We’re kicking off our Due Diligence Series with one of the most fundamental issues in crowdfunding due diligence: making sure that the shares being offered have been properly issued. Pretty basic, right? If the shares haven’t been properly issued the investment may end up being worthless.
Securities lawyers refer to properly-issued shares as being “duly authorized, validly issued, fully-paid and non-assessable”.
- “Duly authorized” means that the shares have been issued in accordance with the law that the company was incorporated under and the company’s corporate documents (such as its certificate of incorporation), and that the shares issued are the sort of securities that the company is permitted to issue. Is the company permitted to issue preferred shares, for example? How many shares is the company permitted to issue and how many of those has it already issued (or promised under an option plan)?
- “Validly issued” means that the correct steps were taken in accordance with corporate law and the company’s corporate documents. In many states the board of directors must approve the issuance of shares. In others, a shareholder vote is needed. The company’s bylaws may add other procedural requirements, as may earlier resolutions of the board of directors.
- “Fully paid” means that the company has received proper “consideration” (payment) for the shares.
- “Non-assessable” means that the investor isn’t required to make more payments to the company by reason of being a shareholder.
In an offering that is registered with the Securities and Exchange Commission, a law firm issues an opinion that says the shares are duly authorized, validly issued, fully-paid and non-assessable. But law firm opinions cost money and a company seeking crowdfunding might not be able to afford specialized help.
So what does a prudent investor do to make sure that her shares entitle her to all the rights of a shareholder and she isn’t going to be on the hook for any future payments? She needs to take all these steps:
- Check the law under which the company is incorporated to make sure these shares can be issued and determine what procedural steps the law requires.
- Check the company’s charter and bylaws for the same things.
- Check the resolutions by the board of directors and make sure they are still valid.
- Check the company’s stock ledger and any option plans authorized by the company and calculate whether the company can issue the number of shares offered.
- Check the terms of the securities themselves.
Alternatively, our prudent investor could look to CrowdCheck. Our due diligence process makes sure that all these issues are addressed. This helps the investor make an informed investment decision, it helps the entrepreneur avoid unintentionally violating the law and it protects platforms from liability.