Financial Contracting With the Crowd

• Jurisdiction: United States,Federal
• Publication year: 2019
• Citation: Vol. 69 No. 3

Financial Contracting with the Crowd

Usha R. Rodrigues

FINANCIAL CONTRACTING WITH THE CROWD

Usha R. Rodrigues^*

Abstract

Equity crowdfunding is broken. The current model imposes too many burdens on entrepreneurs in exchange for too little money. For alternative models, this Article looks to the time-tested venture capital financial contract and the recent experience of initial coin offerings (ICOs). ICOs made headlines over the past two years as the means by which blockchain technology companies raised billions of dollars to launch new cryptocurrency ventures. Although their novelty as a monetary and investing device is well known, ICOs also presented significant, unappreciated insights into financial contracting.

ICOs furnished an unprecedented experiment into how bargains would look if entrepreneurs raised money for a venture directly from the general public without government regulation. Although the setting was novel, the financial contracts of the blockchain replicated mechanisms familiar from the venture-capital context that protect investors against uncertainty, information asymmetry, and agency costs. ICO financial contracts suggest that familiar venture capital contractual provisions such as vesting of founder ownership interests, voting rights, and redemption rights are versatile tools that can protect investors in a variety of settings—including equity crowdfunding. Thus, even if ICOs may not prove a lasting phenomenon, regulators can apply their financial contracting lessons to capital-raising from the crowd. Doing so has the potential both to increase entrepreneurial access to capital and to democratize the investing playing field.

[Page 398]

Introduction .............................................................................................399

I. The Crumbling of the Traditional Public/Private Divide .... 404

A. The Public/Private Divide ........................................................ 405
B. Cracks in the Wall: Private Fundraising Moves Public ........... 409
C. More Cracks in the Wall: Equity Crowdfunding and Reg A+ .. 411

II. Financial Contracting in the Venture Capital Context......418

A. The Risks Investors Face .......................................................... 418
B. Contractual Protections for the Venture Investor .................... 421

1. Staged Financing................................................................ 421
2. Control ............................................................................... 422
3. Compensation/Vesting ........................................................ 423
4. Redemption Rights .............................................................. 424
5. Reputation as an Extra-Contractual Discipline on Investors ............................................................................. 424

III. Financial Contracting with the Crowd...................................425

A. Voice and Exit: The DAO ......................................................... 426
B. Post-DAO ICOs ........................................................................ 428

1. Voice and Exit .................................................................... 431
2. Limitation on Supply .......................................................... 432
3. Vesting/Compensation ........................................................ 432
4. Threshold Raise .................................................................. 434
5. Resale/Liquidity .................................................................. 435

C. Caveats ..................................................................................... 436

IV. The Legislative Solution.............................................................440

A. Threshold Raise and the Power of Escrow............................... 441
B. Exit, Voice, and Staged Financing ........................................... 443
C. Vesting ...................................................................................... 446
D. Liquidity/Resale ........................................................................ 446
E. Raising Crowdfunding Limits ................................................... 448

V. Implementing These Mechanisms within the Current Regulatory Framework..............................................................449

A. Reg A+ ...................................................................................... 451
B. Intrastate Offering ..................................................................... 452
C. Section 28 ................................................................................. 456

Conclusion.................................................................................................457

[Page 399]

Introduction

Pabst Blue Ribbon Inc. (PBR) was up for sale in 2009, and two loyal patrons wanted to prevent the iconic American company from suffering the same fate as Budweiser, which had been sold to Belgian-Brazilian InBev the year before.¹ The two men tried to crowdsource a bid for the company, creating a site called BuyaBeerCompany.com.² The pair obtained over $200 million in pledges from approximately five million Americans, but the Securities Exchange commission (SEC) prohibited the campaign.³ According to the SEC, PBR's would-be acquirers were offering a security, and U.S. securities laws prohibit the sale of a security to the general public to finance a firm without registering with the SEC (in an initial public offering, or IPO), or qualifying for an exemption from registration.⁴

Indeed, before 2012, "crowdfunding" was limited to Kickstarter-like funding campaigns⁵ that rewarded funders with a nominal gift such as a T-shirt or baseball cap. There was no way to raise money from the general public—or the "crowd," as this Article will sometimes call it—in exchange for a stake in the underlying business.⁶ This limitation dates back to the Securities Act of 1933, which requires firms to register for an IPO before selling their securities to the crowd.⁷ Any offer to sell shares in an actual business was thus off-limits— including soliciting offers to buy a beer company.⁸

The somewhat whimsical PBR plan inspired U.S. Representative Patrick McHenry (R-NC).⁹ He wanted to counter U.S. securities law's "paternalistic view that average investors can't make these decisions for themselves."¹⁰ The

[Page 400]

problem McHenry sought to address was a simple one: How can companies— especially small ones—raise equity financing from the general public?¹¹ He introduced a three-page bill that allowed ordinary investors to invest the lesser of $10,000 or 10% of their annual income in companies seeking to raise up to $5 million.¹² McHenry's straightforward bill ultimately became Title III of the Jumpstart Our Business Startups Act of 2012 (JOBS), but along the way Congress amended it to impose substantial requirements on aspiring crowdfunding entrepreneurs.¹³ The SEC layered on even more requirements in its final rule, which weighed in at 228 pages and over 1,700 footnotes.¹⁴ As a result, equity crowdfunding, capped at only $1.07 million, is widely regarded as not being worth the effort.¹⁵

As Part I describes, private fundraising has long offered an alternative funding source to the IPO, for those entrepreneurs willing to seek out funds from a more limited group of accredited (i.e., wealthy) investors,¹⁶ and able to meet the requirements of a "private offering" to raise funds. These private offerings allow for experimentation precisely because they occur outside the gaze of securities regulators.

Accredited and institutional investors can invest in private offerings because they are deemed able to "fend for themselves"¹⁷ —and fend for themselves they must. Investors contemplating investing in a fledgling venture confront significant problems of uncertainty, information asymmetry, and agency costs.¹⁸ They are free to contract as they see fit to address these issues, without regulatory intervention. As Part II.B will describe, a rich literature has detailed financial

[Page 401]

contracting terms in the venture financing realm—like the vesting of founder equity, and staged financing—that strike the appropriate balance between entrepreneur capital-raising and investor protection.¹⁹ The literature argues that venture capital's (VC) financial contracting aligns the incentives of company and investor,²⁰ and helps explain the success of VC-backed companies ranging from Apple to Google to Lyft in raising hundreds of millions of dollars while avoiding burdensome IPO requirements.

On the public side, however, the securities laws and the SEC create a choke point. There is little room for private ordering between investors and entrepreneurs because any offer of a security for sale to the general public must pass muster with the SEC.²¹ The SEC will occasionally allow for experimentation,²² but these instances are at the regulators' whim. Thus, any experiments are at best an imperfect approximation of the contractual terms the public market might desire, if left to its own devices, to contract for its own protection.²³

Without the possibility of such experimentation, Congress and the SEC are left to articulate rules that both foster capital formation and provide adequate investor protection. While the crowdfunding rules and regulations might not strike the proper balance between disclosure, regulatory burden, and investor protection, there generally has been no way of knowing what would work. Yet two examples offer as-yet unexplored models for what investor protection might look like in the equity crowdfunding context.

The financial contracting of venture capital funding and initial coin offerings (ICOs) offer examples of what kinds of investor protections equity crowdfunding might offer. An ICO is an offering of specialized crypto tokens,²⁴

[Page 402]

with the promise that those tokens will operate as a medium of exchange when the blockchain venture is complete.²⁵ The funds raised...