The global financial crisis of 2008 was considered the most devastating financial crisis since the beginning of the Great Depression in 1929. The Eurozone crisis started in 2009, when Spain, Ireland, Italy, Greece and Portugal failed to provide their economies with, among other things, enough growth. These led to a dire liquidity crisis as banks, venture capitalists and angel investors became very hesitant about investing money in new companies. Start-ups were forced to seek out alternative funding mechanisms. This supported the growth of the modern-day Internet crowdfunding platforms first for donations, then loans and subsequently for equity.
As with all business formations, crowdfunded companies sometimes do wrong intentionally. Unlike negligence, intentional wrong (tort) requires the actor to have intended its harmful act. Some of these intentional acts and effects in crowdfunded companies will be explored below.
There are numerous rules and regulations that equity crowdfunded companies have to abide by. These regulations are required because equity crowdfunded businesses are issuing securities. In the U.S., the Securities and Exchange Commission (SEC) has enacted the technical requirements asked for by the JOBS Act, which was passed by Congress. Meanwhile, in the United Kingdom, the Financial Conduct Authority (FCA) has also introduced rules governing crowdfunding. Europe in general has still not put forth any uniform regulations.
Regardless of the organizational formation of a business concern, there are issues that arise and warrant the proper representation and protection of minority investors. Minority stakeholders in crowdfunded businesses need protection.
Some of the problems that could arise are related to violations of investment caps, fraud and the manner in which communications are given to investors.
In the traditional business sphere, well-established investment firms negotiate and have written agreements with companies so that their investments will not be diluted on the event the companies they support issue more shares. To help alleviate this problem for the smaller investors who ideally would not have such leverage in crowdfunded companies, a trustee should be appointed to help negotiate on behalf of the investors, and include consent rights, pre-emption rights and tag-along provisions in all the investment agreements. These are elaborated below.
The consent rights will prevent the company from taking certain actions or making certain decisions that could negatively impact the investment without the consent of the investors. This would be communicated through the trustee representing the investors’ interests.
A pre-emption provision is a privilege extended to select shareholders of a corporation that will give them the right to purchase additional shares in a firm before the general public has the opportunity, in the event there is a further offering of stock. It is also referred to as the first option to buy, and helps the existing stockholders maintain their proportionate ownership of the company and prevent stock dilution.
Tag-along rights are contractual obligations used to protect minority shareholders. If a majority shareholder sells his or her stake, then the minority shareholder has the right to join the transaction and sell his or her minority stake in the company. The majority holder is obliged to include the holdings of the minority in sale transactions.
In order to protect the minority investors, the establishment of a trustee would be deemed proper. The trustee has to be both sophisticated in financial and investment matters, as well as possess the requisite knowledge necessary to be able to review and analyze all situations that might confront the investors. Through trustees, the investors in crowdfunded companies would have adequate representation and periodic due diligence performed on their behalf with respect to important investment decisions.
John Hoffmire is director of the Impact Bond Fund at Saïd Business School at Oxford University and directs the Center on Business and Poverty at the Wisconsin School of Business at UW-Madison. He runs Progress Through Business, a nonprofit group promoting economic development.
Junior de O’Tobo, Hoffmire’s colleague at Progress Through Business, did the research for this article.
Read more about top crowd funding sites: Act Now