Academic journal article Emory Law Journal

Financial Contracting with the Crowd

Academic journal article Emory Law Journal

Financial Contracting with the Crowd

Article excerpt


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 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 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 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. …

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