A Legal Structure for Crowdfunding

It’s official:  Crowdfunding is now in effect and thousands of companies are about to start raising money under the new SEC regulations. If each company offers different deal terms for investors, it’s going to be that much more difficult for investors to make apples-to-apples investment decisions.

Meanwhile, some in the investment community are still concerned that a company raising money through Crowdfunding will be hobbled in raising more money afterward, e.g., from angel groups or venture capital funds.

The sooner the market adopts a standard investment structure, the better for all.

Here is a legal structure that would standardize the Crowdfunding market, satisfy SEC regulations, and ensure that the Crowdfunding round of financing does not preclude later rounds:

  • New Entity:  Form a new entity for the Crowdfunding investors. We’ll call this entity InvestCo, and we’ll call the operating company itself MyCo. InvestCo will be one owner of MyCo, no matter how many investors buy stock in InvestCo.
  • Structure of InvestCo:  InvestCo will be either a limited liability company or a C corporation, based on tax and state-law considerations. InvestCo will be controlled by the same individuals who control MyCo.
  • Percentage Ownership:  Each investor will own a pro rata share of InvestCo based on his or her investment. InvestCo, in turn, will own a percentage of MyCo stipulated by MyCo in the offering materials, based on the amount of money raised and the value of MyCo. Here is a post with suggestions on establishing this ownership percentage.
  • Voting Rights of Investors:  Investors will not be entitled to vote in InvestCo, and InvestCo will not be entitled to vote in MyCo. That is, the investors in a Crowdfunded offering will have no voting rights, except the right to appoint one member to the Board of Directors of MyCo.
  • Preference on Sale or Liquidation:  If MyCo is sold or liquidated, InvestCo will be entitled to receive a return of its investment before any distributions are made to the other owners of MyCo as they exist today. If MyCo raises more money in the future, the rights of InvestCo could be subordinated to the rights of the new investors.
  • Dividend Right:  InvestCo’s stock in MyCo will bear a dividend rate of 5%.
  • Tag-Along Rights: If the founder of MyCo sells some of his or her stock, InvestCo will have the right to participate in the sale.
  • Anti-Dilution Rights:  InvestCo will be entitled to “weighted average” anti-dilution protection.
  • Right to Information:  Investors will have the right to basic information from MyCo, such as annual financial statements. Of course, state law may give them (and any other owners) the right to additional information.

This structure should be acceptable to all of the constituents of the Crowdfunding market:  the entrepreneurs who started MyCo; the broad investing public that will make Crowdfunding a success; the angel groups that help so many startups succeed and currently anchor the early-stage market; and the venture capital funds that provide additional funds for companies that need and deserve them.

Questions? Contact Mark Roderick at Flaster/Greenberg PC.

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7 thoughts on “A Legal Structure for Crowdfunding

  1. […] (For a more complete description of how such a structure might operate, see my blog post here.) […]

  2. Sterling July 21, 2014 at 6:27 am Reply

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  3. […] Act of 1940, Roderick says. For a more complete summary of how this structure would work, click here. Roderick adds, another way, aside from creating an entirely new vehicle for investing to steer […]

  4. […] Act of 1940, Roderick says. For a more complete summary of how this structure would work, click here. Roderick adds, another way, aside from creating an entirely new vehicle for investing to steer […]

  5. […] Act of 1940, Roderick says. For a more complete summary of how this structure would work, click here. Roderick adds, another way, aside from creating an entirely new vehicle for investing to steer […]

  6. Crowdfunding Memo to SEC | CrowdRabbit April 30, 2015 at 8:14 pm Reply

    […] company (LLC) that invests in the startup.  Because the crowdfunders invest collectively, they are just one investor on the startup’s cap table, removing the deterrent to angels and […]

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