — -
orts—it is called an “angel syndicated deal.” An AngelList deal where the lead receives a management — ee is called an “angel advertised deal.” Some venture — und managers are also leads — or angels. For exam- ple, Marc Andreessen, general partner o — Andreessen Horowitz, has 21,512 — ollowers on AngelList.280 Celebrity investors also enjoy special status. Actor-turned-investor, Ashton Kutcher, has 23,060 — ollowers.281 Even i — you are not a “quali — ied purchaser” that can invest in a venture
und, on AngelList you can invest with Marc and Ashton.
273 See generally WILTBANK & BOEKER, supra note 47 (asserting that due diligence, expe- R rience, and participation are the three largest --- actors impacting the outcome o --- angel investments).
274 See FAQs About Angel Groups, supra note 58. R
275 Jeremy Shure, AngelList Syndicates: Why Pooling Resources Is Good --- or Early Stage Investing, INC. (Oct. 10, 2013), http://www.inc.com/jeremy-shure/angellist-why-pooling-re- sources-is-good- --- or-early-stage-investing.html.
276 See OTAF Has Invested $29M in 50+ Companies, REV1 VENTURES, https://www .rev1ventures.com/investments/techangel- --- und/ (last visited Feb. 27, 2016).
277 15 U.S.C. § 80a-3(c)(1) (2012).
278 Jason Fell, The Top 10 Angel Investor Groups, ENTREPRENEUR (Aug. 14, 2011), http:/ /www.entrepreneur.com/article/220149.
279 AngelList is only one o --- several online --- unding portals --- or the purpose o --- startup investment. FundersClub, established in 2011, was the --- irst online venture capital --- irm de- voted to --- acilitating more inclusive startup investment. See Nate C. Hindman, Naval Ravikant, AngelList: A Social Network that Connects Startups with Investors, HUFFINGTON POST (Sept. 20, 2011), http://www.hu ---
ingtonpost.com/2011/09/20/naval-ravikant-angellist-startups-inves- tors_n_966167.html; Laura Baverman, FundersClub Fills Void — or Start-Up Investors, USA T ODAY (Mar. 17, 2014), http://www.usatoday.com/story/money/business/2014/03/17/ baverman- — unders-club-online-venture- — und/6291007/. 280 Marc Andreessen, ANGELLIST, https://angel.co/pmarca (last visited Oct. 9, 2015). 281 Ashton Kutcher, ANGELLIST, https://angel.co/aplusk (last visited Oct. 9, 2015).
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As you can imagine, popular AngelList leads’ rounds get oversub- scribed, but not in the way you would expect. Securities laws limit an angel group size to 100 investors, even i --- that is not enough to su ---
i- ciently — und the company.282 Brad Feld, another very popular lead an- gel,283 blogs about his experience with this problem.284 Due to this quirk in the law, sometimes angel money gets le — t on the table.285 When an angel group decides to syndicate an investment into a star- tup, the group — irst reaches out to its members to see who is interested in
unding the company. In a relatively small group o — twenty — ive inves- tors, — or example, everyone can always participate. The issue — or such a small group is whether they can collectively raise enough money to meet the startup’s capital requirement. Each investor in a small group may have to come up with more than he or she wants to invest in order to close the round. Angels need to diversi — y that investment. Studies show that angels who invest in ten or — ewer startups generally lose money.286 Since 52% o — startups — ail287 to earn a market rate o — return (about 2.5x),288 angels would be wise to invest in about 50 startups.289 In other words, investing in a small number o — startups is like playing roulette in Vegas by betting on a single number again and again. Statistically, such a strategy will eventually result in losing all money. Instead, angels pre — er to invest in a port — olio o — companies. Websites such as AngelList have made it cheaper — or angels to in- vest in more companies, and data show that angels do in — act invest less per startup, even though total angel investment has increased.
282 See Fell, supra note 278. R
283 Mr. Feld has 28,159 --- ollowers on AngelList at the time this Article is being written. Brad Feld, ANGELLIST, https://angel.co/b --- eld (last visited Oct. 9, 2015). He is also the Manag- ing Director o --- the venture --- irm Foundry Group.
284 Brad Feld, The 99 Investor Problem, FELD THOUGHTS (Jan. 22, 2014), http://www. --- eld .com/archives/2014/01/99-investor-problem.html.
285 15 U.S.C. § 80a-3 (2012). A syndicate is a limited liability company created --- or the sole purpose o --- making a particular investment. As such, a syndicate will have to register as an investment company under the Investment Company Act o --- 1940 (the “ICA”), unless it is exempt. There is a straight --- orward exemption. Companies that have 100 or --- ewer members, all o --- whom are accredited investors, are expressly de --- ined as not investment companies pursu- ant to 15 U.S.C. § 80a-3(c)(1). This e ---
ectively limits angel syndicates to 100 members. 286 How Does Diversi — ication Apply to Startup Investing, FUNDERSCLUB, https:// — unders club.com/learn/investment-strategies/diversi — ication/how-diversi — ication-apply-to-startup-in vesting/ (last visited Dec. 19, 2014). 287 WILTBANK & BOEKER, supra note 47, at 3. R 288 Robert Wiltbank, Angel Investors Do Make Money, Data Shows 2.5x Returns Overall, TECHCRUNCH (Oct. 13, 2012), http://techcrunch.com/2012/10/13/angel-investors-make-2-5x- returns-overall/. 289 Id.
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Figure 8: In sharp contrast to average early-stage VC investments, which have recently increased to over $7M per investment, average angel seed-stage investments have — allen to just over $300,000 per investment, even though total angel investment has generally increased over the same period.290
B. Existing Exemptions Do Not Fill the Gap
As discussed in Part II, crowd --- unding is heavily criticized in schol- arly literature. This Article also presents new criticisms about crowd --- unding. But a --- lawed system can still be the best system. As Winston Churchill --- amously said, “Democracy is the worst --- orm o --- gov- ernment, except --- or all those other --- orms that have been tried --- rom time to time.”291 Is crowd --- unding the worst way to seed --- und a company, ex- cept --- or all the other alternatives? Un --- ortunately --- or crowd --- unding, it is not the best alternative --- or a startup to raise seed --- unding o --- less than $1 million. This section discusses how crowd --- unding, as it is currently regulated, is an in --- erior substitute --- or existing options.
Regulators should keep in mind the crowd --- unding alternatives be- cause (among other reasons) i --- crowd --- unding is designed as an in --- erior alternative to direct competitors, only in --- erior companies will choose crowd --- unding --- or equity --- undraising. Alternatively, i --- crowd --- unding is redesigned to --- ill an underexploited niche in the startup ecosystem, which is what this Article proposes as bridge --- unding, crowd --- unding will improve the system as a whole. This Article will next proceed with a discussion o --- the non-crowd --- unding ways in which a private company may raise capital through the sale o --- equities.
290 Data aggregated --- rom CVR Analysis Reports, supra note 38. 291 Ronald Hilton, Democracy and Churchill, WORLD ASS’N OF INT’L STUDIES (Sept. 5, 2003), http://wais.stan --- ord.edu/Democracy/democracy_DemocracyAndChurchill%28090503% 29.html.
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Equity --- undraising involves the sale o --- unregistered securities, so it must be done under an exemption --- rom the Securities Act.292 Regulation D contains three rules (Rules 504, 505, and 506) providing exemption
rom registration.293 Regulation A also allows private companies to raise capital by selling stock without registering with the SEC.294 In addition, the SEC plans to promulgate an expanded Regulation A, known widely as “Regulation A+.”295 O — these exemptions, Rule 504, Regulation A, and Regulation A+ are the most similar to crowd — unding, as all three o — these exemptions allow companies to sell securities directly to non-accredited investors.296 Rule 504 is di —
erent — rom (and less use — ul than) crowd — unding, however, because general solicitation is not permitted in a Rule 504 o —
ering.297 Regulation A is di —
erent — rom (and more expensive than) crowd — unding because an issuer making a Regulation A o —
ering must comply both with — ederal securities laws and state blue sky laws.298 Regulation A+ does not yet exist, but commentators suggest that it will be very similar to crowd — unding, and some are even calling it “crowd — unding plus.”299 Crowd — unding is in — erior to its alternatives in terms o — cost.300 Raising $1,000,000 via crowd — unding will cost between $76,660 and $151,660.301 In contrast, raising a similar amount o — money via Regula- tion D costs about $25,000.302 Additionally, stock sold under Regulation D has — ewer limitations.303 This section will now explain these alterna- tive equity — undraising exemptions in detail.
292 Regulation D O ---
erings, U.S. SEC. & EXCH. COMM’N, http://www.sec.gov/answers/ regd.htm (last visited Jan 13, 2015) (stating that pursuant to the Securities Act, all o —
ers to sell securities must be registered with the SEC unless they are exempt). 293 Id. 294 17 C.F.R. §§ 230.251–.263 (2013). 295 Samuel S. Guzik, Regulation A+ O —
erings—A New Era at the SEC, HARV. LAW SCH. FORUM (Jan. 15, 2014), http://corpgov.law.harvard.edu/2014/01/15/regulation-a-o —
erings-a- new-era-at-the-sec/. 296 Id. 297 Rule 504 o — Regulation D, U.S. SEC. & EXCH. COMM’N (Oct. 27, 2014), http://www .sec.gov/answers/rule504.htm. 298 Ruthe — ord B Campbell, Jr., Regulation A and the Jobs Act: A Failure to Resuscitate, 7 ENTREPREN. BUS. L.J. 317, 322–23 (2012) (“The increase in the relative o —
ering costs gener- ated by the obligations to comply with state registration provisions simply price Regulation A out o — the marketplace — or exemptions . . . .”). 299 James Johnson & David Pricco, Deep Dive: Investment Crowd — unding with “Regula- tion A+,” CROWDEXPERT.COM, http://crowdexpert.com/investment-crowd — unding/regulation- a-crowd — unding/ (last visited Jan. 13, 2015). 300 Id. 301 Neiss, supra note 22. R 302 The model pre — erred stock — inancing investment agreement provides that the company will reimburse investors’ counsel a — lat — ee o — $10,000. Generally, company counsel — ees are 150% o — investor counsel — ees, — or a total — ee o — $25,000. Filing — ees are de minimis. See Series Seed—Term Sheet, supra note 199. R 303 Johnson & Pricco, supra note 299. R
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1. Regulation D
Regulation D includes three exemptions: Rules 504, 505, and 506.304 Common to all three o --- these exemptions is that companies issu- ing restricted stock pursuant to Regulation D must --- ile a “Form D” elec- tronically online a --- ter selling the securities.305 Complying with Regulation D has preclusive e ---
ect over state blue sky laws.306 In other words, an issuer who complies with Regulation D may not have to com- ply with state securities laws.307
2. Rule 504
Crowd --- unding is not entirely new. In --- act, it is similar in many ways to the current Rule 504 under Regulation D o --- the Securities Act. Rule 504 o ---
erings are similar to crowd — unding o —
erings because both are limited to a sale o — up to $1 million in securities in any twelve-month period.308 Prior to 1992, Rule 504 o —
erings could be done through gen- eral solicitation, but the SEC determined that this created too many op- portunities — or — raud.309 To put it another way, Rule 504 allows startups to sell up to $1 mil- lion o — securities in one o — three ways: (1) through a general solicitation to non-accredited investors with a disclosure document, (2) through a general solicitation to accredited investors without a disclosure docu- ment, or (3) without a general solicitation to non-accredited investors without a disclosure document.310 Even i — a startup issues securities
304 Regulation D O ---
erings, supra note 292. R 305 Id. 306 Jean L. Batman, Raising Money Through Private Placements, AM. B. ASS’N, http:// www.americanbar.org/publications/gpsolo_ereport/2012/april_2012/raising_money_private_ placements.html (last visited Feb. 28, 2016) (“Blue-sky compliance (meaning the securities law compliance in each state where the securities are o —
ered or sold) — or Rule 506 o —
erings was simpli — ied by the National Securities Markets Improvement Act o — 1996 (NSMIA), Sec- tion 18(b)(4)(D) o — the Securities Act o — 1933, which preempts a state’s registration require- ments with respect to securities being o —
ered and sold under Rule 506 o — Regulation D. States are permitted only to (i) require a notice — iling — rom the issuer, (ii) impose a — iling — ee, and (iii) require the issuer to consent to service o — process in the state. In accordance with NSMIA, each state generally requires an issuer that o —
ers and sells securities in its state pursuant to Rule 506 to submit the — ollowing materials within — i — teen days a — ter the — irst sale o — securities in that state in order to quali — y — or an exemption — rom registration: (a) an executed copy o —
Form D Notice o
Sale o — Securities, (b) an executed copy o — Form U-2 Uni — orm Consent to Service o — Process, and (c) a — iling — ee. A Form D must also be — iled with the SEC.”). 307 Id. 308 Id.; see also Regulation D O —
erings, supra note 292. R 309 C. Steven Brad — ord, Securities Regulation and Small Business: Rule 504 and the Case
or an Unconditional Exemption, 5 J. SMALL & EMERGING BUS. L. 1, 16 (2001). 310 The current Rule 504 only exempts securities that are not o —
ered to the public and the general solicitation unless one o — the — ollowing circumstances are met: (1) the company regis- ters the o —
ering exclusively in one or more states that require a publicly — iled registration statement and delivery o — a substantive disclosure document to investors; (2) the company
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under Rule 504 without a disclosure document, however, the company is still subject to — raud rules.311 An omission o — material in — ormation may be considered a — alse or misleading statement.312 There — ore, startups is- suing securities under Rule 504 are generally advised to provide a disclo- sure document even i — they do not have a general solicitation or i — they are only selling to accredited investors.313 Because o — this onerous re- quirement, there is limited added value in using Rule 504 as opposed to Rule 506, which o —
ers unregulated o —
erings. Crowd — unding protects investors more than Rule 504 in several ways. First, Rule 504 issuers are subject only to general anti — raud liabil- ity under the Exchange Act Rule 10b-5.314 Crowd — unding issuers, how- ever, are subject to 10b-5 liability in addition to liability under Securities Act §§ 12(b) and 13.315 Rule 504 issuers are not required to make any speci — ic disclosure (although they are liable — or — raud — or material omis- sions), whereas crowd — unding issuers must — ile a “Form C” with the SEC.316 Perhaps the most signi — icant way in which crowd — unding o —
ers greater protection — or investors than Rule 504 is that crowd — unding issu- ers must sell through a broker-dealer intermediary,317 whereas Rule 504 issuers can sell directly to the non-accredited investing public.318 The crowd — unding intermediary is called a “ — unding portal,” which is essen- tially a website connecting investors to investment opportunities.319 Un- like the non-equity crowd — unding portals that exist today (e.g., Kickstarter, Indiegogo), which mainly o —
er listing services but not ac-
registers and sells the o
ering in a state that requires registration and disclosure delivery and also sells in a state without those requirements, so long as the company delivers the disclosure documents required by the state where the company registered the o —
ering to all purchasers (including those in the state that has no such requirements); or (3) the company sells exclu- sively according to state law exemptions that permit general solicitation and advertising, so long as the company sells only to “accredited investors.” 17 C.F.R. § 230.504(b)(1)(i)–(iii) (2014). 311 Rule 504 o — Regulation D, supra note 297. R 312 Id. 313 Id. 314 17 C.F.R. § 240.10b-5 (2014); see also Anthony J. Zeoli & Georgia P. Quinn, Sum- mary o — Enacted Intrastate Crowd — unding Exemptions, CROWDCHECK (Mar. 19, 2014), http:// www.crowdcheck.com/content/summary-enacted-intrastate-crowd — unding-exemptions. 315 Section 12(b) requires that all securities traded on public exchanges be registered with the SEC, and that the issuers o — those securities disclose detailed in — ormation about the com- pany and securities it issues. Section 13 essentially — unctions as a supplement to 12(b), requir- ing companies to — ile quarterly and annual reports in addition to various other documents upon the happening o — certain events. 15 U.S.C. §§ 78b, 78m (2012). 316 17 C.F.R. § 240.10b-5 (2014). 317 15 U.S.C. § 77d(a)(6)(C). 318 17 C.F.R. § 230.504. 319 Joan MacLeod Heminway, The New Intermediary on the Block: Funding Portals Under the Crowd — und Act, 13 U.C. DAVIS BUS. L.J. 177, 190 (2013) (explaining what a “por- tal” is under the Crowd — und Act).
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creditation, diligence, and disclosure services,320 crowd
unding portals that can broker the sale o — securities will be required to per — orm diligence and ongoing review o — listed issuers.321 Some commentators have recog- nized that this mandatory requirement will increase the cost and legal risk — or crowd — unding portals so much that such portals will need to de- vise a new business model.322 On the other hand, there is one important way in which crowd — und- ing is more liberal than Rule 504. Crowd — unding issuers may generally solicit investment — rom non-accredited investors.323 In 1992, the SEC took special notice o — how pump-and-dump operations de — rauded non- accredited investors by general solicitation o — bogus securities.324 Pro — essor Thomas Lee Hazen has raised several concerns regarding startups deceiving crowd — unding investors.325 Pro — essor Hazen reminds us, “as the Internet became more popular and widely used, online securi- ties o —
erings took o —
and many less scrupulous promoters used the Rule 504 exemption — or bogus or — raudulent o —
erings.”326 Many scholars are there — ore concerned that crowd — unding may give rise to a new wave o —
raudsters, despite the protections it o —
ers.327
3. Rule 505
Rule 505 o --- Regulation D allows an issuer to sell up to $5 million o ---
securities in a twelve-month period to an unlimited number o
accredited investors and up to thirty- — ive other persons.328 Stock sold in this man- ner cannot be resold — or at least six months unless the stock is registered with the SEC.329 Rule 505 is distinguishable — rom Regulation A—which also allows — or the sale o — up to $5 million in securities—because Regu-
320 See Tom Cannon, A Challenge to the Concept o --- Crowd --- unding, KICKSTARTER (Nov. 14, 2013), https://www.kickstarter.com/projects/1066541019/thri --- tyvac/posts/662863.
321 See Ryan Calbeck, Why We Are Picky: The Importance o --- Curation in Crowd --- unding, FORBES (Nov. 20, 2012), http://www. --- orbes.com/sites/ryancaldbeck/2012/11/20/why-we-are- picky-the-importance-o --- -curation-in-crowd --- unding/.
322 Heminway, supra note 319, at 199. R
323 See 15 U.S.C. § 77d (2012).
324 See Microcap Stock: A Guide --- or Investors, U.S. SEC. & EXCH. COMM’N (Sept. 18, 2013), http://www.sec.gov/investor/pubs/microcapstock.htm; see also Luis A. Aguilar, The Importance o --- Small Business Capital Formation, U.S. SEC. & EXCH. COMM’N (Nov. 20, 2014), http://www.sec.gov/News/PublicStmt/Detail/PublicStmt/1370543532516#.VKGSZEB- ums.
325 Hazen, supra note 148, at 1737. R
326 Id. at 1763.
327 Id. at 1767–68.
328 Rule 505 o --- Regulation D, U.S. SEC. & EXCH. COMM’N (Oct. 27, 2014), http://www .sec.gov/answers/rule505.htm.
329 Id.
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lation A allows general solicitation, whereas Rule 505 does not.330 This advertising advantage — or Regulation A is outweighed by the — act that Rule 505 and the other Regulation D o —
erings have preclusive e —
ect over state blue sky laws, whereas Regulation A o —
erings are subject to both — ederal and state securities laws.
4. Rule 506
Rule 506 o --- Regulation D is the only “unlimited” exemption --- rom the Securities Act, meaning that only under Rule 506 can issuers raise an unlimited amount o --- money --- rom issuing unregistered securities.331 Rule 506, there --- ore, is a popular exemption. Rule 506 may also become more popular now that the SEC has amended the rule to allow --- or general solicitations to accredited investors.332 Similar to Rule 505, under Rule 506 issuers may sell securities to an unlimited number o --- accredited in- vestors and thirty- --- ive other purchasers.333 Unlike Rule 505, however, under Rule 506 non-accredited investors must be “sophisticated.”334
Until recently, issuers hoping to take advantage o --- Rule 506 were generally not allowed to solicit or advertise in order to market their se- curities. Rule 506 was recently amended to include Rule 506(c), which allows general solicitation i --- : (1) the investors in the o ---
ering are all ac- credited investors, and (2) the company has taken reasonable steps to veri — y that its investors are accredited investors.335 Most startup investments are made pursuant to Rule 506 not only because it allows — or unlimited — undraising, but also because issuing companies engaged in Rule 506 o —
erings are not required to use an inter- mediary such as a registered broker-dealer.336 Crowd — unding, on the other hand, will require issuers to sell stock through a broker-dealer or a
330 Id.; see also David Rodman, Regulation A+, the Jobs Act, and Public O ---
ering Lite, 90 DENV. U. L. REV. ONLINE 99, 100–01 (2013), http://www.denverlawreview.org/dlr-onlinear- ticle/2013/4/27/regulation-a-the-jobs-act-and-public-o —
ering-lite.html. 331 See generally 17 C.F.R. § 230.506 (2014). 332 Gary Simon et al., SEC Amends Rule 506 to Permit General Solicitation in Securities O —
erings, HUGHES HUBBARD & REED LLP, http://www.hugheshubbard.com/PublicationDocu ments/eAlert%20%20SEC%20Amends%20Rule%20506%20to%20Permit%20General%20So licitation%20in%20Securities%20O —
erings.pd — (last visited Feb. 28, 2016). 333 Rule 506 o — Regulation D, U.S. SEC. & EXCH. COMM’N (Oct. 6, 2014), http://www.sec .gov/answers/rule506.htm. 334 Id. (“[T]hey must have su —
icient knowledge and experience in — inancial and business matters to make them capable o — evaluating the merits and risks o — the prospective investment.”). 335 Id. 336 See generally Jumpstart Our Business Startups Act Frequently Asked Questions About the Exemption — rom Broker-Dealer Registration in Title II o — the JOBS Act, U.S. SEC. & EXCH. COMM’N (Feb. 5, 2013), http://www.sec.gov/divisions/marketreg/exemption-broker-dealer-re- gistration-jobs-act- — aq.htm.
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unding portal.337 Rule 506 is also superior to Rule 504 or 505 in that only Rule 506 permits general solicitation o — securities.338
5. Regulation A
Crowd --- unding and Rule 504 o --- Regulation D are not the only ways to sell stock to non-accredited investors. The Securities Act also con- tains an unpopular and in --- requently used exemption called Regulation A.339 Regulation A permits the sale o --- up to $5 million in startup equity to non-accredited investors.340 Nonetheless, Regulation A is rarely used because it requires issuers to circulate a complex disclosure document called an “o ---
ering circular,” and it does not preempt state securities laws.341 There — ore, issuers may be subject to a wide range o — additional regulation depending on where the investors live.342 Regulation A issuers must — ile a Form 1-A with the SEC, to which they must attach the o —
ering circular and — inancial statements that are compliant with generally accepted accounting principles.343 This is not only expensive, but it also subjects the issuers to liability i — the in — orma- tion on the circular is determined post hoc to be de — icient or inaccu- rate.344 Moreover, the public — iling o — such a statement makes it impossible — or the startup to remain in “stealth mode,”345 so such disclo- sures can be detrimental to both the startup and its investors. Once the stock is sold, however, the company does not have to continue making disclosures, thus making it di —
icult — or secondary purchasers to value
337 15 U.S.C. § 77d(a)(6)(C) (2012).
338 Eliminating the Prohibition Against General Solicitation and General Advertising in Rule 506 and Rule 144A O ---
erings, U.S. SEC. & EXCH. COMM’N (Sept. 20, 2013), http://www .sec.gov/in — o/smallbus/secg/general-solicitation-small-entity-compliance-guide.htm. 339 17 C.F.R. §§ 230.251, .263 (2014). 340 Rodman, supra note 330, at 100. R 341 Guzik, supra note 295. R 342 Rodman, supra note 330, at 99 (“Reg A’s unpopularity stems — rom a number o —
ac- R tors. These include the low ceiling on the amount that can be raised, the applicability o — state blue sky laws, and the costs o — the required disclosure, including the obligation to — ile an o —
ering circular.”). 343 Id. at 100. 344 Id. at 103; see also Small Company Capital Formation Act o — 2011; Regulation A Revival?, MORRISON & FOERSTER (Mar. 30, 2011), http://www.mo — o.com/ — iles/Uploads/ Images/110330-Small-Company-Capital-Formation-Act-2011.pd — (“Taking a small business public is an important, but expensive process that requires millions in underwriting costs.”) (citation omitted). 345 See Matt Villano, Why Startups Launch in ‘Stealth Mode’ and Others Don’t, ENTRE- PRENEUR (Oct. 17, 2013), http://www.entrepreneur.com/article/229461 (explaining that startup “stealth mode” is the practice o — running a company in secrecy, or at least in relative anonym- ity, and that while this may be done — or a variety o — reasons, stealth mode is most commonly used to protect ideas or other types o — intellectual property — rom the public and potential competitors).
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stock issued under Regulation A and there
ore limiting the liquidity o —
those shares.346 Due to the problems with Regulation A and the superiority o — its alternatives, Regulation A is rarely used. There were only 19 Regulation A o —
erings — iled in 2011,347 compared to 15,500 Regulation D o —
erings.348
6. Regulation A+
The JOBS Act not only created crowd --- unding, but also expanded Regulation A to include a new type o --- securities issuance under what has become known as “Regulation A+.”349 The change is most likely to in- crease the use o --- Regulation A+ vis-à-vis Regulation A in that an issuer can raise $50 million350 instead o --- just $5 million. More mature startups may thus consider using Regulation A+ as an alternative to Regulation D, where the costs o --- the Regulation A+ disclosures are outweighed by the bene --- its o --- obtaining investment --- rom non-accredited investors.
Regulation A+, however, similar to Regulation A, is not designed to help startups begin their --- irst round o ---
unding. Regulation A+ still re- quires onerous and expensive disclosures that make it cost-ine —
ective to raise a small round.351 Regulation A has proved to be too costly — or startups trying to raise up to $5 million.352 While Regulation A+ may gain use by startups who want to raise between $5 and $50 million, it is unlikely to provide a meaning — ul vehicle — or Series Seed investment o —
less than $5 million.353 In summary, the current crowd — unding regulation most closely re- sembles the — ailed Regulation A. That regulation — ailed to be a viable exemption — or startups to raise capital because it was too expensive and too limited.354 Likewise, crowd — unding is exponentially more expensive than its alternatives, and it can only be used to raise $1 million.355 Bridge — unding is similar to Regulation A+, which recognizes the — ailures o — expensive regulation by increasing the amount that can be raised. Regulation A+ provides a potentially viable alternative to an initial pub-
346 U.S. GOV’T ACCOUNTABILITY OFFICE, GAO-12-839, SECURITIES REGULATION: FAC- TORS THAT MAY AFFECT TRENDS IN REGULATION A OFFERINGS 5, 7 (2012).
347 Id. at 9.
348 Id. at 10–11.
349 15 U.S.C. § 77c(b)(2) (2012).
350 15 U.S.C. § 77c(b)(2)(a).
351 Guzik, supra note 295. R
352 Id.
353 Id.
354 Id.
355 Id.
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lic o
ering. Similarly, bridge — unding may provide a potentially viable alternative — or private equity — inancing.
CONCLUSION
This Article has introduced “bridge --- unding,” a new way to think about crowd --- unding. Crowd --- unding is not only a way --- or the general public to have the opportunity to invest in startups. It can also provide an opportunity --- or startups to access a new source o --- capital where they need it most. Bridge --- unding views crowds as a potential third type o ---
investor in the startup
inancing market. Crowds have special — eatures that make them better at certain types o — investments. This Article has shown that crowds can occupy a valuable niche in the startup — inancing market by investing $1 to $5 million in startup companies, helping them sa — ely navigate the Series A gap. Promulgating regulations that allow and encourage crowds to invest in the “bridge — unding zone”—between the initial sub-million-dollar “seed stage” and the “Series A” stage o — the startup — inancing cycle—would be extremely bene — icial to startups. Crowds have proven on numerous occasions that they are willing to in- vest millions o — dollars in compelling products, products that may very well — ail to secure su —
icient — unding despite their success — ul premise and o — ten promising starts. Crowds could provide the proverbial “shot in the arm” necessary to make those companies success — ul. Additionally, in- vesting a — ter angels—who may still provide the initial round o — startup
inancing—lets crowds take advantage o — pro — essional investor diligence, oversight, and in — luence. Following up initial angel investment also as- suages — ears that crowds may be subject to rampant investment — raud, as investing a little bit later in the startup — inancing cycle makes investment signi — icantly sa — er — or unsophisticated crowds. This bridge — unding pro- posal not only articulates the above solutions — or the currently backwards anti — raud measures o — the JOBS Act, but also illuminates how securities regulation can be made more e —
icient by accounting — or market dynamics.
Electronic copy available at: https://ssrn.com/abstract=2544365