Startup investors all hope for a great “exit.” Most startups, of course, will never get to that point, but for the successful ones, the principal ways that investors get repaid for their faith in a high-growth early stage company is an eventual IPO, hopefully at a price much higher than the price they paid, or through the acquisition of the startup by another company.
It can take a very, very long time for a startup to get to the point of an IPO. We aren’t aware of a company crowdfunded under Regulation CF having done an IPO yet. Mergers and acquisitions are a much more likely option for an exit for a company that raised funds in a Regulation CF offering.
We’ve seen some of those. And there’s a big issue there.
The source of the issue is Rule 145 under the Securities Act of 1933. That says, in effect, that when a shareholder votes to accept or reject a merger proposal, they are making an investment decision with respect to the offer of the acquiring company’s shares. That means that when a company offers to acquire a company that has a number of investors from a previous round of crowdfunding (presumably after the Rule 501 holding period), that offer needs to be registered under the Securities Act or made in compliance with an exemption from registration (such as Regulation A, Regulation D, or Regulation CF). The problem is, this will be difficult for many companies to achieve, and near impossible for some.
A merger may require the vote of shareholders even if they hold shares designated as non-voting under the crowdfunded company’s certificate of incorporation. Depending on the state where the company is organized, there may well be inalienable “statutory voting rights.” And having given someone else a proxy to vote the shares doesn’t help either. The person holding the proxy is still going to have to make an investment decision. If there is a vote, there is an offer that has to comply with the securities law.
Registration of such offers is prohibitively expensive unless the acquiror is already a public company. Regulation A is also likely to be too expensive unless the acquiror has a Regulation A offering open that it can amend. Regulation D is unlikely to be an option since most of the crowdfunding investors will be non-accredited. Regulation CF might work if the acquiror is eligible to use it (so no acquisitions by foreign companies or investment companies) and the value of the securities to be offered to the crowd investors is below the $5 million limit. But if the crowd is holding more than $5 million worth of securities from previous crowdfunding rounds, that’s not going to work, either.
As a result, in some proposed acquisitions, the acquiror has not been able to offer its shares to the crowd investors, and had to offer to cash them out. That approach comes with its own problems, since depending on the structure of the tender offer, there may be a public tender offer that has to follow tender offer rules. But it isn’t subject to the requirement to register the offering under the Securities Act.
In other acquisitions, the acquiror seems not to have addressed the issue of registration or exemption at all. It may be that acquiring companies and their advisers are using merger docs developed for private companies where all the investors are accredited and just not thinking how crowdfunded companies are different.
What we don’t seem to be seeing is acquisitions of crowdfunded companies that comply with not just corporate law but also securities law. It’s not easy to suggest solutions here. A cash-out is compliant. Possibly SAFEs could be modified to provide only for cash-outs in these circumstances (as opposed to the investor being able to choose between cash and conversion, which is generally the case upon a liquidity event). But cash can be a disappointing exit for investors who believed in the company’s future, and acquiring companies may not have a heap of available cash.
We’re hoping that the new secondary trading markets that are standing up for crowdfunded securities may help here, and we are always open to suggested solutions.