Crowdfunding and the consumer protection conundrum

For today's post, I am reproducing the prepared remarks I gave yesterday in Georgetown, Seattle, at a hearing of a Washington State legislative committee considering "Access to Capital for Washington Start-Ups." My given topic was crowdfunding. Check out the crowdfuding bill introduced by Representative Cyrus Habib, that Joe Wallin has played such a key role in.


Prepared remarks of William Carleton
Member, McNaul Ebel Nawrot & Helgren PLLC
for the
Washington State House Committee on Technology & Economic Development
Georgetown, Seattle
July 19, 2013

Chair Morris, Vice-Chair Habib, other members of the Committee: Thank you for inviting me to speak.

My name is William Carleton and I practice at the law firm of McNaul Ebel Nawrot & Helgren in Seattle.

For 22 years I have worked with startups and emerging companies in Washington. It’s hard to say just what stage of the private financing cycle is the most critical, but the seed financing stage is certainly not the easiest. By “seed” I mean that initial round of outside capital, these days anywhere from $200,000 to $1 million, usually supplied by angel investors. that a small new company typically needs to launch and support a product or service and to hire talent.

When these companies get seed funding it is yet anyone’s guess whether or not they will be successful in the marketplace. It is the riskiest investment space that there is. Most fail to generate returns for investors. Even when a company manages to stay alive and in the game and succeed on a second, third or fourth pivot, by that time it is not uncommon for the earliest investors to have been substantially diluted. Sometimes, the last money invested in a company takes a disproportionate amount of the investment reward. For these and other reasons, many experienced angel investors I know think average citizens should steer clear of investing in startups.

But to emphasize the riskiness of startup investing, and that alone, is to miss a larger point about freedom and liberty and self-determination. Startups are part of how our nation reinvigorates itself. Along with the arts and other fields of human striving, it's how individuals push themselves and learn new things about leadership, connecting with community, and developing new skills. People who found startups never to go back to 9 to 5 jobs. If their startup is bought out by Microsoft or Google, sure, they may "do time" for a couple years at the big company, but they are eager to get back out into the field to do another startup. To paraphrase Yoda from Star Wars, once you join the startup side of the innovation economy, forever will it control your destiny.

And if you put even a modest amount of your personal capital to back an entrepreneurial neighbor you know, a niece you want to support, a colleague whose dreams you want to play a part in, or a company you are a part of, it can change the way you see yourself and your role in your community.

Right now the law says only the affluent can be owners. We tell average citizens, in effect, you have no power or efficacy to participate in startups, in the wellspring of the state’s economy, in the business lives and dreams of your friends, family and neighbors. Pack up your money and send it 3,000 miles across the country to Wall Street. You know your money will be safe in the hands of Wall Street. (That last remark was meant to be sarcastic.)

That’s not right and it underestimates the citizens of Washington State. We know aerospace and communications and productivity software and cloud computing because we live in the epicenter of all of it. While most Americans think technology is cool, Washingtonians further appreciate it’s hard work, because we see family, friend and neighbors working in technology, or are involved in it ourselves.

I applaud Representative Habib and Represenative Morris for the crowdfunding bill introduced last session in the Washington legislature.

But I do have a critique and a caution. The experiment, if braved at all, should be given a fair chance. Investment crowdfunding so far, once it gets written out in a bill or a regulation, tends to get weighted down with legal liabilities, conditions, reporting obligations - the kind of restrictions that are not imposed when deals are restricted to angels. The challenge is not how to protect investors. If we’re honest, we already know investors are likely to lose all their money anyway, and not because of fraud, but because of competition, or failure to execute, or a thousand factors not foreseen when the startup starts spending captial. The challenge with crowdfunding is how to not prematurely burden entrepreneurs with reporting, accounting, privacy and record retention obligations that make sense only if the company has revenues. If entrepreneurs have to spend $50,000 in legal fees to comply with crowdfunding regulations in order to raise $200,000, they will skip it, they will stick with accredited investors, angels only.

Investor protection in crowdfunding should consist of two things and two things only: (a) mandatory disclaimers that an investor is likely to lose all of her or his money; and (b) a strict limit in how much the investor can put at risk.

What's the right limit for investors? I don't know, but I would encourage you to ask, what is an amount that it should be okay for citizens to spend on lottery tickets, on charity, on raffle tickets at a fair, gambling at a casino? What is an amount we are okay with letting people lose, if they want to? $2,000? $500? A dollar?

I have circulated copies of investment crowdfunding regulations and bills pending in other states and would be happy to answer questions about them and how they compare.

These remarks are personal and do not reflect the views of my law firm or organizations I represent in private practice.

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