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To Crowdfund or Not to Crowdfund

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To Crowdfund or Not to Crowdfund, That is The Franchisee and Franchisor’s Question

Not long after the internet became a widespread tool, small businesses began searching for ways to raise capital from the general public without breaking state and federal securities laws. (*1) Crowdfunding was a possible route, but companies often couldn’t issue equity in their company when seeking funds from the general public. A possible solution came in 2012 with the passage of the Jumpstarting Our Business Startups Act, or JOBS Act for short.

Title III of the JOBS Act allows for a ‘crowdfunding’ exception to securities laws that would otherwise require investors to be accredited.

After the stock market crash of 1929 and The Great Depression, the United States government passed the Securities Act to protect against fraud by placing certain requirements on the issuance of a security--unless an exemption applied. The internet and crowdfunding didn’t exist in the 1930s, so there was no exemption for small businesses to seize. Title III of the JOBS Act creates such an exemption for crowdfunding.

Regulation Crowdfunding

Regulation Crowdfunding is the raising of capital via issuances of securities on an online broker-dealer platform. This method of securities issuance bypasses the need for accredited investors and, subject to some limitations, the need for determinations based on income or net worth. Issuers use third-party intermediaries registered with the Securities and Exchange Commission to make their offerings.

Regulation Crowdfunding has some limitations including how much capital an issuer can acquire in each 12 month period, how much money an investor can commit, and restrictions on reselling securities within 12 months. For example, in one year, the total amount of securities issued to an individual investor cannot exceed $100,000. Limitations also exist based on an investor’s income and net worth. If an individual’s annual income or net worth is less than $100,000, the limit is $2,000 or five percent of the lesser of either his or her annual income or net worth, whichever is greater. If both an investor’s annual income and net worth are equal to or greater than $100,000, then the limit is 10 percent of the lesser of either his or her annual income or his or her net worth.

Another limitation of Regulation Crowdfunding is that securities must be sold through a funding portal or through a broker-dealer registered with the SEC. The purpose of this requirement is to offer some protection to people investing through crowdfunding. But issuers should know limitations regarding what funding portals can offer. For example, a funding portal cannot offer investment advice. Issuers can find a funding portal by visiting the website of the Financial Industry Regulatory Authority, also known as FINRA.

Another requirement related to Regulation Crowdfunding is the inclusion of Bad-Actor provisions, meaning if a covered person, such as an issuer or a director of the company or equity owner, had criminal convictions or other disciplinary action against him or her, something known as a ‘disqualifying event,’ then the issuance of the securities would not be allowed. These disqualifications, however, will not look back at actions before May 16, 2016, when Regulation Crowdfunding provisions went into effect.

Reg CF also requires certain disclosures. While the Act itself is meant to reduce the regulatory burden on issuers, certain disclosures still exist, generally falling into one of five categories: director and officer information; principal shareholder information; the issuer’s business plans, including their risk factors; a description of the offering; and financial disclosures.

Disclosures to the SEC and potential investors are made through Form C, a 31 question form that must be filed with the SEC. But the issuance of these securities must be made through a registered third party, and this third party can usually offer guidance about filling out and filing this form with the SEC. Ongoing reporting requirements exist with regulation crowdfunding, such as annual reports that must be filed 120 days after the end of an issuer’s fiscal year.

Franchise Use of Regulation Crowdfunding

Pros and Cons for A Franchisee

Franchisees should carefully examine the potential benefits and liabilities of issuing securities through Regulation Crowdfunding. Some of these challenges may overlap with or conflict with challenges facing a franchisee. Regulation Crowdfunding can work extremely well, so long as it is carefully considered and planned.

Reg CF is beneficial for: the purchase of a unit franchise, especially if there are substantial build-out costs or other factors that would cause a significant initial capital outlay; avoiding debt when purchasing a franchise; and expanding from one franchise to many. If an issuer has already demonstrated success once, investors may be more likely to commit funds now. Required financial disclosures also include a history of success if an issuer has financial disclosures related to an existing successful franchise.

So what are some of the possible downsides?

One of the biggest downsides to a Reg CF offering is cost. While the JOBS Act reduced regulatory burdens of complying with securities laws, it did not eliminate them entirely. Some compliance costs still exist and likely require the hiring of outside counsel to protect against legal liability.

Unlike dealing only with accredited investors, Regulation Crowdfunding raises the risk of having hundreds of small investors, creating operational burdens like shareholding meetings.

A potential issuer should also consider the liability that comes with any material missteps or omissions. Since any issuance greater than $100,000 requires a financial statement, or in some cases, a fully audited statement, franchisees must undertake an additional step, one not normally associated with the franchise process. Mistakes with this step are very costly. The penalty for an untrue statement under Section 11 of the Securities Act is the difference between what an investor paid for a security and the price at which an investor can sell the security. Essentially, an issuer would have to make the investor whole again if there are any mistakes on a disclosure statement. These concerns don’t exist in a typical franchisee consideration. And since franchisees have other overhead costs, additional securities liabilities can be particularly risky. Don’t expect franchisors to give a forbearance to help the franchisee with their securities liability, as this could be a serious risk.

It isn’t all bad news for would-be franchisee issuers

While risks are significant, a franchisee can improve his or her situation if he or she still desires to make an offering. Since Regulation Crowdfunding allows for oversubscriptions, the franchisee would be wise to oversubscribe without exceeding the $1.07 million cap.

Franchisees should be careful about how they handle advertisements for their offerings. A franchisee can advertise an offering by directing potential investors to the offering’s intermediary platform if the advertisement includes only: a statement that the offering is being conducted using Section 4(a)(6), the Crowdfunding Exemption, and that identity of the intermediary; the term of the offering; and factual information about the issuer, so long as it is limited to their name, address, phone number, website, and email. According to the SEC, brief social media communication is also acceptable if it follows these rules.

Lastly, franchisees must keep in mind the restrictions on promoter compensation if they are planning to offer investments through Regulation Crowdfunding. While promoters can be compensated, they must be acting directly on the issuer’s behalf. Issuers must also take reasonable steps to ensure that anyone promoting an offer offers receipts of any compensation made in connection with the communication.

Pros and Cons for A Franchisor

Some of the pros and cons of Regulation Crowdfunding for a franchisor are somewhat similar to those faced by franchisees. Some of the concerns are unique to franchisors and may mean that Regulation Crowdfunding isn’t as good a choice for them. For example, when dealing with a sizable franchise, the $1.07 million dollar cap might make a Reg CF offering worthless.

Positives also exist for franchisors. Since franchisors are already required to prepare audited financial statements, the requirement to do so for Regulation Crowdfunding is not as onerous as for a franchisee. Similarly, much of the information required on Form C is similar to what they are already required to disclose. In fact, Form C can be more detailed in some cases.

While having this information already gathered is convenient, if a franchisor is in one of the situations where Form C requires more, he or she may be unwilling to make that disclosure.

If a franchisor is going to offer securities through Regulation Crowdfunding, he or she should consider forming a general holding company to make the offering and becoming a subsidiary of the holding company.

Should Franchisors Approve of Their Franchisees Issuing Securities Through Regulation Crowdfunding?

Most franchise agreements include a restriction on transfer, which means franchisees must have their franchisor’s consent before offering securities.

The biggest concern for a franchisor is whether he or she is subject to liability if the franchisee violates securities law. Under Section 11, the scope of parties potentially liable can include a franchisor if he or she has anything to do with the registration. Franchisors may not even want to review it, despite some strong arguments in favor of reviewing the statement.

Some of these considerations are ensuring disclosure statements do not include trade secrets such as pricing strategies. Franchisees should also consider whether such information goes so far as to violate any confidentiality agreement with the franchisor.

Beyond these concerns, franchisors must consider whether they want to allow the dilution of franchisees’ principal shareholders to include additional parties, including parties with whom franchisors may not want to deal. For example, if a franchise fails, the dilution of principal shareholders might mean that more people lose money at the hands of the failed franchise, meaning more people might air their grievances online about the franchise’s failure.

If a franchise fails, what is the risk of negative publicity from additional investors involved? In other words, even if a franchisor is protected from legal liability for potential securities violations by the franchisee, he or she must consider the possibility of a damaged reputation, and whether that is worth the risk of allowing Regulation Crowdfunding.

*1 Based on Wieczorek, S. G. (2016). “Regulation Crowdfunding: A Viable Option for the Franchising Industry.” Franchise LJ, 36, 275.
*2 finra.org/about/fundint-portals-we-regulate

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