Equity Crowdfunding | The Transaction Costs

The JOBS Act is set to enable equity crowdfunding.  In equity crowdfunding unsophisticated investors make small investments without the investments being registering with the Securities Exchange Commission or the state securities regulators.

Equity crowdfunding, which will be new to the US, aims to tap the power of online commerce to spur economic growth.

I ponder how the costs of funding a transaction will balance against the value of the transaction.

Legal Costs

First, there are legal costs.

Presumably, the issuer (the company selling equity to investors) will need “legal” help.

It will need a legal entity, like a corporation or an LLC.  Some people create entities like that without the help of a lawyer.

The issuer will need one or more contracts and related documents that govern the deal (e.g., you invest $500, and in return you get X shares of common stock in the issuer company subject to specified rules and limitations).

The issuer will need disclosure documentation like a prospectus that describes the issuer, the offering, the market, the risks and other material information so the investor can make an informed decision.  Traditionally this kind of documentation is prepared with the help of a lawyer.

Maybe the costs of this legal help can be kept down by (a) imperfect, cookie-cutter forms, (b) software that (imperfectly) enables the issuer to do some or a lot of this on its own, and/or (c) the flood of young lawyers emerging from law school without jobs.  I wonder whether young lawyers (many deeply indebted with student loans) will take on this work for low fees, and not worry about malpractice insurance because they are already in debt.

Accounting Costs

Under the JOBS Act, deals over $500,000 require audited financial statements.  Deals between $100,000 and $500,000 will require some kind of a review by a public accountant.

Deals under $100,000 do not require involvement by an accountant.  Instead, the issuer just releases its most recent tax return (if any) and the issuer’s CEO attests to the issuer’s financial statements.

I am not aware that large numbers of certified public accountants are unemployed, desperate for work.  CPAs bear malpractice risk, so they will charge enough to more than justify their malpractice insurance.  (Furthermore, before a CPA takes on a crowdfunding deal, the CPA would be wise to review the terms of her malpractice insurance.  Theoretically, the risk to a CPA in a small-business crowdfunding deal is larger than in a typical CPA review/audit of a small business.   The reason is that in a crowdfunding deal, there is potentially a large number of little investors; a bad deal might economically support a class action lawsuit.  Hence, the terms of insurance for a CPA who audits small business may not cover high risk transactions, like crowdfunded deals and initial public offerings.)

I wonder, therefore, whether we will see large numbers of deals for

a.  $100,000 or less

or

b.  new entities that have financial statements are perfectly clean and therefore easy to audit/review.

Intermediary Costs

Under the JOBS Act, crowdfunding requires an intermediary.  The intermediary must be either a registered broker or a registered “crowdfunding portal.”  It will be the intermediary’s responsibility to supervise the transaction, and make sure various rules are followed.  The intermediary will want enough compensation to justify the work it must do and the risk it must bear.

Maintaining broker registration involves quite a bit of overhead (such as recordkeeping).  It remains to be seen what all the overhead of a crowdfunding portal will be.

Both brokers and portals will bear substantial costs in doing such things as running background checks on issuers and securing the privacy of investors.

Banking Costs

Money will have to be processed.  For example, if investors use credit cards to pay, then there will be card transaction fees.  If a bank is collecting payments into, say, an escrow account, then the bank will expect compensation.

I have not thought all of these issues through.  What do you think, dear reader, about the costs?

–Benjamin Wright

Mr. Wright teaches the law of data security and investigations at the SANS Institute.

Employee Privacy in Social Networks | Poor Draftsmanship in Illinois

Some state legislatures are passing laws to restrict the ability of employers to see the social network pages of employees.

The Illinois Legislature passed House Bill (HB) 3782, amending the state’s Right to Privacy in the Workplace Act.  I hear the governor is expected to sign HB 3782 into law, but I have not seen confirmation of that.

HB 3782 confuses me.

A Confusing Chain of Verbs

HB 3782 contains the following long sentence:

“It shall be unlawful for any employer to request or require any employee or prospective employee to provide any password or other related account information in order to gain access to the employee's or prospective employee's account or profile on a social networking website or to demand access in any manner to an employee's or prospective employee's account or profile on a social networking website.”

Notice how many times the sentence uses the word “to” followed by a verb.    When I get to the words “or to demand access . . . ,” I’m not exactly sure how that last part of the sentence connects with the preceding words in the sentence.  But I guess that the legislature meant: “It shall be unlawful for any employer . . . to demand access in any manner to an employee's or prospective employee's account or profile on a social networking website.”  (What do you think, dear reader?)

Theft Scenario

I understand the legislature’s desire to protect employee privacy relative to matters that do not relate to employment.  But the legislature’s words seem to go farther than that desire.  Imagine the following scenario:

Social Circles

The employees are executives of the employer, and they have signed agreements not to abuse the employer’s intellectual property and business opportunities.  They set up among themselves a closed Google Plus circle, that is, a social network account or profile protected by HB 3782.  The purpose of the circle is to hatch an elaborate, interactive scheme – with formulas, spreadsheets, custom apps and inter-operating parts and software -- to create a business that competes with the employer.  The scheme subtly steals the employer’s intellectual property and business opportunities.

If the employer sues the executives for theft, it might be hampered in its ability to get justified access to the evidence.  Under the rules of civil discovery in litigation, the employer would normally demand disclosure of the evidence in the Google Plus circle.  But the executives would stymie the employer by citing the precise words of HB 3782.  The employer may not “demand access in any manner”!

Construing the Words Narrowly Still Impedes the Employer

Ok. Maybe I’m misinterpreting the words of HB 3782 because I am reading them too literally, and I am forgetting that the spirit of HB 3782 is just to protect privacy of weak employees, not to enable powerful executives to steal.

Maybe a court would understand the true spirit of HB 3782 and construe it narrowly to mean this: Although the employer cannot be given direct access to the Google Plus circle, it can demand under the rules of e-discovery in civil procedure individual relevant records – one-by-one – from the Google Plus circle.

However, this interpretation could still thwart the employer’s justified need to see the Google Plus circle.  The theft is subtle, elaborate and interactive.  It may become apparent only when the Google Plus circle is accessed in its fullness, and one tests all of its functionality, interactivity and interconnectedness.  If the employer cannot force the executives to disclose the whole scheme, as it operates inside the Google circle, the employer may not obtain the evidence necessary to convince a judge and jury that theft had occurred.

Conclusion

HB 3782 is poorly drafted and could make it unjustifiably difficult for an employer to investigate theft and other wrongdoing by employees.

–Benjamin Wright

Mr. Wright teaches the law of data security and investigations at the SANS Institute.