January 1, 1970 (Vol. , No. )
Krist Werling McDermott Will & Emery
Bob Cohen McDermott Will & Emery
Michael Pilo McDermott Will & Emery
Crowdfunding could revolutionize fundraising for early-stage biotech companies, but beware of the pitfalls.
Since the passage of the Jumpstart Our Business Startups (JOBS) Act (H.R. 3606) last year, the financial and medical press has been buzzing about the potential for crowdfunding to revolutionize fundraising for early-stage biotech companies. Even more recently, a portal that is exclusively dedicated to crowdfunding biotech and healthcare start-ups launched at medstartr.com. Although there may be reason for biotech entrepreneurs to be excited about crowdfunding, there are significant limitations and risks to this approach as well.
- Understanding the different models: There are two distinct crowdfunding models. The first is the donation model exemplified by existing portals like Kickstarter. Portals such as these simply post interesting projects, and individuals donate largely unlimited sums for no return or, at most, access to discounts or early release of products. The second model is an equity-based or investment-based model and involves an actual investment in an entity that is pursuing a project. Members of the “crowd” that provide funding receive an ownership interest in the entity. This investment model has been highly anticipated by early-stage biotech investors since it was authorized in the U.S. under the JOBS Act in 2011. However, as of the date of this article, the Securities and Exchange Commission has not released the regulations establishing equity crowdfunding, and although it is anticipated that the regulations will be released sometime in 2013, it will likely take many months following release for the SEC to establish procedures for registering portals and issuers.
- Access to markets limited by portals: Companies that seek to use investment-based crowdfunding will not be permitted to send out mass solicitations at will. Equity-based crowdfunding must take place only through brokers or portals that are registered with the SEC. In addition to registering with the SEC, equity portals will be responsible for conducting due diligence on potential investments, including background checks on directors and executive officers. The portals that are currently active, such as Kickstarter.com, Medstartr.com and indiegogo.com, are not equity-based portals, but rather donation portals. Since the donors do not receive any equity in return for their donation, the SEC is not involved in regulating such portals.
- Cap on equity raises: The aggregate amount sold to equity investors through an investment-based portal in any 12-month period may not exceed $1 million. Individual investors will also have caps placed on their equity investments of (a) the greater of $2,000 or 5% of the annual income or net worth of the investor, as applicable, if either the annual income or the net worth of the investor is less than $100,000, or (b) 10% of the annual income or net worth of an investor, as applicable, if either the annual income or net worth of the investor is equal to or more than $100,000. In no event may an individual investor exceed a maximum aggregate amount purchased of $100,000. Given the extremely high costs of clinical trials, equipment, and supplies in the biotech industry, such limits may prove to be too low to add any real value for an interested start-up company, especially give the added regulatory hurdles involved in such a equity raise.
- Fees expected to be high: Due in part to the broker registration costs and due diligence requirements imposed on brokers, it is expected that the fees charged by approved portals may be upward of 10–20% of the total amount raised. This grossly exceeds the typical 3–5% charged by broker-dealers in a registered offering and the 6–10% typically charged by investment banks running an initial public offering. Crowdfunding through a licensed platform may therefore be an extremely expensive way to raise what is ultimately a relatively limited finite amount of equity capital. But for at least some entrepreneurs this will not be viewed as a “deal killer” because their company would not otherwise have access to funds.
- High regulatory burden: If a company raises between $100,000 and $500,000 through an equity crowdfunding portal, the JOBS Act requires such company to have financials reviewed by an independent certified public accountant and if the company raises over $500,000 such company is required to have audited financial statements. Reviewed and audited financial statements are costly and are not typical for startup companies raising less than $1 million. Additionally, an informational memorandum must be drafted and filed with the SEC prior to the launch of the crowdfunding offering, and once the offering is closed, the issuer will be required to annually file with the SEC and provide to investors reports of the results of operations and financial statements of the issuer as the SEC determines is appropriate. These will be extraordinarily burdensome regulatory obligations for startup companies to comply with—particularly if less than $1 million is raised through a crowdfunding offering.
- Loss of confidentiality: The biotechnology world is extremely competitive, particularly with the emergence of mega-biotechs that are constantly scouring the environment for new investments. Crowdfunding portals and the information requirements established by the JOBS Act will require significant disclosures from early-stage biotechs. Having a large number of shareholders after a successful crowdfunding further threatens a biotech’s ability to keep its information confidential, as, depending on the amount and type of information that will be released to shareholders, it will be difficult to regulate the flow of information after it is out of the company’s hands.
- Long-term ramifications of having a large number of shareholders: If a company is successful in raising funds through a crowdfunding portal, it may create future issues with the company’s capitalization table. Having 25, 50, or even possibly 1,000 shareholders in a start-up entity can create serious issues for raising the next round of capital as many state corporation laws provide shareholders with protections such as approval rights over certain actions, one of which may be funding through additional investors. Getting large numbers of shareholders to approve a future round of funding may be so difficult and cumbersome that it may ultimately threaten the long-term viability of the company. Many venture capitalists may avoid crowdfunded biotechs due to the potential problems in getting approval for and funding subsequent rounds.
Aside from crowdfunding, there is one more type of change coming for early stage corporate funding. Changes to Regulation D’s Rule 506 will loosen restrictions on publicizing private offerings. This will allow companies to advertise more openly for investors—such as on patient advocacy websites or even possibly magazines and newspapers. Unlike with equity crowdfunding, Rule 506 investors must be accredited investors (for an individual this means having over $200,000 per year in income in each of the two most recent years or having at least $1 million in assets, excluding the value of the individual’s primary residence) who because of the economic situation are better suited for risky biotechnology investments. In addition, unlike the limits placed on equity crowdfunding portals, a Regulation D Rule 506 offering does not limit the amount of equity raised.
Early-stage biotech entrepreneurs should closely watch the development of crowdfunding regulations by the SEC over the coming months and be aware of the significant risks and downsides of crowdfunding.
Krist Werling, Bob Cohen, and Michael Pilo work for McDermott Will & Emery.