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STARTUP ETHICS: General Solicitation and Startup Fundraising

Thursday, May. 8, 2014
Source: Wikipedia

The regulations overseeing startup fundraising got a boost late last year with startups now allowed to publicly advertise they are seeking investments, but its effect is still not clear. General solicitation, the act of announcing and inviting the general public to participate in an investment round, was previously banned by the SEC in order to protect investors and to entice companies to go public via IPO. With the ban in place, startups had to seek out investments through private conversations and going direct to investors, severely limiting the pool of money they could draw from. With the ban on general solicitation removed, startups can use newsletters, social media, and public speaking to announce their investment rounds to the general public. Is the investor now at risk?

Startups can only receive investments from “accredited investors” and will now have to ensure that their investors are in fact accredited; that is, either having an annual income of $200K or a net worth of over $1 million. Does a system that restricts investments to accredited investors do enough to protect against snake oil salesmen? Some have argued the burdensome system for verifying that investors are accredited will inevitably lead to a new set of problems: a compliance nightmare, resulting in both fines and an impediment to innovation. Will it?

  Elizabeth Powers: Trade secret law is the only law that protect ideas – patents protect inventions (more than an idea); copyrights protect unique expressions of the idea; trademarks are marketing tools. Trade secrets must remain secret, which inherently challenges an entrepreneur who needs to disclose her idea to a potential investor. Often, potential investors do not want to sign a Non-Disclosure Agreement (NDA), that would restrict the investor’s right to copy or use the disclosed information – what if the investor had already invested in another company with the same idea? Or chooses to invest in a different company that presented the same idea? Investors simply don’t want that risk.

So, as with any potential investor pitch, the entrepreneur seeking investment in a new business idea, either from a commercial bank, an angel investor, a venture capital fund, or a family member, must carefully consider the information disclosed to the investor. The entrepreneur must carefully remove any unnecessary information from the publication or disclosure (e.g., the actual algorithm, how the website will function, etc.)

Easier said than done. For example, if the idea is for a website (or a mobile app) that allows users to post and organize photos of garden designs, the idea itself is the trade secret. Once the entrepreneur tells someone that idea, without an NDA, there is no clear restriction preventing that person from creating the same website/mobile app, because there is no “secret” algorithm or functionality associated with implementing this particular idea. When solicitations for investment are published, there is no NDA associated with the publication – it makes any idea or information essentially available to the public. With this new freedom to advertise, the entrepreneur must carefully consider what MUST be published to convey enough information to entice investors, and what does NOT need to be published. I see an opportunity for a creative solution here.

  Joe Schmid: Opening a new avenue for raising money doesn’t mean going down that road is right for every situation. The JOBS Act did not eliminate the struggle between disclosure and protection of ideas and intellectual property as Elizabeth warns.

“Misrepresentation” and “concealment” are watchwords for both the issuer and the investor coming to terms with the definition of “material facts”. The JOBS Act did not strip away compliance with antifraud prohibitions; and it didn’t lessen the requirement of investor diligence.

Startups are high risk. The classification of accredited investors by wealth and income uses a presumption of investor sophistication as well as a notion of limiting exposure. The verification process is to protect the issuers not the investors. Non-accredited investors tend to be more problematic anyway.

The best advice is to thoroughly understand where the venture is at any point in time and carefully select how to manage increasing cash demands. Because its ‘new’ or you can leverage ‘social media’ doesn’t mean it’s a fit for the situation at hand. Maxing credit cards and Uncle Bernie may still be the better option.

  Martin Zwilling: It remains to be seen whether the right to general solicitation by entrepreneurs brings more value to them than the cost of validating that every potential investor is accredited. I believe the entrepreneur is more at risk than the investor. Compliance is definitely a new burden, and could become a nightmare.

Investors have long been required to "certify through signature" that their net worth or income qualifies them to become accredited, so their burden and risk haven't changed yet. Some investors fear that this new general solicitation rule will lead to bank statement or tax return disclosures, which will be a bigger burden, and will likely cause many qualified investors to back out of the pool. Angel groups fear the loss of many members for the same reason. Here again, the entrepreneur will be the one hurt, having less access to money.

We are all still waiting for how general solicitation to non-accredited investors (equity crowd funding) will work. Overall, it's still too early to jump to conclusions

 Eliminating the Prohibition Against General Solicitation (SEC)

A Framework for Ethical Thinking (Markkula Center) 

 

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